Short-Sellers: Unfairly Targeted in the Market Crisis?

During the nearly three-week ban on shorting financial shares, the market sank 21.5%. Are regulators after the wrong parties?

As the panicked selling in equities markets around the world has accelerated over the past two weeks, there have been several attempts to slow the process, including the temporary suspension of trading on stock exchanges from Moscow to Milan. In the U.S., the Securities & Exchange Commission banned short-selling—bets that shares of certain companies would fall—on a list of more than 800 financial stocks whose balance sheets have exposure to risky mortgage-backed securities and other distressed products.

When the ban, which lasted 13 trading days, was lifted on Oct. 9, it signaled a return to business as usual for the financial sector. Shares of Morgan Stanley (MS), one of the last-standing investment banks, which recently became a bank holding company subject to tighter government regulation, sold off with a vengeance, finishing almost 26% lower on Oct. 9 and dropping an additional 24% on Oct. 10. Insurance stocks such as Prudential Financial (PRU) and Hartford Financial Services Group (HIG) were also among the biggest losers on Oct. 9.

Whether the ban had the intended effect remains open to debate, given the 21.5% drop in the Standard & Poor's 500-stock index from the market close on Sept. 19, before the ban took effect, through its last day, Oct. 8. And the nearly 33% plunge during the same period in the KBW Bank Index (BKX), which has a much closer correlation with the 800 names traders were prohibited from shorting, is enough to make one think regulators were trying to pin blame for the extended sell-off in financial stocks on the wrong people.

Cover for the SEC?

Some market strategists think the ban was nothing but political cover for the SEC to show it was paying attention. In reality, the regulator has been behind the curve in reining in dubious financial reporting practices by the major financial institutions, which helped create the current crisis. By preventing short-selling for two and a half weeks, the SEC disrupted "a legitimate way for investors to convey information to the market" about the pricing of stocks, says Gerald Buetow, managing director of Portfolio Management Consultants, the investment arm of Envestnet . If anything, the ban on selling short seems to have exacerbated market volatility by depressing trades in the options market and forcing investors who couldn't hedge their long stock positions to take offsetting options to sell their stocks.

The market-makers who provide much of the liquidity in the options market curtailed their selling of options on financial stocks during the ban because they couldn't cover themselves by selling short, says Peter Bottini, executive vice-president for trading at optionsXpress (OXPS) in Chicago. He thought they would jump right back in after the ban ended, but that hasn't occurred. That's probably because the key liquidity providers tend to be the options desks at the larger banks, whose shortage of cash isn't allowing them to play that role right now. That's one driver, he believes, of the unprecedented volatility in the equities market at the end of this week. The Chicago Board Options Exchange Volatility Index (VIX) soared 20%, to a record-high 76.94 on Oct. 10 before sliding back to close just under 70.

For those who are determined to drive down the price of a stock, there are far more effective and less costly ways to do so than by selling short, says Buetow at Portfolio Management Consultants.

"If you're a big player, you'd go into the derivatives market because you can do it with far more anonymity," as well as by being able to use more credit than cash to put on a much larger number of positions, he says.

Averting Government Regulation

Perhaps most toxic among those derivatives are credit default swaps, the contracts that investors buy as insurance against a bank or other financial institution defaulting on the debt the investor has bought. What's quickly become apparent with the cascade of corporate bailouts and bankruptcy filings over the past month is that none of the financial firms selling credit default swaps has adequate capital reserves to cover these insurance policies if the companies whose debt they guaranteed fail. By calling them swaps instead of insurance, the investment banks that created them were able to avert government regulation.

The widening of bid-ask spreads on credit default swaps shows that the market is pricing in a bigger chance of companies' defaulting on their debt, and that's prompting portfolio managers to dump those stocks. "That's what drove the sell-off, not short-sales," says Buetow. "Those spreads [on the CDSs] in hindsight are turning out to be pretty accurate. For the financial institutions, spreads widened as much as they did because people started understanding how weak their balance sheets were and saw a bigger chance of default."

George Feiger, chairman of Contango Capital Advisors, a subsidiary of Zions Bancorp (ZION) in San Francisco, describes the relentless selling over the past two weeks as a spiral of doom, where each effort to get cash forces down asset prices, triggers margin calls for other players, and precipitates further selling. "If this spiral of doom wasn't happening, you wouldn't make any money being a short-seller," says Feiger. Those who blame the short-sellers for the sell-off are "mistaking the symptom for the disease."

OTC Derivatives on the Way Out

To ensure this doesn't recur in the future, more transparency needs to be introduced to credit default swaps and other over-the-counter derivatives products that have been free to operate without regulatory oversight, market strategists say. The Federal Reserve is working with CME Group (CME), the owner of the Chicago Mercantile Exchange, and others to create an electronic trading platform for credit default swaps, which would provide pricing information and eliminate counterparty risk by taking on that role. "Over-the-counter derivatives markets are essentially finished," says Feiger. "Who can trust anybody else?...Exchange-traded derivatives have the exchange as the counterparty, and the exchange has every incentive to mark to market immediately and to collect margin [collateral] immediately."

The real lesson of the financial crisis is that there has never been an effective mechanism for settling derivatives trades in bulk, he adds.

He believes the Federal Reserve and its partners will be able to get exchange-traded credit default swaps up and running within the next few weeks, since the International Swaps & Derivatives Association (ISDA) standardized CDS contracts last year. The creation of an exchange won't make the unwinding of all the existing swaps contracts any less painful, however, he adds.

The auction on Oct. 10 of more than $400 billion worth of Lehman Brothers' credit default swaps has revealed a little of how the market will value these products. The Lehman swaps ended up being pricing at 8.625 cents on the dollar, below the initial estimate of 9.75 cents on the dollar earlier that morning and well below the 12 to 13 cents originally expected. "Conversely, payout of the insurance on those contracts will be 91.375% by AIG, JPMorgan (JPM), Goldman Sachs (GS), Wachovia (WB), and RBS (RBS), among others," Action Economics said. If some of those institutions aren't able to come up with the cash required to settle those contracts this weekend, it could trigger a fresh wave of liquidation sales, much like Lehman's bankruptcy did.

Michael Wallace, global market strategist at Action Economics, sees the auction as the ultimate mark-to-market mechanism, revealing what buyers are truly willing to pay for these products. "It's discomfiting to see what these assets are returning, but the silver lining is we're seeing what these assets are returning," he says. "It's part of the cleanup, the transparency, you need to start to establish some normalcy again."

Jim Dunigan, chief investment officer at PNC Wealth Management (PNC) in Philadelphia, says he's not sure greater transparency around the pricing of derivatives contracts will reduce short-selling, but it would bring some structure and boundaries to the derivatives market.