July 24, 2008
Since the restrictions on naked short selling went into effect on July 14th Lehman is up 70%, Citigroup is up 40%, Freddie Mac is up 53%, Merrill Lynch is up 30%, Fannie Mae is up 63% etc. This level of positive stock performance, despite the relatively negative news from the sector, clearly suggests that restrictions on naked short selling created a positive updraft for financial stocks.
Naked short selling is an abuse. Most importantly, it is reduces the cost of capital to sophisticated investors (hedge funds). If you sell short and do not have to pay interest on the borrow, your cost of capital for a short sale is effectively 0%. The cost of capital to go long a stock is your borrowing cost - lets say 5% to 7% for sophisticated investors. Thus, the disparity between the long and short cost of capital inserts a distinctly negative bias into the market. It can be far more profitable to naked short than to buy long.
Sophisticated investors with a 0% cost of capital for short sales will spend a disproportional amount of time searching for negative stories in the marketplace and in many cases try to create or enhance a negative thesis with rumors and/or paid for research (with the intent to destroy as much value as possible in the target company). Once shorts pile on, and with no cost to do so they can theoretically sell as many shares as it takes, longer term investors start to flee the stock, enhancing the downward pressure on a security.
Bringing back the uptick rule and enforcing the legal requirements on short selling (there is no reason that a short seller should be able to sell a stock without borrowing it first) would balance the incentives for long and short trades in a positive way and limit the destructive bias inherent in the current lack of enforcement of todays short sale regulations.
Attached, please find a Reuters article on the decline in short selling in the financial firms after the regulations were put in place. Clearly, the regulations reduced short sales in these names, I would suggest due to the increased cost of carrying true short positions (which have a corresponding borrow and cost associated with them) as opposed to (no cost) naked short selling. The sooner the better.
Copyright material redacted. 25 July 2008. Author referenced the following article: Emily Chasan, UPDATE 1-Short sells drop in firms after SEC rule--S3 data, July 22, 2008, http://www.reuters.com/article/marketsNews/idINN2233071920080722?rpc=44.