Learning from Mistakes: The Short Sale Ban

The verdict is in.  There is growing recognition that last September's ban on short selling in certain financial stocks was a mistake.

Most of the professional trading and investment community do not see short selling, per se, as a problem.  There are several debatable issues:  the uptick rule, credit default swaps, and mark-to-market accounting for assets intended as long-term holdings.  Short sales were not controversial among professionals.

The Academic Verdict

There is some fast work from the academic community.  A team led by Columbia Professor Charles Jones, Chairman of the Economics and Finance Division, has a strong data-based analysis of the short-selling ban.  They note that despite the initial pop in these stocks, they actually did worse during the market decline over the period of the ban.  More importantly, they note that liquidity in these issues got much worse.  The average trader faced wider bid-ask spreads leading to more costly trades.  Short sales add liquidity and even fuel rebounds when fundamentals change.  As many noted at the time, there were various ways to avoid the ban, including purchases of put options and inverse ETF's.

The SEC Verdict

SEC Chairman Christopher Cox acknowledges this error.  In a just-released interview in the Washington Post, he is quoted as follows:

Cox said the biggest mistake of his tenure was agreeing in September to an extraordinary three-week ban on short selling of financial company stocks. But in publicly acknowledging for the first time that this ban was not productive, Cox said he had been under intense pressure from Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke to take this action and did so reluctantly. They "were of the view that if we did not act and act at that instant, these financial institutions could fail as a result and there would be nothing left to save," Cox said.

Our Take

We should note first with applause the rapid data-based effort by unbiased academic investigators.  We can all enjoy the effect of the Internet.  Instead of waiting more than a year for academic publication in a peer-reviewed journal, results are now available more quickly.  If there is criticism, that is also available to all.  It is a major improvement in the way academic research becomes relevant.

We find more difficulty in the Cox "go slow" concept.  It is clear that events were moving more rapidly than policy.  Paulson and Bernanke were correct in identifying a problem, but the focus was wrong.

Eventually we will see an academic study that pulls together the key elements:

• The unregulated credit default swap market, easily manipulated with modest amounts of capital;
• The widespread publicity surrounding the CDS trading, implying insolvency of the institutions in question;
• The speculative put buying by those profiting from this pattern;
• The mark-to-market implications for institutions not involved at all;
• The possible manipulation of widely used ABX indices, affecting the entire market.

This all needs investigation.  Will it be on the agenda for the new Obama team?  We hope so.  Learning from this lesson is absolutely essential.