Short Selling

I was curious to learn more about short selling after reading Wall Street’s Naked Swindle (strong language warning), a pretty intense piece on the fall of Bear Sterns, the role of government (FED, SEC) and practice of naked short-selling.
In particular, the author blames naked short-selling for the “murder” of Bear Sterns, and government for both playing a part it in (Bernanke’s confidential meeting with major banks except Bear a few days before the fall, Paulson forcing Bear’s aquisition by JP Morgan) and not policing the market enough (SEC not going after short-sellers which defraud buyers by “failing to deliver”, SEC not investigating the hitmen traders).

To me, it seems that Bear Sterns was in a mess, some people knew how much mess, and they benefited from the inevitable fall (insider trading). On the other hand, Bernanke’s and Paulson’s role seems murky at best.
I didn’t quite understand one of the points of the article, that naked short-selling allows cheating by casting more shareholder votes than there are shares. That seems really broken and preventable with a proper design.

Finally, the article made me wonder about competition between markets. Why would there not be competitors to the Wall Street exchange? Is there some government-induced monopoly? Otherwise, it seems that different exchanges would compete on setting better frameworks for both buyers and sellers, and enforcing those rules.

 

Bob Murphy has a good introduction to short selling, and naked short-selling. In particular, he brings up a good argument to explain that markets are naturally resistant to manipulation, and short selling does not allow more manipulation than regular trading.
In general, speculators help the market, by smoothing prices and adjusting the price signals to the latest information and future expectations.

There is a good debate in the comments on whether naked short-selling constitutes fraud (bad or broken contract) or simply incompetence (which would lead to bankruptcy of the mis-calculating brokers). That’s not obvious and actually depends on what the contracts and IOU state exactly (what are the expectations of each parties?). Either way, the problem should be solvable by proper contracts, enforcement, system design (a share is held by a single person at any given time) and competition.

Art Carden also has a good overview of short selling and the function of financial markets in this recording from Mises University 2009.
Short Selling: Explanation and Defense (mp3)

Recorded 1 August 2009 at the Ludwig von Mises Institute; Auburn, Alabama. [49:00]

Play Art Carden

A few notes from Carden’s lecture:
“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” – F.A. Hayek

“Just because some cannot be trusted with liberty doesn’t mean that some should be trusted with power.” – (sounded like Sheldon Richmond?)

I’ll need to dig some references (found one so far) around Carden’s remark that the stock portfolio of Congress representatives vastly outperforms the market.
He makes another interesting claim (without going into a detailled argumentation) that today’s opaque financial instruments are side-effects of previous attempts at regulating markets.

Carden re-iterates two general points: the knowledge problem (how do you know? how would the government know better?) and the nirvana fallacy (something may be imperfect and yet remain the best available realistic solution).

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