First it was Bear Stearns. A few months later Lehman Brothers Inc. filed for Chapter 11, AIG was rescued by a survival plan and Merrill Lynch was saved by a last-minute acquisition package from the Bank of America. In all cases, short-sellers have been blamed for the drop in prices of financial stocks. The financial press uses the terms ‘betting against’ to describe short sales. Price declines have been deemed artificial and the result of market manipulation. In the meantime, the SEC has taken part in this debate by prohibiting naked short sales during the summer and by imposing a recent, stronger prohibition on all kinds of short sales on a big group of 799 financial stocks.

My previous research on short sales predicated that in countries where short sales are prohibited, stock markets are less efficient. By efficiency we1 mean that stock prices incorporate information, and especially negative information, slowly. When markets are not efficient, the only information that moves prices is market-wide news. Therefore all stocks move together, which hinders portfolio diversification and makes risk pricing difficult.

We instead found no evidence, at least statistically significant, in favour of the regulators’ claim that short sales make financial crises more likely: when a crisis starts, short sales make it happen faster, but short-sellers alone do not induce market panics. We reached our conclusions by comparing the stock market performances in countries with and without short sales. Of course, the problem is that many other factors beyond short sales can determine the different market quality in, for instance, the UK and Venezuela.

When the SEC announced in the summer that there would be a prohibition against naked shorts in 19 financial stocks during approximately one month (from 21 July to 13 August), I saw this decision as the realisation of the academic dream. The regulator was creating for me a testing lab where I could really isolate the effects of naked short sales on market performance and quality. This was like injecting a drug to a group of rats and a placebo to another. I just needed to study both groups and measure the effects.

In my study2 I analysed three groups of stocks. The first group includes the 19 stocks that were affected by the SEC 15 July Emergency Order.3 I compared the G19 stocks to a sample of US financial stocks not covered by the prohibition, a group that includes 59 companies. I also constructed a sample of 79 non-US financial stocks. I could then test whether the prohibition had any effect on the market quality for the G19 stocks, and whether it had the intended effect of preventing those stocks from falling even further.

The wrong target

The first result that is worth highlighting is that the SEC definitely chose the wrong target; at least, if the SEC’s intention was to reduce the undesirable behaviour of naked short-sellers. Short sales in the G19 stocks had been much less frequent during the pre-prohibition period (between January and June) than in the 19 most shorted stocks in the two other groups (see Figure 1). While days to cover had been on average 1.72 for the G19 stocks, they were 4.93 and 93(!) days respectively for US and non-US financial stocks.

The core of my analysis deals with the effect of the prohibition on market quality. Note that Morgan Stanley, Freddie Mac and the like are very big firms with very liquid stocks. Affecting the pricing quality of these companies can have a terrible effect on the financial system. The measures of market quality I computed are the usual ones: the open-to-close volatility, the close-to-close volatility, as well as the positive and the negative semi-variances, which is the mean squared standard deviation of returns, conditional on returns being positive/negative. I also computed three measures of market liquidity: quoted spread relative quoted spread and trade price range4.

By all means, after 21 July the G19 stocks suffered a significant reduction in intra-day return volatility and an increase in spreads, which suggests a deterioration of market quality. For example, from the pre-EO period tothe post-EO period, relative quoted spreads for G19 stocks increased from 18% to 48%, but they increased only from 11% to 29% for comparable US financial stocks. There was no significant change in the relative quoted spreads for non-US financial institutions. Regression analyses confirm a significant reduction in intraday volatility and increased spreads for the G19 stocks after 21 July (See Figure 2).

I have also looked at the impact of the Emergency Order on market efficiency. The standard measure of market efficiency computes how fast stock prices incorporate information, both positive and negative. Positive information is incorporated naturally into markets because anybody who receives good news about a company can buy the stock. However, bad news flows slowly if short sales are restricted. Only those who own a stock (a few) can react by selling stock. The non-owners cannot profit from their information unless they can short the stock. It is very easy to measure how fast prices respond to negative market news. Indeed I find that, after 21 July, the G19 have become significantly slower at responding to a negative market return, both compared to themselves before 15 July, and also compared to the two control groups.

For me this is a discussion of the utmost importance. In a free market, regulators should not be there to rescue firms, but to ensure that markets operate smoothly and that information is incorporated fast into prices. If markets are not efficient they are not reliable. Individual investors run away from financial markets because prices do not reflect value; the economy suffers. There is no such thing as a trade-off between efficiency and stability of the market. Companies enter the market and leave it; investors make money because they take risks. If the regulator and the government are back there to prevent companies from failing, they will create a severe moral hazard problem and companies and executives will naturally seek excessive risk. Too much has been written, in recent weeks, about Fannie Mae, Freddie Mac and AIG: the bailouts, may have been ex-post desirable; but bailouts are ex-ante detrimental.

In the final part of my study I have looked at stock returns following the prohibition. In absolute terms the G19 stocks went up from 21 July to 13 August. This is misleading. First, because the overall market went up; second, because the performance of the G19 stocks was certainly bad prior to the Emergency Order; third, because the G19 stocks were considered riskier in 2008, so they must naturally yield higher returns. Here I ran the standard ‘event study’: I computed stock returns adjusted by the market performance and by firm-specific risk. The results are summarised in Figure 3. The risk-and-market-adjusted return of the G19 stocks is significantly worse during the prohibition period than for the control group. Relative to other US Financial Stocks, the G19 stocks lost 10% (equivalent to US$150 billion in market capitalisation). They also did worse than non-US financial institutions.

An additional proof that short-sellers did not manipulate prices in the case of Lehman Brothers can be seen by looking at at the short selling transactions on 9 September 2008, the day Lehman Brothers fell 45%. This shows that short sales were much more frequent during the second part of the day. The weighted average price at which short-sellers executed their trades on 9 September was US$9.29. As LEH opened at US$12.72 and closed at US$7.69, the average execution price represents only 32% of the price decline of the day.

One final comment is in order. Claims against short-sellers which compare them to market manipulators are unfounded, at least in the case of financial stocks. Market manipulation involves the dissemination of false information with the intent of making a profit. Were short-sellers fooling the market when they were ‘betting’ against the stocks of Bear Stearns, Lehman, AIG and the like? If the stocks of these companies were not correct after short-sellers picked them, we would have seen a queue of potential acquirers lining up at their door to buy them. But we did not: the Federal Reserve had to provide JP Morgan with a favourable financial package in order for the New York firm to agree to buy Bear Stearns. Wall Street executives and officials were not able to find anyone interested in buying Lehman Brothers, so it had to file for Chapter 11.

The government had to take over AIG’s troubled assets. Short-sellers have not been greedy, only fast and well-informed. And they were right in the first place. THFJ

Arturo Bris is a Professor of Finance at IMD, in Lausanne (Switzerland), a research associate at the Yale International Center for Finance, and a research fellow at the European Corporate Governance Institute.