Government Policy Created Too Hastily

I have been no fan of naked short selling; I have long argued that the brokers must locate shares before a short sale can be done.  Anything less than that is fraud.  But I do not support eliminating shorting, even though I almost never do it.  What would be the effects of eliminating shorting?

  • No more merger arbitrage funds.
  • No more statistical arbitrage funds.
  • Wait, no more arbitrage?
  • 130/30 funds go away.
  • Other quant funds go away.
  • Barbarian hedge funds that do real research go away.
  • Put option implied volatility goes way up.  (A lot depends on whether specialists/market-makers can still short…)
  • Because of put-call parity, call implied volatility goes up as well.
  • Players move to credit default swaps, oh wait, might those get banned as well?
  • Those relying on securities lending income lose out.

Eliminating shorting is stupid.  Enforcing getting a locate is smart.

Now for something that could be smart or dumb, depending on how it is done.  The possibility of a new RTC could be a good or a bad idea.  The main criterion is whether it is proactive or reactive.  My answer my surprise many: reactive is good, proactive is bad.

What we don’t want to do is provide a place for companies to dump lousy assets at inflated prices.  Instead, a new RTC should be a last resort place that the assets of failed companies go to until they are disposed of.  Common and preferred equity should be wiped out, and bondholders should take haircuts.  New loans should be senior to all old loans, similar to the situation with AIG.

Anyone going to the new RTC should feel pain, and a lot of it.  It should be the last resort for companies that are failing.  It should not try to keep companies alive, but merely conserve the value of assets, and prevent contagion.  Remember, if the risk is not systemic, the government should not try to bail it out.


  • Mariano says:

    Who is going to buy my shares in order to cover if they were to fall 10 or 20% or beyond?

  • David, excellent commentary, as always. Any thoughts on whether the original RTC functioned along these lines? It seems that Congress is likely to model its response in the image of the old RTC….

  • Sometimes desperate times call for desperate measures. I agree that short sellers are not the real issue here – it’s the companies problems in overleveraging in risky instruments that have caused the problems.

  • matt says:

    Mr. Merkel:

    It sounds like they are going with the proactive strategy. I agree with you – reactive is better in this case.

    I’m also afraid of the speed at which this is being pushed through. I’m afraid that the Congress critters will not give this healthy debate in order to shotgun it through before the elections.

  • James Korman says:

    Implementation of new Short Sale rules aka ‘uptick’ is absolute insanity and will in the end drive this business offshore; more importantly it will contribute to the continuing decline in capital formation in this country.

    Government at its worst!

  • Fintas_1981 says:

    Dave you make many valid observtions.

    I’m not in agreement with you re ban. And here’s why. ENFORCEMENT has ALWAYS been required. That’s the problem, no one is doing it. And in fact without mandates it can not be done. We just saw the damage that can be done in 3 days. Just think what a pack of wolves can do during that t-3 and then don’t deliver and then skirt the timeline of ftd and while that happens. GEESH..LEH is forced to bk/AIG goes and shares required to be delivered just don’t happen due to either not existing or are done at much lower prices. So what you suggest is IDEALISTIC. The reality is look at BSC and many others. The DTCC is broken and the numbers are skwed. The media has been negligent and complicit for a long time. Heck one only has to go back to Sec whistle blower to recognize time lines and who was contacted. MAY 2006.

    Or the misaligned Patrick Byrne who clearly identified there were more shares shorted than existed. NOW how can that be? Easy, no one ENFORCED the laws.

    What could be done and should be done is very simple and it’s accounting 101. Close it down. Do an inventory. Regroup to know just how many shares are out their on the short side. Once they get the real numbers then one can track and enforce. Here and now those who think Short selling and the abuse of such was not the cause should spend some time reading xxxthesanitycheckxxx or xxxdeepcapturexxx.

    Finally I too have no angst re shorting but when the ILLEGAL use of NAKED SHORT SELLING occurs then the solutions are simple. STOP IT. Force buyins, deliver the stock ad then throw the criminals in jail.

    Finally, for those who use te well the companies were doing this and that. problem but again NO company should be taken down like a pack of lions do to a zebra. Shorting should exist and if the company can not right itself then that will happen over time. NOT in 3-5 days and across the board risking our financial system.

    So ban the shorts. DO IT FOR THE ENTIRE MARKET. Then fix the SEC/fix the trakcing DTCC/put in regulators who do their jobs and put those in JAIL who engage in criminal acts and also those complicit.

    Once that is done then shorting can begin again. OH and the uptick rule just allows the errors in tracking to continue. NOPE. DTCC has to go or be fixed. THERE is a pending ammendment for those who are interested. Just go to

  • dd says:

    Another unintended casualty might be certain ETFs, particularly those like SDS, QID and so forth which attempt to duplicate short positions on a particular index. I wonder how these ETFs might be unwound?

  • matt says:


    It is my understanding that short and ultrashort ETF exposure is through futures and equity swaps. It hardly seems like the short ban will affect them.