Efficient Markets and the Economic Meltdown
I found myself this week addressing the chairman of the SEC and three other commissioners at a forum on short sales, and the discussion illustrated how much the attitudes of some lag behind the realities of our current crisis. After the repeated meltdowns of numerous markets over the past year, the open minds at the forum belonged to the members of the SEC and not the other economists on the panel, who repeatedly cited now-outdated research to bolster their disdain for regulation and faith in the optimal outcomes of markets.
Plenty of people believe in “free markets,†but markets are never free, because without elaborate rules and regulations, they regularly run amok. Truly unregulated markets have no place for fiscal stimulus in deep recessions or even for central banks which regulate the supply of credit. Yet, without them, our business cycles could consist mainly of long recessions and runaway inflations. Thankfully, all but the economic version of wingnuts accept that over time, we learn many useful things about how economies behave and can craft rules that reduce the incidence of developments which can needlessly impoverish a society and increase the likelihood of other developments that enrich us.
Yet, in the face of the evidence all around us that, just to start, our many multi-trillion dollar markets for housing, mortgage-backed securities, and credit default swaps all had become profoundly dysfunctional, an esteemed professor from Columbia University, another from Ohio State, and a Nasdaq senior economist all insisted that regulation would interfere with our best of all possible worlds. This adamant refrain seems to be heard most often from those who study and participate in financial markets. While in our current condition, it seems to bespeak serious cognitive dissonance or a touch of economic insanity, it may come down to the simple fact that in recent years, those markets have been the special province of America’s richest people and companies. Regulation which could constrain their freedom to get even richer seems to be an offence against economic nature.
The particular context for this week’s SEC forum involved short sales, which some blame for turning blue-chip firms like Bear Stearns, Lehman Brothers and Merrill Lynch into penny stocks. They’re partly right and partly wrong: Short sellers weren’t responsible for the collapse of those firms and others, but certain abuses of shorts sales accelerated the process, with very damaging results for all of us.
First, a brief primer in how short sales work. Short sales are stock trades in which an investor bets that a stock will go down. He places that wager by borrowing a company’s shares from another investor (for a fee) and then selling them. If the stock declines, he can purchase new shares in the market to replace those he borrowed and pocket the difference between the lower price and what he sold them for originally. Short sales are a good thing for a market, because they signal that some investors have negative information or intuitions about the outlook for a company, a sector or the overall economy. The result is that a stock’s price can reflect all of the information available to the market.
But some short sellers don’t play by the rules and distort those prices. The biggest abuse is what’s called “naked short sales,†where an investor sells the shares, receives payment, but fails to borrow and deliver the shares. The system has a way of papering over the problem: The organization that clears and settles most trades in U.S. markets, the Depository Trust and Clearing Corporation, “borrows†the shares from its depository of all shares, settles the trade, returns those shares, and waits for the short seller to borrow them himself. Naked short sales contribute nothing to the market, since the value of the negative information depends on the short seller putting up the ante for his bet by actually borrowing and delivering the shares. Otherwise, short sellers can flood the market with so many “sales†that it drives down a stock’s price.
That’s part of what happened with Bear Stearns and Lehman Brothers. As they began to sink, their short sales went up four-fold — and their naked short sales increased 150 times. By the time of their collapse, each had tens of millions of naked shorts out against them. Those firms would have failed without naked shorts, but the flood of those abusive trades helped drive their sudden, chaotic, and unmanaged collapse. Imagine how much better off the economy might be today, if smart regulation had prevented the avalanche of naked shorts and the last administration had managed the demise of Bear Stearns and Lehman Brothers in much the same way that the current administration is managing the final days of Chrysler.
By the way, naked shorts aren’t just a problem of a few firms during a crisis. SEC data show that on any given day in 2007 or 2008, large scale naked shorts afflicted between 1,200 and 3,500 companies, across every sector and on all exchanges. And the number of outstanding “failures to deliver†— that’s the shares sold nakedly short — on any given day totaled between 500 million and 1 billion shares.
There’s a simple solution which other countries use: Require that short sellers borrow the shares before they sell them. At the SEC forum, some such answer seemed to hold some appeal to the new chair of the SEC, Mary Schapiro, and some of her colleagues. But suggest it as a way to protect average shareholders who unwittingly pay for stock that isn’t delivered until the price has already fallen, and to safeguard the rest of us from markets running amok, and the wailing about the optimal outcomes of unregulated markets can overwhelm you. This time, hopefully, it won’t deafen the SEC, the President and his economic advisors.