This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org
This article is from the
November/December 2018 issue.
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Is “Short-Selling” Bad for the Economy?
Dear Dr. Dollar:
Many a Wall Street investor makes money by “short selling,” which, as I understand it, involves buying stocks that the investor believes are likely to fall in value in the near future. How do they manage to make a profit by buying stocks whose value is likely to fall? Does this practice threaten the health of the larger economy or is it relatively harmless? —Clifford Anderson, Sacramento, Calif.
Yes, short sellers take action when they believe a stock’s price will fall in the near future. But they don’t buy the shares of the stock; they borrow the shares.
They sell the borrowed shares of stock at the existing price. Then, when the price falls, they purchase the shares of stock at the now lower price and return them to the lender (plus some interest or fee). The amount of money (profit) that the short seller makes is the difference between the price at which the shares were sold and the price at which they were later purchased times the number of shares involved (minus the interest or fees).
For example, a short seller borrows 100 shares of a stock at a current price of $75 a share. The shorter immediately sells the stock for $7,500. Then, as the short seller had hoped, the price drops to $50 a share. So the short seller buys 100 shares for $5,000 and returns the shares to the lender. The profit is $2,500 (minus the interest or fees).
If, contrary to the short seller’s expectation, the price of the stock rises, she/he suffers a loss instead of a gain. While the profits in the above example are limited to $7,500, because the price cannot drop below zero, the loss is, in theory, unlimited—i.e., there is no limit on how high the price could go. In practice, however, if the price starts to rise significantly, the short seller can cut her/his losses by buying and suffering only a small loss. Nonetheless, short selling is risky.
Short selling is one way to bet (speculate) against a stock (or, for that matter, other assets such as bonds or various kinds of financial instruments), but it is not the only way. For example, if a speculator believes the price of a stock will fall, she/he can buy a “put”—the right, but not the obligation, to sell the stock at a fixed price at a certain date in the future. If the price falls below the price agreed upon in the “put,” the buyer can buy at this lower price and sell at the “put” price, making a profit. If the price does not fall below the “put” price, the sale doesn’t take place. The person who bought the “put” only loses what she/he paid for it. All the risk is born by the seller of the put.
A speculator can also buy a “credit default swap,” which is essentially an insurance policy on a security. If the price of the security drops (or, in the case of a bond, if there is a complete default), the buyer of the “swap” gets the par value of the security (i.e., its value as originally issued). The speculator does not actually have to buy the security to buy the “swap,” the de facto insurance policy. Betting against a security in this manner is a bit like buying fire insurance on the house of a neighbor who you know smokes in bed at night.
Broader Impacts?
Because short selling can be so risky, with possible losses far exceeding possible gains, many analysts warn against it. Clearly, it is a dangerous practice for the amateur investor. But aside from what’s bad or good for the individual, what about the broader impact?
Critics of short selling argue that it creates undesirable and excessive ups and downs in securities markets, and that unstable securities markets are bad for the wider economy. Also, when there is significant short selling of the stock of a particular company, the short selling itself may cause the value of that stock to fall. Investors who learn about the short sells might believe the short seller knows something they don’t. So these other investors sell their shares, the stock price falls, and the short seller wins. Again, the problem is excessive gyrations of securities markets.
Defenders of short selling see it as a useful practice, a method of forcing companies to operate effectively. If the companies don’t operate well, short sellers will bet against them. In this view, short selling is seen as desirable because it forces companies to be accountable for their errors—which is supposedly good for the economy in general. Whether one likes it or not, it is hard to see how securities markets could exist without winners and losers, without some investors having different appraisals of particular companies than other investors. So short selling seems to be part of the necessary operations of the casino-like financial markets.
Short selling—or, more generally, betting against a security—becomes a real problem when used in ways to game the system. One of these ways is “short and distort.” A large investor—a hedge fund, for example—can short the stock of a company and then undertake a campaign to discredit the operation of the company. If the campaign generates a fall in the price of the company’s stock, the investor wins—but not because of any real weakness of the company.
An Odious Example
Another, especially odious example of using negative speculation was an operation by the investment bank Goldman Sachs in the early 2000s. During the housing bubble that led to the financial crisis and Great Recession, Goldman Sachs created packages of mortgaged-backed securities—collateralized debt obligations (CDOs)—that it sold to its clients, which included pension funds, insurance companies, and various other investors. Believing these CDOs were good investments, presumably because Goldman Sachs was urging their purchase, the clients spent billions buying them. For a while the clients made money off these investments.
Then, according to the New York Times, “Worried about a housing bubble, top Goldman executives decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly”—that is, the firm did not tell its clients. So Goldman Sachs started making CDO investments (i.e., shorting the CDOs) that would pay off only if the housing bubble deflated.
When the housing market started to go bust and the CDOs did fall in value, Goldman Sachs made billions and its clients lost billions. Goldman Sachs was not the only financial institution to profit from this sort of duplicitous practice. Others, according to the Times, included Deutsche Bank and Morgan Stanley, as well as some smaller firms. On January 13, 2010, at hearings of the Financial Crisis Inquiry Commission, established by Congress to investigate the crisis, the commission’s chair, Phil Angelides, confronted the head of Goldman Sachs, Lloyd Blankfein, on this issue: “I’m just going to be blunt with you. It sounds to me a little bit like selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars ... It doesn’t seem to me that’s a practice that inspires confidence in the market.”
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