CMKM Diamonds Inc. (fka CMKX)

[jetfish]

Short selling long on trouble
By FLOYD NORRIS
Columnist

http://www.kansascity.com/mld/kansascity/business/15615955.htm?source=rss&channel=kansascity_bus...

He who sells what isn’t his’n must buy it back or go to pris’n.

— Attributed to Daniel Drew, 1797-1879

The annals of short selling have no better exemplar than Daniel Drew, whose career demonstrated both the risks and rewards of pursuing such an unpopular strategy. He made, and lost, several fortunes, along the way founding a Methodist seminary that bears his name.

He died broke.

In an era when insider selling was not illegal — and in fact was deemed a sacred right of insiders — it was Drew who persuaded members of the New York City Council to first sell short shares of a railroad company controlled by Cornelius Vanderbilt and then to revoke the company’s license to operate a street railway in Manhattan. The idea was that the councilmen, and Drew, would profit when the share price plunged.

The scheme backfired when Vanderbilt bought shares, keeping the price from falling. Eventually he owned more shares than existed, leaving those who were short at his mercy. They needed to buy shares to cover their short positions, and he was the only possible seller. The city councilmen were allowed to exit with small losses, in return for reinstating the license. It cost Drew much more to get out.

The market was much wilder in those days, but fights over short selling are still lively. The Securities and Exchange Commission finds itself caught between economists, who tend to think that markets are more efficient if everyone can bet on whether a price is too high or too low, and politicians and corporate executives who argue that markets are being manipulated by traders who sell shares without either owning them or borrowing them.

That is called naked shorting, and it is the major cause of failures to deliver shares for heavily shorted stocks. It makes sense: Those who borrow shares must sometimes pay hefty fees if a lot of others want to borrow the same stock. Why pay if you can get the same benefits by shorting without borrowing?

The SEC has a rule aimed at reducing such shorting, but the practice has risen, and a proposed tightening of the rule may not have much effect.

But economists testifying before the SEC recently produced an interesting idea: Make those who do not borrow pay the same, or more, than they would have had to pay if they did borrow. In other words, use the market to police the market.

That would require shining light on the market for borrowing shares.

If the lending price for any given stock was available, it would make it clear just how overvalued the shorts thought a stock was. Those who failed to deliver shares could be subject to fines based on the price for borrowing.

Some economists warn that restrictions on shorting can lead to overvalued shares, damaging the economy by leading to inefficient allocation of capital and depressed future returns for those who buy at the higher prices.

But the companies whose shares are subject to heavy naked shorting say it must be stopped, and they fume at the SEC’s argument that stocks can be manipulated by those trying to force prices up through short squeezes, as well as by those who dump large volumes of stock in an effort to overwhelm the market.

In the long run, prices will adapt to reality. If stocks are unreasonably cheap, someone may bid for the entire company, creating a big problem for the shorts. If shares are far too expensive, prices will eventually plunge no matter how eager a company’s fans.

If the SEC wants to continue requiring that shares be borrowed before they can be shorted, then an effort to make the stock loan market more transparent — and force every short to pay the price — makes sense.