About short selling

July 16th, 2008 by Rick Drain

You may have read yesterday’s headlines that SEC officials are banning short selling of Fannie Mae and Freddy Mac and some other financial stocks.

First of all, most of the headlines are slightly inaccurate: the ban is on naked short-selling.

A normal short sale involves actually borrowing shares from your broker and selling those, hoping to buy them back cheaper to return them to the broker later. Naked short selling means that you don’t actually borrow shares, you just sell a fiction, to be bought back and erased later.

You and I, and Longsplice and almost all the other financial companies in the world, were never able to do naked short-selling. It’s been the exclusive province of BIG companies such as the brokerage and investment banking companies. It makes sense to allow it for market-makers, who sometimes need to fill a customer ‘buy’ order, even though they don’t have the shares in hand.

In my opinion, that’s the only legitimate use of naked shorting, and all other uses should always have been banned. By side-stepping the requirement to borrow stock, these big players were able to short massively more shares than anyone else could have, more shares even than existed. That extra selling could very well have been sufficient to manipulate prices.

This new ban, even if it were made permanent and applied to all stocks, would not affect Longsplice’s long-short investing style. Our shorts have always been, and will always be, covered.

One final note: in previous crises involving non-financial companies, the Financial establishment has always said “Oh, we don’t need to ban anything, (naked) shorting doesn’t cause any harm.” Now it is some of their own shares being trampled, they care. It always depends on whose ox is being gored.