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Summer School: Naked short selling
Financial summer school
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TEXT OF STORY
Tess Vigeland: Well, we just went through your notes, so now it's time for you to take some.
Last week, the Securities and Exchange Commission put limits on something called naked short selling. Trust me, it has nothing to do with the altogether.
At the blackboard for today's Marketplace Summer School session is our very own Amy Scott.
Amy Scott: Short selling is basically a way to make money when a stock price falls. Think about a stock as a box of Girl Scout cookies, maybe Thin Mints. So let's say I'm pretty sure the price of Thin Mints is going to go down, so I borrow a few boxes from my neighbor and sell them at today's price. My hope is that when it's time to pay my neighbor back in a few weeks, the price will have dropped and I can buy the Thin Mints at the cheaper price and pocket the difference.
There's nothing illegal about short selling and in fact, many people say it's good for the market. If a stock is overvalued, short sellers can actually drive the price down and that can lead to more accurate stock prices for the rest of us. But recently, short sellers have been blamed for driving down the stock prices of some pretty big financial companies and the Securities and Exchange Commission is investigation whether there was some actual manipulation going on.
To try to prevent market manipulation, they've cracked down on a form of short selling known as naked short selling. Let's go back to our Girl Scout analogy. So let's say I never actually borrowed the Thin Mints from my neighbor, but I sold them anyway. That's known as naked short selling. I may have located some Thin Mints from a friend a few blocks away, but never actually sealed the deal. Then when it was time to deliver the boxes, I couldn't meet my end of the bargain. The reason they call it naked is because I'm left uncovered when the deal is actually supposed to be sealed.
For the average investor, short selling can be a good thing because it sort of keeps stock prices honest, but naked short selling allows stock manipulators to drive the price down artificially, which is why the SEC is cracking down on it.
Vigeland: Amy Scott is our New York bureau chief. Somebody get her a cookie, please! And next week, tune in for tax credit versus tax deduction.
Selling America Short
Imagine a world in which anyone can buy any amount of fire insurance on any building, regardless of its value or ownership. Imagine that anyone can buy any amount of life insurance on any unrelated individual, without their knowledge or consent.
The economic incentives in such a world guarantee that many buildings will burn, and many will die, to the financial benefit of those buying the insurance policies where they have no risk of actual loss.
Wall Street and the SEC have created such a world. Credit default swaps allow a party to reap a financial reward when a company fails. Shorting the ABX index allows a party to reap a financial reward when asset values of certain financial instruments decline in value. Unlimited shorting of stocks, without restraint as price declines, magnifies both the speed and magnitude of the price decline. Purchase of puts sends a stock price lower as the option market makers sell unlimited, unregistered, un-issued shares into the market.
Where the capital markets once functioned as a source of financing for new business ventures, Wall Street and the SEC have turned the capital markets into an unregulated, rigged casino where gambling and asset destruction are the main attractions. Economic incentives now heavily favor the destruction of investment capital, rather than the creation of additional capital.
What can we expect to be the logical result of the past 8 years of SEC and Wall Street corruption of our capital markets?
