Don Dahler
Author, Journalist
Short Selling, Short Sighted?

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September 19, 2008

A good fisherman can look at the ripples and stirrings on the water's surface and know whether it's nothing but the river's eddy, or a hungry trout searching for food.

So, too, watching the numbers on the stock market can tell you there's something going on below the surface, but they don't tell you what.
There are many reasons for the turmoil the world markets have been experiencing of late. Today, of course, it's the U.S. government's unprecedented actions to shore up the nation's financial institutions and guarantee the safety of investors' money. That buoyed the Street and gave traders and investors alike hope that this was not, as REM's lyrics go, the end of the world as we know it.

But the financial world, and its rules, are certainly going through a period of change.

In the preceding weeks and months, the convulsions in the markets were caused primarily by the impact of the catastrophic mortgage crisis finally coming home to roost where it really all began, with the companies that extended risky loans to people who couldn't afford it when their rates adjusted upwards, and the banks that underwrote those loans, and the insurance companies that underwrote those banks.

And now, the U.S. taxpayer has become the ultimate guarantor of that debt. One estimate has it this will cost you and me and our children half-a-trillion dollars. All to cover mistakes made by some very smart people.

What was the ultimate motive for those decisions that turned out to be so terrifically wrong-headed?

Why, money, of course. By selling the American Dream to people who weren't quite ready to grasp it, with mortgage instruments that were structured on the fantastical notion that interest rates would forever remain low, when history clearly shows otherwise, this collapse was something that our Federal regulators should have seen. But they didn't.

And who is to be held accountable for that? We have yet to see.

But one of the results of this economic tragedy may well be a renewed call to regulate, if not ban altogether, the practice of short-selling stocks. The Securities and Exchange Commission placed such a ban, temporary though it is, on a list of 799 primarily financial institutions most at risk of being victims to this investment tactic.

Short selling, in a nutshell, is when an investor or fund manager guesses that a particular stock's price is going to fall. They then borrow a certain number of stocks from a brokerage house at a specific price. When the stock's value falls, they buy an equivalent number of that stock at a lower price, then hand those back to the broker, fulfilling the loan, and pocketing the difference in the prices.

The reason the SEC is taking the unprecedented step of halting that practice is because when done in large lots, short-selling can pummel a stock's value into the dirt, and thus create devastating consequences for the company itself. Their operating capital can disappear overnight.

A lot of people have gotten very rich doing this, especially when the mortgage mess hit the financial companies. Almost all of those companies involved were expected to see diminished value.

Those hedge funds you hear about now and then, especially when the rankings of the people getting most wealthy on Wall Street come out, do a lot of short-selling, and their managers are almost always at the top of those earnings lists. Hedge funds don't have to reveal much about their doings, because they fly under a lot of regulations by limiting the number of their investors to a very select group of very rich people.

And, to be clear, short selling stocks is, usually, completely legal. But there are those who've constantly questioned why that is.

We forget sometimes what the real purpose of the stock market is. We treat it like it's nothing more than a self-enriching lottery game.

But in fact, the U.S. stock market exists to raise capital in order to build, hire, create, and develop. The very structures of our economy, our way of life, depend on the financial lifeblood donated by investors like you and I. The money in your 401K helps factories re-tool, pharmaceuticals develop anti-cancer drugs, and, yes, banks lend money to people who want to follow the American Dream.

Short-selling stocks, it is now being argued, creates no new jobs, no new products, and no new industries for our nation. It creates nothing but more wealth for a special few by taking money away from the very companies that need it. And in fact, economists say part of the reason so many financial institutions have fallen over the brink of collapse, been forced to sell at ridiculously low prices, or are seeking mergers with other banks, is because their capital values have been hammered so low by short-sells that they are literally worth less than the sum of their parts.

And if a lot of Americans can't understand how that can be allowed to happen, they can at least understand what it feels like. Since millions of people have been forced into foreclosure because the actual value of their own personal American Dream is now less than the amount of money they owe to keep it. 

(© MMIX, CBS Broadcasting Inc. All Rights Reserved.)

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Short Selling, Short Sighted?