Everyone has heard everyone else say that politicians are liars. As readers of mine, you know that, save a very few, I agree with that statement. Regardless, I do my best to stay emotionally detached to their disregard for truth and honesty. I could have picketed or rioted at the RNC (I live in Minneapolis), but I’ve decided to take a different approach in dealing with my angst towards the political process, such as:

When November comes, I’ll write in my vote for Ron Paul. As this crisis pans out, I’ll make as much money as I can by staying one step ahead of the masses (Let’s hope the government doesn’t ban that). Finally, the most important thing I do to “not let the man get me down,” is exactly this: writing to you.

Let’s briefly digress. When referring to politicians, I prefer to use the word sociopath over liar when describing them. We’re splitting hairs here, but the former better encompasses the lack of moral responsibility and social conscience that truly describes the Nancy Pelosis and Hank Paulsons of the world. Please understand that I have no intention to sit here and bash our political leaders for this whole article. I simply feel this foundation is necessary in really understanding curtain motives.

I use the term sociopath because these politicians FEED on the public’s lack of education and knowledge on relevant issues in order to pursue curtain agendas. Politicians use this sociopathic behavior in order to create fear and anger that will allow them to do a number of things including, but not limited to: dismissing blame on the opposing parties (political and otherwise), pursuing policy desired by special interests, and attempting reelection.

I will be writing the rest of this article on the sociopathic issue of blame dismissal. More specifically, I will be discussing the recent ATTACKS and BANS on SHORT SELLERS.

The Solution to Sociopathic Politicians: Knowledge

Our political leaders have been extremely successful in completely dismissing the real causation of the credit crisis. They have done so, large in part by using the media to make the short seller the bad guy. Am I wrong? Even the words short seller or speculator brings up negative cognations. I have had discussions with people who have no idea what a credit derivative is or how to short a stock for that matter, who blamed the demise of Fannie, Freddie, Lehman, and AIG completely on short sellers. That has been the exact goal of these sociopaths, and they have been extremely successful in doing so.

I will do my part to counteract their doing. The best way to do so is to simply educate the masses of the truths surrounding short sellers. I’m not going to sit here and say all forms of stock shorts are proper, but I will bring my experience in the exchange pits and otherwise to help understand the benefits and consequences of short sales.

The SIMPLE Truths of Short Sellers

I’ve discussed in prior articles the moral hazard in removing an essential part of the free market. We’ve looked at the macro issues, but let’s look a little deeper into the actual role of the short seller.

The very first myth we need to quickly dispel is that short sellers are pushing these financial stocks below real market value. Considering that the every investment bank (or former investment banks) and many of the commercial banks have negative asset value. I wrote about this in my most recent Bourbon & Bayonets article, but it’s worth noting again. Simply put, this means that if the banks were to sell all of their assets on the open market, they would not have enough cash on hand to cover their liabilities. Unless short sellers can push a stock to negative levels, they cannot undervalue these companies.

Moving on, there are many self proclaimed short sellers. These are simply traders or fund managers who simply work backwards. They sell the asset first and then buy it back later. That is obviously the premise behind a short sale.

These individuals/funds are ESSENTIAL in the market place. We need to look at how a short seller works in order to understand this. The idea of a short sale is to sell the stock as close to its peak as possible and buy it back at, or near its bottom. This provides SUPPORT at market bottoms.

That support couldn’t be more necessary than it is in today’s financial climate. I’m sure you’ve noticed, but today’s market bottoms have been accompanied by mass fear and near panic. If the short sellers didn’t have to buy back stocks at these points, we could be facing situations where the market goes “no bid” when it needs the buying the most.

Then there are the infamous hedge funds. They tend to be the most synonymous when it comes to short selling. I will agree that as liquidity has been drying up, hedge funds have been violently selling short any and all equities that aren’t in their portfolios. This sort of short selling should be regulated, and I will get more into that when I discuss more of the aspects of short selling that shouldn’t be allowed.

What hedge funds also do is hedge their long positions with short positions. This is simply a way to reduce risk. If they can’t short equities, than they have to drastically reduce their long positions. This is obviously bearish as hedge funds have been unloading their longs in large chunks as a result of the ban on shorts.

The last issue that I will discuss in relation to the ban on short sales is a few specific, undesired consequences of this ban. There are many examples of this, but I would just like to share a few with you in order to show the sort of imbalances this creates.

Convertible bonds are simply bonds that can be converted into the underlying security. We also must remember that the locals (pit traders) and other career traders are the reason many of these markets are liquid at all. Convertible bond traders short the underlying securities of their bonds in order to hedge their risk. The direct result of the short sale ban has been a massive decline of convertible bonds demand/liquidity as many of the traders are simply not trading them because if their inability to hedge their positions.

The stock options traders are also greatly affected. Just like the convertible bonds and the hedge funds, stock options will hedge their long calls or short puts with stock shorts. Understand that a lot of career options traders like to trade what’s called gamma neutral, especially during times of volatility.

Gamma neutral simply means they have a very limited amount of risk. An example of this would be going long a call option and short a futures contract (both of the same underlying security). These are the same individuals who are called speculators, but you have to understand that the locals risk their own money. The OVERWHELMING MAJORITY of these traders have systems in place to take on as LITTLE RISK as possible. They aren’t the guns slingers who make and lose fortunes everyday as portrayed by the sociopaths via the media. The locals who do take on massive risk usually don’t last long.

When we break it down and look at the details of the marketplace, it’s easy to see how a ban on short sales can cause all sorts of disruptions and imbalances that aren’t meant to be handled by the free markets. Please understand the above material and the next time someone points a finger at the speculator, you can right their misunderstandings.

Short Sellers Without Pants

Just as massive longs over exaggerated the rise of curtain equities markets, there are certain types of short sales that I feel need to be reduced and more transparent.

I’m referring to naked shorts. The problem with naked shorts is more of a problem with brokerage clearing houses. In fact, I imagine that many short sellers aren’t even aware that their shorts are naked.

We need to first discuss what a naked short sale is. It is simply a short sale where the broker doesn’t locate the shares before they are sold. The reason for this is as simple as the brokerage house not wanting to lose its client. If I called and wanted to short a security that is “hard to borrow,” the broker definitely doesn’t want to say he can’t secure it, because I might get mad and threaten to switch to a broker that can secure the shares. So, the broker will simply take the trade and either attempt to locate the shares at a later time, or not locate them at all.

The most extreme example of this comes from the quant funds. These are massive piles of money that are run by eccentric mathematical modeling. These funds trade millions of shares a minute and the clearing house often can’t keep up the shorts. Obviously the brokerage fees on these funds are enormous and the brokerage house will do everything in their power to keep these clients on board. This often results in massive naked shorts simply do to the volume of the trades.

Transparency –vs- Regulation

The types of naked shorts that I discussed above need to be more transparent. Transparency will bring about a better understanding as to the size and speed of capital transitions in and out of these shorts. This will allow us to set some proper policy that will benefit the markets by reducing volatility, all the while keeping free markets just that…free.

Regulations otherwise set to manipulate shorts of all nature are not the solution, and in fact do just the opposite. They cause more imbalances and limit essential parts of the market place from doing their job.

Please understand that the speculator isn’t the enemy. It is the goal of the political sociopaths to brew this fear and anger that we now see on a daily basis. That fear and anger has one purpose; to divert our attention from the real issues: monetary inflation, excessive leverage, mispricing of risk, mal leadership, a bailout that will cost trillions before it’s all said and done, an economy trending towards socialism, a nation that’s closer to bankruptcy than anyone realizes, etc…

I could go on and on regarding the problems we face, but plain and simple, overregulation is not the answer. It definitely didn’t work for Pakistan’s Karachi Stock Exchange, and it definitely won’t work here in the United States.

Nicholas Jones
Analyst, Oxbury Research