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information there really is nothing illegal about it is a phrase often heard in descriptions of the practice of Short
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Selling or shorting perhaps that's because many casual stock market observers know only one thing about the
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practice it's a bet that a particular stock will soon decline in value to bet
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in favor of someone else's bad fortune carries a nefarious ring for many people
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but there really is nothing illegal about short selling at least not in the United States that phrase has been
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repeated frequently in the days since the Securities and Exchange Commission announced that it would impose at least
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temporary restrictions on certain methods of shorting the stock of 19 key financial institutions including the
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government sponsored mortgage firms Fanny May and Freddy Mack those rules were introduced after short sellers were
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said to have helped drive down the sh of several major financial institutions knowledge at Wharton asked Wharton
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Finance professors Marshall Bloom and Franklin Allen to talk about these issues could you describe for us the
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mechanics of Short Selling Short Selling is a a very simple uh procedure uh normally when you buy a stock let's say
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you buy it at $50 you uh make money if the stock goes up and you lose money if the stock goes
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down so if the stock goes from 50 to 60 you make $10 if it goes from 50 to4 you lose $10 well short sale reverses that
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so if the stock goes from 50 to 60 you lose $10 and vice versa if it goes down you
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make money now how does this work well it's not really a very complicated uh
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process uh let's say this $50 stock I think it's going to go down to 40 what I
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do is I borrow the stock from somebody and then I sell it when I sell it I have $50 in the bank the stock then uh Falls
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to 40 I buy it back at $40 give the stock back to the uh person uh from whom I borrowed it and that person still has
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one share but I have $10 ahead 50 uh less than 40 now it's important to realize that there's many other ways to
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make money when stocks go down uh you can buy uh uh puts uh I could buy a put at
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$50 and a put at $50 allows me to put the stock uh to the uh writer of the put at any time within say 3 to 6 months or
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longer depending upon the put if the price goes down now to 40 I buy it at 40 and I put the stock to the uh writer of
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the put and make $10 he'll give me 50 and I but just paid 40 now there are other ways too for
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instance I could do what's called a swap a swap is basically I swap my one return
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for another return so what I do is I say to a broker when uh I want to enter into
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a swap contract uh and if the price of the stock goes down they'll pay me uh
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the amount that it goes down if the price goes up they'll pay me the uh um I
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have to pay them now of course I've got to give them something for this and it's
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usually a short-term interest rate plus a premium uh and there are many other ways to short stocks so um we I think we
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lose focus when we say that we only can short stock by borrowing shares the's
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new rules focus on the first of those the borrowing of shares specifically it prohibits what are known as naked shorts
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on the shares of those 19 firms can you tell us a little bit about naked shorts a naked short
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sort of pejorative term uh a naked short uh means that I sell a stock and I don't
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borrow it first uh now if I do it within a day there's no real problem because I uh
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short the stock and then I buy it back and there's a netting so I never have to
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deliver the stock what the SEC rules uh said is even if I want to short it for a
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day I've got to borrow the stock first and then uh uh sell it and then buy it back uh now when you have liquid
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stocks that's not really a major uh concern it's easy to borrow liquid stocks
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um uh very easy to borrow um when a stock is in short supply then it's hard but here is just going to increase your
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transaction cost a little bit to go short as in any Market bet there are upside and downsides for short sellers
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but are there not also upsides and downsides for the companies that are the subject of their bets I think that's a
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question of manipulation underlying all these concerns that people have about short sellers so particularly for small
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companies they can have a big problem if people simply go out and and short sell
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their shares and drive the the price down and that's an example of trade M manipulation where people wonder is
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there some information that these people have and so that can cause problems for
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the for the company particularly if they're not doing very well anyway among
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the bigger companies the the real problem is what's known as information-based
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manipulation which is where you circulate rumors about something negative about the company and hopefully
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Drive its if in terms of making money hopefully Drive its price down and then close out the short now that's illegal
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but it's very difficult for the SEC to to prosecute those kinds of cases and I
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think that's that's the thing that the the SEC is currently most concerned
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about that was why it was made difficult back in the 30s when the SEC was founded
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because there was some evidence then of that kind of information-based manipulation Franklin what would you say
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to the following um a u person has a negative view on the stock they uh sell the uh
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stock short and they then call up their friends and say I had a negative view on
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this stock I sold it short and then they the other people then sell short helping
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to drive the price down is that market manipulation so some people would call that a be raid and in that case it would
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be illegal if they did it with the intention of driving the price down so I think one has to be very careful as to
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how exactly one does this but you're quite right Marshall there are there are
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many cases where if you have a negative View and you talk with your friends then
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then that's you know quite legal to do that and I think there's a very fine
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line between those so I think it it it is very difficult to to draw these lines as to what's legal and what's illegal
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and it's very difficult for the SEC to prosecute any clearly illegal actions
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some people have said that the downfall of Bear Sterns and the swoons of Freddy Mack and Fanny May have been
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attributable at least in part to the activ activities of short sellers what do you think about that theory well I
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think certainly there are some views that uh these P these companies were overpriced correctly so and they drove
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the price down more rapidly than they would have otherwise but they drove it not to a price which was inappropriate
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what are the stakes for the broader markets in which these bets are placed so I think in general that the way to
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the academic evidence is that it has a good effect because it helps price discover and helps information get into
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prices much more quickly than in is the case in countries where for example it's
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illegal to short stock so I think it's a by and large a very good thing in the
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case of these financial crisis it's a little bit more delicate I think because
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there is an issue if there is manipulation which as say it's illegal but it's very difficult to Pro prosecute
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but if people can successfully circulate rumors which are which are patently untrue they have the
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potential to make a lot of money from doing that little chance of being court and going to jail but they could
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seriously disrupt the financial system so this the classic example at the moment is Leman for example so the
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chairman of lhan thinks that there are people out there trying to do that and he's very concerned about that and it
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may well be that that they have serious problems and Lan could for example be forced to uh be sold and some people
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believe that that's what happened with bare Sterns that really this was just a
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form of manipulation and of course the SEC is looking into that so I think they do have to be careful and they do have
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to check these this potential breaking of the law uh but it's a delicate issue
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more delicate than in general I would say what benefits might ACR from the new regulations I think it won't have much
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effect in terms of stopping shorts it it'll raise the transactions costs a little bit as Marshall was indicating
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earlier but I think this is part of a wider campaign that the SEC is involved in which is to send a signal to the
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markets that they're concerned about short selling and I think this is one way of them them doing that so whether
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or not it affects directly apart from the slight increase in short sale I think it's it's more
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that they want they want to signal to the market that they're worried about this I I think that they will
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aggressively pursue some of the hedge funds if they find any emails which suggest that there were false rers being
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circulated and this is all part of of that campaign do you see any unintended consequences I I don't see any uh
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unintended consequence of this elimination of uh naked uh uh shorts for a particular group of stocks it's a a
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minor change in the rules I would agree with that yes for more information please visit
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