Short-selling made Joseph Kennedy's fortune before he became head of FDR's new Securities and Exchange Commission in 1934.
The practice of selling stocks short is legal, but there is a reason for its roguish reputation. Speculative short-selling may not cause fundamental economic problems, but it can exploit, worsen, and amplify them perniciously as Mr. Kennedy knew from firsthand experience. That's what is happening again today after the current SEC dropped Kennedy's essential "uptick rule" last year.
Unlike individual or institutional investors, speculative short-sellers abhor stability. The typical individual or institutional investor takes a long view and tries to pick stocks whose prices will rise. At most, they occasionally sell short to hedge against declines in value. But speculative short-sellers want prices to fall, and at worst, some actively work to promote declines, bombarding the markets with rumors. Which bank's liquidity is under pressure? Whose counterparties are getting nervous? Which bank will fail next?
Banks of all sizes — from Main Street to Wall Street — are vulnerable to such speculation, and it is in their interest to ask the SEC to reinstate the uptick rule.
By fueling anxiety when both investors and financial institutions are vulnerable, too many short-sellers enrich themselves at the expense of legitimate shareholders and the American taxpayer. When short-sellers succeed at causing panic, even well capitalized companies do not stand a chance.
Citigroup Inc. is a case in point. For months, its shares ranked among the top five of all U.S. companies in "short interest," or bets that the stock price would fall. There can be little doubt that short-selling helped drive down Citigroup's share price by 60% during the week of Nov. 20, just as it helped doom Bear Stearns, Lehman Brothers, and a who's who of U.S. financial companies in the preceding eight months. As it has done before, the government stepped in Nov. 24 with an infusion of taxpayer money to stop Citi's market headaches.
This pattern is occurring and recurring despite the facts that bank capital has been bolstered, banks are highly liquid, and regulators are well informed about their financial condition. The Federal Reserve has made massive loans, and will make more, to tighten the slack left by a weakened capital market. The Federal Deposit Insurance Corp. has expanded deposit insurance coverage and provided historic protections for bond holders.
Yet time and again, just as the latest financial salve is applied, short-sellers arrive on the battlefield to dispatch the wounded and the war-weary.
To be fair, short-sellers should not be scapegoated for the whole financial crisis. They are not responsible for the illiquid and deteriorating assets cluttering many balance sheets, or for the government's inconsistent, costly stabs at fixing the problem. Nor is there any law against speculating on companies' health.
But regulatory remedies are available to limit the economic damage from speculative short-selling, and we should apply them. The uptick rule that Joseph Kennedy's SEC established in 1938 bars selling a stock short until an uptick in its price, counteracting some of the "piling on" that occurs when stocks begin to falter. The rule was dropped in July 2007, during a bull market when liquidity was no problem, but markets have swung wildly since then.
During the seven decades the uptick rule was enforced, finance remained cyclical; we still had ups and downs, including recessions. Banks sometimes lost money but survived to prosper again. What is different this time is that, without the moderating influence of the uptick rule, speculative manipulation is out of control, eroding the trust and confidence on which all financial institutions are built, threatening premier banks and community banks alike.
Former short-seller Joseph Kennedy was famously effective as the first SEC chairman, in part because he knew from personal experience where the bodies were buried. We ignore his wisdom at our peril.
Our 16-month experience of short-selling without the uptick rule has been a disaster. Reinstating it would go a long way toward restoring confidence that the market is not being run by manipulators bent on profiting from wrecking real value.