January 2010
Moderator: Welcome to Research Insights, an occasional podcast from the Federal Reserve Bank of Atlanta. We're talking today with Gerald Dwyer, director of the Center for Financial Innovation and Stability at the Atlanta Fed, and I'm speaking with Jerry after his October 2009 conference on the cost and benefits of short selling. Jerry, thank you for joining us.
Jerry Dwyer: It's a pleasure to be here.
Moderator: I'd like to begin with a real simple question, and that is, what is short selling?
Dwyer: Short selling's actually really simple. It's in the stock market, generally, that we are talking about, and short selling just means that you sell stock and you actually don't own it when you're selling it, and that's literally what it means.
Moderator: OK, and this is a very active marketplace in the trading community?
Dwyer: Yeah, lots of people short sell. Actually, I even know some people as individuals who do, so you can do it as an individual. Large institutions do it all the time. They'll do it for lots of different reasons. One reason might be that you think the price of a stock is going to go down. So the idea is, is you sell it today, and then you have to buy it back tomorrow, or some other time in the future, and if the price goes down in the meantime, then you gain that. If the price goes up, you lose. And so one of the disadvantages from a personal standpoint of short selling—and the reason most individuals don't do it—is you can lose an enormous amount because the price of the stock can go up an arbitrarily large amount, and you can lose an arbitrarily large amount.
Moderator: Well, short selling is not very popular for those who hold the stocks and run the businesses; it is often criticized in the marketplace. So, tell us why that's the case. What are the costs of this activity, the cons of it?
Dwyer: Well, if you're running a company and somebody sells your stock with the hope of buying it back for less later, what that means is they're betting the price of your stock is going to go down. And so they're betting that bad news is going to come out about your firm, and implicitly they basically think that you're not running the firm very well. And so it's a negative vote for what you're doing. And so naturally enough, people don't like that. That's part of the reason that the people who run firms don't like it.
In terms of costs, I think the major things that really arise there is, short selling historically is associated with what's called a "bear raid." That term gets used in a way that's well beyond what it really means. But basically, the idea is the following: If I sell enough of the stock in a short period of time maybe I can drive the price down, and if I can drive the price down, then I can buy it back at a lower price, and I make money... cool! And so that's a good deal. And so the idea is, it can introduce volatility in the stock price that wouldn't be there otherwise. I actually think a lot of the negative connotations associated with short selling are actually related to just selling something you don't own. It's like if I sell you a car and I don't even own it. It just seems like a bad idea.
Moderator: So that's a perception problem?
Dwyer: Yeah.
Moderator: But in reality we know that short selling has a viable role in the marketplace, and it serves a purpose, so let's look at the other side of the token here. Can you talk little bit about some of the benefits that short selling provides and why it serves a viable function?
Dwyer: Well, the reason financial economists, in general, don't have any trouble with short selling, even though other people do, is because if I think a firm is going to do badly, and I'm willing to bet my money that it's going to do badly, then I'm going to sell the stock short. And that's basically a way of registering that opinion. And so it's controversial, but one of the things that ends up happening is that the stock price then reflects those negative views as well as the implicit positive views by the people who are holding the stock. So part of the idea is, if you don't have people short selling because it's not allowed, then basically what happens is the only people whose views are reflected in the stock price are people who have a positive view. And, like I say, it's a little bit controversial, but a lot of people think that means that the stock price actually ends up being artificially high. So, if you're running the company you like that. The higher it is the better, and if it's artificially high—hey, I don't know artificial versus real.
Moderator: Well, of course you can always cast a negative vote on a business by selling the stock itself.
Dwyer: Well, but if you don't own it, you can't sell it.
Moderator: But if you own it...shareholders...
Dwyer: I mean, implicitly you're casting a nonpositive vote if you don't own it.
Moderator: Right.
Dwyer: That's true. But you can't—you're not casting a negative vote. It's a little stronger.
Moderator: Short selling introduces information in the marketplace that's useful?
Dwyer: Yeah, and it makes the prices more informative. I mean it does introduce certain kinds of volatility, I think on a fairly predictable—but not too predictable, but kind of predictable way—at least, after the fact you can see it. Whereas if the price of the stock rises, then what ends up happening is that a lot of people that are short get margin calls. And so they end up having to buy to it back, and that makes the price go even higher temporarily, and then it will come back. So it does introduce certain kinds of volatility, but at the same time it means the price is a lot more informative than it would be otherwise.
Moderator: Well, let's look back at 2008 and earlier this year as well, when short sellers had a field day with bank stocks. Should we learn anything about that experience?
Dwyer: It's not obvious that the short sellers drove down the price. The price might have gone down earlier than it would have otherwise because people were selling the stock short. But generally speaking, I don't know of any evidence that short sellers drove prices down below levels that they have settled to since, for example. If anything, they're lower now than you might have thought back then. So, it's not obvious that short selling actually drove the prices down to values that didn't reflect the information that was really available. During the crisis, I mean, what did happen is that stock prices... one of the things is, stock prices were actually just reflecting other things that were going on. With Bear Stearns, they had certain kinds of problems, and so did Lehman Brothers, and those underlying financial problems were reflected in the stock price. So the stock price is really a reflection of the financial crisis and didn't cause it. The stock prices, for most of us, were just the visible way it really hit our retirement accounts very noticeably.
Moderator: So it wasn't the case that the short selling accelerated the decline in the stock?
Dwyer: It probably happened faster because short selling was occurring than it would have otherwise, but it doesn't mean it wouldn't have happened anyway, and that it didn't happen anyway, even with it restricted. I mean, some people have actually tried to tease out—it wasn't one of the papers at the conference, but it's a paper by somebody who was a discussant at the conference—where they've tried to look at what was the effect of the short sale restrictions on prices. And the trouble you run into trying to sort out data during something like that is, there are so many things happening on a daily basis that you can't pick one of the five things that happened that day and say that's why it happened; cause you've got four other things happening, and they could have done the same thing. But, it's possible that prices were lower because people were short selling the stocks or that they rose because of the restrictions, that's true.
Moderator: Well, are there any recommendations that your policy revealed that could apply to, perhaps, help stabilize the financial markets or help us to do better and avoid future crises?
Dwyer: This is actually kind of, paradoxically, the interesting thing, I think, that came out of the conference in terms of an idea. Up until the 1930s, evidently, there was a central location where you could go to buy stock—to rent stock, not to buy it. You have a central location with the New York Stock Exchange. But the idea is, if you want to borrow stock you have to borrow stock in order to sell it short; because you have to deliver the stock. So you borrow it from somebody, and the way you do it now is people just call around to various brokers and see who's got stock that they're able to lend. And up until the 1930s there was actually a central place where you could go and just borrow stock. And so short selling was actually more efficient. It was actually easier to short sell; it was actually a lower cost. And it's kind of interesting; it seemed to me like the major policy implication that most people at the conference took away from it was an idea that maybe a central repository where you could borrow stock would actually make it more efficient, and it would occur more predictably. And so, in that sense it might reduce a little bit of short-term volatility. If anything, it would actually increase short selling, not reduce it.
Moderator: Would that reduce the cost of short selling, the premiums that you have to pay? Would that be the benefit?
Dwyer: Yeah, well, and it would reduce the search cost. What he talked about is that in short selling it's not like the New York Stock Exchange, where you've got some central place you can go. Like I say, you have to call around. It's more like trying to figure out where's the lowest price of gas, so you've got to call around to find out where you can borrow the stock for the least.
Moderator: It's inefficient?
Dwyer: Yeah.
Moderator:So, your idea, or the idea that was put forth, was to re-centralize this borrowing or renting of shares?
Dwyer: Yeah.
Moderator: Well, that's interesting. Thanks, Jerry, I appreciate your time.
Dwyer: Thank you, it's been a pleasure.
Moderator: Again, we've been speaking with Jerry Dwyer. He is the director of the Center for Financial Innovation and Stability at the Atlanta Fed. This concludes our Research Insights podcast on the costs and benefits of short selling. Thanks for listening, and please return for more podcasts.