Thursday, December 17, 2009

Morality of short-selling

Short-selling pops up a lot as a topic of discussion, usually when the markets are distressed in some way. I finally decided to write down some of my thoughts on the topic.

Stated simply, my position is that short-selling (as opposed to selling to liquidate a long position) is 100% immoral since you are acting counter to the interests of the party that actually owns the shares that you are selling short, although mostly legal. Naked short-selling is illegal in addition to being immoral. A short sale is the sale of something that you do not own. You may be able to "borrow" shares to sell them short, but that is usually somebody's broker "loaning" shares of a customer who has a long position that is "held in street name" without informing them of that "loan" or in any way compensating for either the "value" of the "loan" of the stock or any of the loss that results from the downwards pressure on price from the short sale. This is all legal, but still 100% immoral, unless you have the moral values of a Wall Street trader.

I would be tempted to say that short-sellers have the moral values of a piece of dog poop, but that would be an insult to dog poop. In my personal hierarchy of moral values, short sellers and the brokerage firms that "enable" them have moral values somewhere well below the moral values of al Qaeda. The only people with worse moral values than short-sellers might be partners at Goldman Sachs and pedophiles. [I have already decided that I will never be applying for work at Goldman.]

Sure, non-naked short-selling is still legal, but slavery and a lot of other barbaric practices were also legal at some point, so being technically legal is no justification of moral value. Contributing to the detriment and even destruction of the economic value of a portion of the real economy (since each short sale does place downwards pressure on the stock price and stock price is a key factor in a company's ongoing ability to raise capital) is clearly immoral. But, some people clearly place a high value of short-term "financial" profit even if it comes at the expense of real economic "value."

There is one exception on short-selling, "shorting against the box", which is the short sale of shares that you in fact own is perfectly reasonable since you do in fact have an economic interest in the financial instrument that you are selling. I wouldn't say that it is 100% moral, but at least it is marginal.

Shorting a stock when you own the bonds is borderline in many cases and immoral in some cases. If you bought the bonds at face value, I would say that a short sale is a reasonable form of "defense". But if you bought the bonds at a steep discount to par (a "fire sale" price), then short-selling becomes borderline predatory. At a steep enough discount, the bounds can become more valuable if the company goes into bankruptcy, wipes out the stock equity, and causes the company to fire employees and void a variety of contracts. "Inciting" that prospect by pushing the stock price low enough that the company cannot raise capital would constitute predatory behavior and be a solid indicator of lack of moral values.

And if you throw CDS into that mix, you are downright and outright "evil" and that may in fact qualify you as a partner at Goldman Sachs.

The only "natural" sellers are owners -- by definition. So, the only "natural" position of a "natural" seller is that they are an owner. In other words, it is "unnatural" to sell that which you do not own.

How can any short-seller believe that selling that which you do not own can be anything other than immoral?

How can any short-seller believe that selling that which you do not own can add productive value to the economy and society?

Buying, owning, and holding stock finances the development of productive capacity in the economy. That is generally considered a good thing.

The additional downwards pressure of short selling during times of financial and economic stress can also damage the ability of normal, average, everyday retail investors with 401K accounts to withstand the dire fear-mongering promoted by short-sellers. These innocent retail investors end up selling at the worst time. Short-sellers add no productive value to their finances or their lives. How much more immoral does an activity need to be before we acknowledge that it is anti-economic, anti-social and plain old immoral? How can we consider such harm to individuals as anything other than immoral?

OTOH, in normal, healthy economic times any financial "games" (e.g., short-selling) are a tiny portion of market activity and can simply be ignored with no great loss. But in times of stress, such activities can begin to be the proverbial tail that wagged the dog, and it is at such times that harm is starting to occur, so it is at that stage when dysfunctional activities that might be marginally tolerated in good times need to be completely shut down. And, they need to be shutdown before any damage occurs, not after, as the SEC did last year when it temporarily banned short-sales of financial stocks. As the old saying goes, it does no good to close the barn door after the horses are gone.

Right now, here we are in the early stages of an economic recovery when the near-term outlook is uncertain. It is at such times that additional capital is critically needed to boost economic activity back to something resembling "normal". Short-selling at times such as this adds no positive contribution to the ability of firms to raise capital.

In short (ha-ha!), short-selling NEVER makes a positive contribution to the economy or the lives of normal people. It interferes with the primary function of a market, to mediate the flow of information between real economic buyers and real economic sellers. Interfering with that flow of information could never possibly be considered a good for society, an essential requirement for morality.

A short-seller may eventually "cover" their "short sale", technically known as "buy to close" or "short covering", but as a general proposition that hardly compensates society or the economy for any economic destruction of value that may have occurred in the interim. Just because short sales eventually are covered or closed in no way makes up for the interim period where non-owners are interfering with the ability of a company to raise capital in the capital markets. The harm has already been done.

Putting it simply (again), short-selling is a form of predation and does not add productive capacity to the economy or "value" to society. It may be profitable, but financial profit by itself does not mean an improvement in the productive capacity of the economy or an increase in "value" to society.

Any number of purported "benefits" are repeatedly put forward, but no list of excuses or purported "benefits", no matter how long or how artfully constructed, can ever excuse immoral behavior.

I have seen a number of arguments (and even formal academic papers) in favor of short-selling over the years and some of them do superficially "sound good", but superficial is not good enough. It is usually deep down in the assumptions were the problems lie. A lot of cute and clever logic and reasoning means nothing if the assumptions are bogus. Bogus assumption #1: "If used responsibly, in moderation, and according to law..." Well, I guess that eliminates 99% of short-selling.

Oh, and I would add that buying "put" options on stock that you do not own is 100% equivalent (and just as immoral) as short-selling.

Even "hedging" a long position with a short position is of very dubious economic or social value. Once again, it hides or distorts the information flow in the market.

And for those in the financial markets who are "morally-challenged", I would put forward the following simple test: simply imagine if your neighbor did something equivalent in the real world (outside of Wall Street and "the markets") - would you conclude that they are "a good person"? If a neighbor or person who you do not know "borrowed" your car without your permission and returned it badly damaged and killed or badly injured several pedestrians and other motorists while driving your car (again, without your permission), would you say that their behavior was consistent with being "a moral person"?

It has been said that if you leave your securities with a broker you can ask to have them delivered to you so no one can short them. True enough (I think), but that simply is not true for retirement accounts. No such option is made available to customers with retirement accounts, such as 401K and IRA Keogh accounts or for mutual funds. I would also note that no broker that I have ever heard of discloses the short-selling  aspect of keeping stock "in street name." Sure, a lot of people may informally know that, but it isn't even recorded in writing or in any official documents of brokerage firms on the Internet.

To repeat one point: Some forms of short-selling may be legal (currently), but legality is never a moral justification. No amount of excuses can erase or balance out the inherent immorality of selling something that you do not own along with the negative economic and social consequences that can result from that attempt to "make a fast buck".

Anyone engaging in short-selling has no business referring to themselves as an investor.

-- Jack Krupansky

5 Comments:

At 8:34 PM EST , Blogger Lexa Flasher said...

Sometimes shortselling is the only source of downside pressure and hence the only source of truth in the market. Truth is never immoral.

The system for shorting, much like the entire stock exchange, needs some serious overhaul though. Too much abuse and manipulation.

I recently started doing lendingclub myself. What are your thoughts on trading notes through foliofn? Have you tried it yet?

 
At 11:58 PM EDT , Anonymous Anonymous said...

Mr. Krupanski:

Stop spewing your puritanical moral views on the market. Short-selling is neither moral nor immoral. It's simply a judgement call as to whether you think the stock price is too low or too high.

If I think a stock is overpriced, and I short the stock to profit from its (hoped for) decline, that is no different than you thinking a stock is underpriced, and buying the stock to profit from its (hoped for) rise. I could just as easily accuse you of "immorally" trying artificially inflate a stock price by buying it.

The financial markets are SUPPOSED to be driven by rational self-interest, not by some misguided sense of religious morality. As long as you're not spreading false rumors about a company to deliberately drive down its stock price, there's nothing with short-selling.

 
At 8:54 PM EST , Anonymous Anonymous said...

Think about Enron, or Worldcom: More people doing proper analysis and shorting these overpriced stocks would actually have saved money for 401k owners with clueless analysts who would not stop buying them!

 
At 1:56 AM EDT , Anonymous Anonymous said...

Like this guy said "At 11:58 PM EDT , Anonymous Anonymous said... ", you got it all wrong Krupanski.

Think short selling(speculation) as a bet against moronic idiots who can't judge the reality well.

If there isn't a way to call the bluffs of morons by betting against them, these morons will go unpunished !

What rights you have to ask other person not to call the bluff of a moron (or group of morons!) by the process of betting !?

Should I just nod my head (investors) and swallow in whatever judgements (i.e usually long) others call or stay away from people who overestimate the value because of their stupidity!?

If a better's judgement is right why the devil should he afraid of a counter bet (i.e short selling)!?
He should be delighted to profit from those counter betting party if he can put the money where his mouth is !!!

your basic mistake in thought process is you don't see trading as 'betting' which is essentially confrontational in nature.

 
At 2:10 AM EDT , Anonymous Anonymous said...

continuing the above comment:

short selling speculators are not evil, they are just like thermometers which show high temperature when the patient has a fever. Don't blame the thermometer!
Thermometer is doing a splendid job of identifying the weakness and protecting the health !

 

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