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December 1, 2008

Stopped Short

When things are going really badly, blame a conspiracy. It's been a standard move in the playbook of third-world dictators, cult leaders, and the unwashed guy on every college campus fighting the military-industrial complex. And now conspiracy theory has come to Wall Street.

As the financial sector began imploding in early September, we quickly learned that it wasn't some toxic stew of bad luck and bad judgment that brought Wall Street to its knees. It wasn't a bizarre perfect storm of unfortunate and unforeseeably linked events. We were told the bank failures were caused by a secret society of short sellers.

Short sellers were deliberately driving each financial stock down, in a bold and successful attempt to create a run on the bank. Thanks to the removal of the uptick rule, there was no market mechanism to stop them. And thanks to the lack of a disclosure rule, the vast short-selling conspiracy could remain cloaked behind a veil of hedge fund confidentiality, laughing anonymously in their glass and brushed aluminum offices while American capitalism burned.

After this narrative of the evil short sellers moved from the street corner to the corner office, on the morning of Friday, Sept. 19, we awoke to learn that short selling for a list of financial stocks had been completely banned. The list went way, way beyond the 19 financial stocks in a previous July emergency order, quickly metastasizing to include a huge chunk of the overall U.S. stock market. The banned list swelled to almost 1,000 stocks, including leading financial companies like CVS drugstores and Goodyear Tire & Rubber, which wisely stopped the shorts from causing a run on steel-belted radials.

Those damn ruthless shorts were themselves stopped short. So, what happened? Was the vicious cycle of fear and greed finally over? Did the sun rise that morning on a new era of upwardly mobile stock prices? Was a shortless America a stronger America? What followed was a fascinating experiment in market dynamics and market structure. Similar to George Bailey in that classic holiday movie, "It's a Wonderful Life," we got a rare gift: the chance to see what the markets would look like had the shorts never been born at all.

In a surprise to some, for the 14 trading days that short selling was banned, the market was not pretty. The empirical data clearly show that the ban led to higher bid/ask spreads, lower overall volume and increased trading costs for both institutional and retail investors. Furthermore, the ban was likely one of the causes of the extreme volatility in the period that followed.

The fundamental problem with restricting short selling is that there is a massive amount of money in market-neutral "long/short" hedge funds, and virtually no money in funds that are net short. The Credit Suisse/Tremont Hedge Fund Index as of August 2008 showed only 0.7 percent of hedge funds to be net short. In other words, virtually all hedge funds live up to the name. For the vast majority of funds, for every dollar they are short, they are long another dollar. Take away their ability to go short, and you have also taken away their ability to go long.

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