Friday, September 19, 2008

SEC tries to bankrupt Wall Street

We are in the mode of dumb panic policymaking.

I wake up (jet lagged) and read that the SEC is considering a temporary ban on short-selling.

Ok - just because this is quick-off-the-mark and the SEC hasn't thought it through I thought I might do a little thinking for our pals in Washington.

Last I looked when I was short a stock the broker borrowed the stock (yes, Virgina you do get a borrow) and sold it. They then had cash.

That cash was not available to me - it was pledged to whoever provided the stock to remove or reduce the risk that the stock won't be returned.

That means it is generally available to the broker (who will generally lend me the stock from their inventory or margin or prime broker clients).

Now there are a few hundred billion of short-sales out there. Probably more than normal - but a lot in almost all markets.

And those short sales produce cash balances of a few hundred billion, most of which are available to Wall Street brokers.

If you ban short-selling those balances will taken away from Wall Street brokers.

That would be rather unpleasant. Last I looked the debt market was skittish and was hardly going to replace that money.

So I conclude that the SEC in their "infinite wisdom" are going to stick the knife into Wall Street and bankrupt the lot of them. For political optics. So they can be seen to be doing something about short-selling.

Its one thing to blame short-sellers for political effect. It is another thing altogether to risk the collapse of the financial system on some dumb-ass policy put up in a panic by incompetent bureaucrats.

Sometimes I worry about America.

John Hempton

PS.  I am aware of the limitations on the availability of this cash to brokers.  That limitation however differs by such things as the jurisdiction of the client and the arrangements between client and broker.  

I am also aware that the SEC does not wish to force short sellers to buy back existing positions - rather just stop putting new positions on.  However the effect will not be dissimilar.  

If someone can quantify the end effect on broker liquidity I would love to see the model.

But in summary: this is a darn big move with huge financial implications being discussed by the SEC in a panic after meeting with a few congressional officials just before an election.  And on the face of it, it will exacerbate the financial crisis.

That is not how policy should be made.


Anonymous said...

Short sale is like freedom of speech in financial world.
The whole things reminds me of the index futures/options bashing (index arbs in particular) in Japan in early '90s, when we Japanese should/could have located and tackled the problems.
But in the case of Japan we utterly failed, time wasted, and got the "lost decade" instead.

MattJ said...

Is it really the case that the broker gets the profit from lending stock to shorts, when the stock is owned by the brokers' client?

Anonymous said...

It's State intervention which terrifies me. Firms collapsing, market problems - bad news, very bad news, but quantifiable and not things which change the rules of the game. State intervention? arbitrary, changes the rules of the game, can be entirely unpredictable and irrational, pays no attention to reality and has no awareness of the true consequences of its actions.

State intervention is the catastrophic meteor strike of finance and economics. Comes out of nowhere and can kill everything off in an instant.

Things are bad right now, but life goes on. If the State start meddling and do the wrong things, they can *really* destroy things.

That's my nightmare - not the market falling over - but the State meddling.

Anonymous said...

Why can't SEC ban all selling? Just buy and hold. (yet don't ever forget to buy before holding.) This is the way to prosperity!

John Hempton said...

Mattj asked:

Is it really the case that the broker gets the profit from lending stock to shorts, when the stock is owned by the brokers' client?

Well it depends a little on contractual terms and jurisdiction. But I have just had a discussion with Goldman Sachs Hong Kong Prime Brokerage business.

The way it worked was that if I shorted $100 of shares then the $100 went into an account for the benefit of the person who lent me the shares.

I would also have to pledge some stock (say my long positions) to Goldies - and they would have the right to repledge those longs. They would be commingled in Goldies Balance sheet.

However these stock could of course be given to another short-seller who could short-sell them and Goldies would receive cash funding.

And the stock I shorted might be pledged to Goldies elsewhere as part of client security.


There are however limits to the extent that a broker can commingle its funding with client accounts. Those differences vary by jurisdiction - at the extreme being firms like Opes Prime in Autralia which commingled everything. That extreme though is not unusual.


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