December 17, 2008

Assessing the Shorting Ban

Short sellers are often targets in a down market, but without them, argues Charles Jones, prices are off the mark.

Short sellers are mostly a force for good. Research has shown that short sellers ferret out overvalued companies and can keep stock prices from getting too high. In 2001, for example, short sellers uncovered the Enron fraud. If there had been more short sellers in 1999, firms like wouldn’t have had outrageously high share prices and couldn’t have wasted huge amounts of shareholder money buying Super Bowl ads featuring sock puppets.

However, in down markets like the one we are currently experiencing, it is hard to convince the investing public that this watchdog role for short sellers is still important. In fact, short sellers are always blamed when prices fall, and they have been blamed for the recent stock market decline. Never mind that it was becoming clear that the economy was slowing markedly, or that financial institutions like Citigroup, Bear Stearns, and Merrill Lynch were up to their eyeballs in subprime mortgages, leveraged loans, credit default swaps, and other troubled investments. Short sellers should have received accolades for seeing this ahead of others.

Instead, regulators yielded to politicians’ impulse to find a scapegoat. Shooting the short-selling messenger was a bit out of character for a Republican administration ostensibly committed to free markets. So it was decided to tranquilize the messenger for a few weeks instead. On the evening of Thursday, September 18, 2008, three days after Lehman Brothers filed for bankruptcy, the U.S. Securities and Exchange Commission (SEC) adopted a surprise emergency order that banned most short sales in nearly 1,000 financial stocks. Under U.S. law, these emergency orders can last at most 30 days, and the shorting ban was kept in place until October 8, a few days after President Bush signed the $700 billion bailout package into law.

What happened to stock prices during the ban? I’ve done some preliminary work with Ekkehart Boehmer of Texas A&M and Xiaoyan Zhang of Cornell. We find that there is an artificial bump in the share price at the start of the shorting ban, and this bump is basically reversed by the time the ban ends. For example, on Friday, September 19 (the first day of the ban and also the first day the market could react to the announcement of the ban), stocks subject to the ban rose by 10.90, while the rest of the market only rose by 4.46. Figure 1 shows the cumulative stock price performance for 146 NYSE common stocks that were on the SEC’s original shorting ban list versus a set of 1,066 NYSE control stocks that weren’t subject to the shorting ban. During the three weeks of the ban, stock prices cratered, falling by about one-third. Financials fell even more, completely reversing their initial gains.

Even more troubling was the ban’s effect on market liquidity. Stocks subject to the ban suffered a severe degradation in liquidity, as measured by bid-ask spreads. We looked at effective spreads, which are a standard measure of market quality. Effective spreads are defined here as the distance in percentage terms between the reported trade price and the midpoint between the bid price and the ask price prevailing at the time of the trade. Wider effective spreads mean less liquidity. Figure 2 shows the effective spreads on the two groups of stocks before, during and after the ban. While the shorting ban is in effect, these market-quality measures diverge wildly. Effective spreads average 92 basis points for stocks on the initial ban list versus 45 basis points for the control stocks. Compared to an average effective spread of 25 basis points preban, this represents an almost fourfold increase in effective spreads on stocks subject to the ban. We think that the shorting ban forced many informal liquidity suppliers out of the market, making it very expensive for others to trade financial stocks during the shorting ban.

Virtually every piece of empirical evidence in every journal article ever published in finance concludes that without short sellers prices are wrong. The evidence from the 2008 shorting ban is consistent — exactly — with previous research. So what was the SEC thinking? One possible answer is that it was not.

But it’s more likely the SEC was thinking that maybe, just maybe, the world had changed. Perhaps we were back to the early 1900’s when professional operators regularly drove stocks up or down, earning profits by manipulating prices. In principle, manipulative shorting could be a disaster for financial stocks. If a short seller can somehow get a bank run started, the share price goes to zero (or close to it), and the short seller makes a huge profit. A century ago, bank managers and owners were well acquainted with this possibility, and it was not an accident that most banks were privately held at that time.

In 2008, the SEC might have been trying to avert just such a run on the largest investment banks. Lehman Brothers filed for bankruptcy on Monday, September 15. Over the next three days, other investment banks were hit hard, and there were rumors that some hedge funds had pulled their assets from Morgan Stanley and Goldman Sachs. Without a shorting ban, would those two firms have collapsed? I doubt it, but we’ll never know for sure. We do know that Washington Mutual (WaMu) and Wachovia went under during the shorting ban, collapsing under the weight of bad loans. These examples suggest that bad business decisions by banks, not nefarious short sellers, are the real cause of the current crisis.

As I write in mid-December 2008, the temporary shorting ban is now past, but the stresses on the financial system do not seem to have abated much. Overall, the ban was a bit like drinking a Coke on a long-empty stomach. It might have stopped the growling for a little while, but it made the patient more jittery, the crash at the end of the sugar high was fairly unpleasant and the systemic pain returned in full force. Here’s hoping there’s no next time anytime soon. But if there is, we need to reach for something much more nutritious than the quick sugar fix of a short-sale ban.

Charles M. Jones is professor finance and economics and Chair of the Finance and Economics Division at Columbia Business School.

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