Think Short-Selling Rules Don't Matter?

For those who don’t think that the suspension of the uptick rule or unfettered naked short-selling are to blame for the downfall of Bear Stearns, Lehman or AIG, as we have claimed on over and over again on Mad Money, here’s an edited version of a comment I posted over on Kevin Drum’s Blog at Mother Jones. 

First, the uptick rule, which forced the shorts to wait for a buyer who was willing to pay a higher price than the last trade for a stock before they could short it again, slowed things down. It made it impossible for shorts to jam stock down with endless selling, because the stock had to go up a little first, and if it didn’t, you couldn’t short it—so the shorts could only push things down so much. Without the rule, it’s much easier for the shorts to hit stocks down and create a lot of fear, which causes more selling, etc. Longs don’t have the same ability.  You could bid a stock up in the hopes of attracting momentum buyers the same way short-sellers knock ‘em down, but I think fear is a fundamentally more powerful force than greed, which is one reason we need rules that prevent unfettered short-selling.

What about the pervasive naked short-selling that SEC Chairman Christopher Cox finally put an end to earlier in the week? Does it matter? Yes, especially when we're dealing with financial companies that desperately need to raise capital. One of the main ways companies raise capital is buy selling stock. This is one of those rare cases where the stock price directly impacts the solvency of the business. If you look at how quickly Bear Stearns, AIG , and to a slightly lesser extent Lehman collapsed, without, I should add, much in the way of news (AIG fell from $20 to $2 in a week—that seemed like too much, after all, it’s not like it was news a week and a half ago that they’d written insurance for a lot of bad mortgage paper), I think you can see the influence of hedge funds relentlessly shorting these stocks and driving them down by creating a free-fire zone, as they didn't have to borrow the shares first.

Now, maybe it was right for AIG to fall from $20 to $2 in a week. But with its stock at $20 AIG could have raised capital with a secondary offering, something that would have at the very least given it some more time to spin off some of its valuable but illiquid properties and stay afloat. 

The same pretty much goes for Lehman. You can argue that the prices the shorts took these stocks down to were justifiable given the fundamentals. But you can't deny that naked short-selling and the lack of the uptick rule allowed these stocks to fall much faster than they would have in the 1990s when the uptick rule was in place and naked short-sellers got in trouble. 

How significant is this? Intelligent, well-informed people can disagree. But it seems clear to me that with the old rules in place, at the very least, Lehman and AIG would have had more time to raise capital (and in AIG's case, all it needed was time because it has many valuable businesses that it could have sold if given the opportunity). 

Naked short selling without upticks pushes stocks down faster and harder than legit short selling with the uptick rule in place. No one would ever claim otherwise. It's possible AIG and Lehman would have failed eventually, but the aggressive, naked shorting, by making it pretty much impossible for these companies to raise money through an equity offering, had at least some impact on their demise. 

Not long ago Merrill Lynch did a huge secondary offering at $22 to raise capital after selling off $30 billion worth of bad paper at 6 cents on the dollar. On Sept. 9, AIG opened at $22. You saw it fall to $2 over the course of the next week. If it had had more time to do a stock offering at $22, it might not belong to the Soviet Socialist Republic of North America (and I say that with all the love in the world for Leon Trotsky). One of the shorts pushed AIG under $10, there was no way it could do a stock offering to raise capital. Same thing happened to Lehman. 

Don’t forget, why do stocks exist? They exist so companies can raise money! They do not exist simply to tell us what number the invisible hand of the market is pointing to on the valuation Ouija board.

No one’s suggesting that the shorts were the sole reason for the fall of any of the recent casualties. Obviously the shorts couldn’t kill a solid company with plenty of capital, but if a company needs to raise capital to survive, the shorts can eliminate issuing stock as an option, which could be the death of many a company.

Yes, these companies were in trouble, but unfettered short selling was the marginal cause of the collapses of Bear, Lehman and AIG (aren’t economists supposed to think at the margin?).  On Mad Money we’ve been relentless in our criticism of Dick Fuld (now former CEO of Lehman) and Robert Willumstad (now former CEO of AIG, along with his predecessor Marty Sullivan), going so far to put them on our CEO Wall of Shame. Both companies also had toxic assets and opaque financials, with the lack of transparency making it much easier for the shorts to inspire fear. There’s no reason you can’t believe both that LEH and AIG were poorly managed with nightmare balance sheets, and that the relentless, unchecked short selling played a role in causing their downfalls. Even if you only think the shorts sped up the inevitable that still matters, as the speed certainly contributed to the pervasive sense of panic earlier in the week. 



Cliff Mason is the Senior Writer of CNBC's Mad Money w/Jim Cramer, and has been that program's primary writer, in cooperation with and under the supervision of Jim Cramer, since he began at CNBC as an intern during the summer of 2005. Mason was the author of a column at TheStreet.com during 2007, which he describes as "hilarious, if short-lived." He graduated from Harvard College in 2007. It was at Harvard that Mason learned to multi-task, mastering the art of seeming to pay attention to professors while writing scripts for Mad Money. Mason has co-written two books with Jim Cramer: Jim Cramer's Mad Money: Watch TV, Get Richand Stay Mad For Life: Get Rich, Stay Rich (Make Your Kids Even Richer). He is 100% responsible for any parts of either book that you did not like. 

Mason has also had a fruitful relationship with Jim Cramer as his nephew for the last 23 years and will hopefully continue to hold that position for many more as long as he doesn't do anything to get himself kicked out of the family.

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