For an introduction to credit default swaps, see the Wikipedia entry.
As part of the government's efforts to contain panic in the financial markets, the SEC announced that the $700 bailout would be accompanied by a ban on (initially) 799 financial stocks considered vulnerable to "predatory" speculators. Besides the abstract argument over liberty versus security, there is the very practical question of whether the ban will actually provide a floor—versus a ceiling—for financial stocks in the long run.
When an investor expects a stock's price to rise, he can profit by "going long"—i.e., by buying shares of the stock. If, however, an investor is pessimistic about a stock, she can sell its shares at the currently overvalued price. If the investor doesn't own any shares to begin with, she can "short" the stock. What happens is that her brokerage borrows shares of stock from current owners and then sells them to lock in the current price for the investor. Assuming that the price of the stock drops as the investor had anticipated, she then instructs her broker to "cover the short" by buying back the shares and returning them to the lender. During the period of the short, the investor, in effect, owns a negative amount of the stock, to counterbalance the extra positive shares held by the new owner (who bought the shares when the investor shorted them). Because the short-seller owns a negative quantity of shares, her wealth increases when the share price drops.
Now, some people view the stock market merely as a giant casino and see no rhyme or reason to speculation in the financial markets. Indeed, politicians blame greedy speculators for skyrocketing oil prices in one breath, and then blame those same greedy speculators for collapsing bank stocks in the next breath. Is it just a coincidence that the speculators "caused" these trends, rather than the opposite? Is there really any danger that unregulated speculators could now cause a bubble in mortgage-backed securities or could drive Exxon into bankruptcy merely on the basis of rumors and naked short- selling?
Of course not. In a relatively open market in which speculators are allowed to pocket gains but also suffer losses, competition punishes the true "gamblers" and rewards those who best anticipate future price movements. Speculators bought oil futures because they predicted that demand (for whatever reason) would outpace supply, just as speculators shorted Bear Stearns and AIG because they thought they were in trouble. If it really were a simple matter of a self-fulfilling prophecy—where the speculators could go make guaranteed profits by forcing commodity prices up or by forcing a financial firm into insolvency—then one wonders why the speculators started employing this money machine only within the last few years. Presumably, speculators were just as wily and greedy during the 1980s, when oil prices fell sharply.
Once one accepts that there are underlying forces that move prices and that speculators try to ride these waves rather than direct them, the harmful effects of the SEC become clear. Successful speculators buy low and sell high, or they short-sell high and cover low. This is a countercyclical strategy that actually makes stock or commodity price movements less volatile than they would be in the absence of (successful) speculation. By banning one side of this "governor" on financial prices, the SEC will make these particular stocks riskier investments.
It is true that the threat of an immediate "attack" by short-sellers has been taken away. But now, when bad news comes out about a firm on the SEC's list, its share price will be jolted more than before the ban. This is because the people least likely to anticipate bad news about the company are those currently holding the stock. With the SEC's short-selling ban, as more and more people learn of the impending bombshell that will go public in a few days, their only incentive is to unload shares they already own. They can do this quietly without causing ripples. In contrast, when short-selling is allowed, then people who learn bad news about a company can sell many more shares if the news is really that bad. There is an incentive for a knowledgeable person to announce his views to the world, as it were, by massively shorting the stock. Thus, the shareholders will be less surprised by the bombshell announcement because their share prices had been getting pummeled by speculators for days before.
More generally, the ban on short-selling will make investors less willing to buy stock in, or lend money to (i.e., buy the bonds of), the companies on the SEC's list. With the possibility of speculative shorting, investors know that the "vultures" are looking for weak targets to attack (by shorting their stock). This means that the remaining companies get an implicit stamp of approval from the speculators. The financials who are not being "attacked" are less likely to be holding crippling amounts of mortgage-backed securities, and, hence, rational but ignorant investors—including institutional investors handling huge accounts where safety is paramount—can more confidently expose themselves to these financial companies. The SEC ban takes away this important source of information to investors and makes the financial industry less attractive to them.
Finally, the SEC ban will make it harder to buy insurance against bond default by financial companies and, thus, will make it that much more difficult for these beleaguered firms to raise private capital. Currently, a financial institution can act as a type of insurer by entering into a "credit default swap"1 (CDS). The insuring firm (such as AIG) might issue a CDS to the manager of a teachers' pension fund. The CDS obligates the manager to make a stream of premium payments to AIG, but if Goldman Sachs (say) defaults on its bonds—what is called a "credit event"—then the CDS is triggered and AIG makes a large payment to the pension manager. (It wasn't that the manager was betting Goldman would default, but that he had invested in some Goldman bonds and was insuring himself against the event.)
Now, one of the standard ways that insuring firms such as AIG could hedge themselves—perhaps if AIG executives became concerned about their CDS exposure—would be to short shares of Goldman Sachs. This possibility allows the CDS market to unfold more naturally because AIG can short stocks if its clients want to buy more total protection against a certain credit event than AIG wants to sell them. The SEC ban will, therefore, make bond insurance on Goldman Sachs and other "protected" firms more expensive, providing yet another disincentive for outside investors to deal with these firms.
Continuing the above logic, there are other firms that might use shorting as a hedge, rather than as a speculative move. In the extreme, suppose that an analyst is dead certain that Medium Bank XYZ behaved beautifully throughout the housing bubble, that there is not a single "toxic" mortgage-backed security on its balance sheet, and, moreover, that XYZ has been very careful to become intertwined only with other financial institutions that have played it safe. The analyst is convinced that Medium Bank XYZ is one of the safest banks out there.
Even so, it does not follow that the analyst will recommend buying large numbers of shares in XYZ. After all, it is a minor player, and if bad news about a regulatory change or some other event sweeps the market, then XYZ's stock might go down with the herd. A much safer bet, therefore, would be the spread between XYZ and comparable financial stocks. For example, the analyst might recommend that clients take out a large long position on XYZ, while taking out much smaller short positions on the largest five banks. The SEC's ban has now made this hedge illegal, and thus our hypothetical analyst may now recommend less aggressive buying of XYZ.
Above, we have described several mechanisms through which the SEC ban could reduce investor confidence in financial stocks, ironically reducing their share prices in the long run. In practice, the market will probably invent ways around the new regulation. There are many ways to implement a "synthetic short"; simply buying put options2 is a different way to bet against a stock (though the move is not equivalent to shorting). If the SEC just stood still, the current ban on short-selling would merely translate into a deadweight loss from higher transaction costs, because investors would eventually find (costly) ways around the regulatory roadblock. The real danger is if the SEC continually updates the regulations to chase the speculators from one strategy to another. This "whack-a-mole" process would reduce confidence in U.S. financial markets altogether, causing investors to flee to other countries' exchanges.
One final comment on the SEC's ban is in order: As of this writing, two firms—Diamond Hill Investment and JMP Securities—have asked to be taken off the list,3 and the SEC has approved their request. This will pose an interesting dilemma for the regulators if the trend snowballs. If more and more firms voluntarily take themselves off the no-short list, the remaining firms will look more and more suspicious to investors. This possible development is just another illustration that limited interventions in the market are pointless. As Ludwig von Mises warned,4 they are counterproductive in their stated purposes and provoke cries for even more interventions.
As with the SEC ban on short-selling, the $700 billion bailout proposed by Treasury Secretary Paulson and passed by Congress will further cripple the weak financial markets. In the first place, the possibility of such a generous package arguably caused the year-long "credit crunch" in the first place. The real estate boom and bust explain why so many financial institutions are now holding hundreds of billions in possible losses. But the frozen credit markets—the fact that large banks are afraid to lend even to each other—are specifically due to the problem that investors aren't sure who is exposed to these bad assets.
These are two distinct issues, and at first glance, it seems odd that the location of these risky mortgage-backed securities remains so mysterious. After all, if a firm realizes that it made some horrendous decisions and now must announce losses, why not just get it over with and move on? Even if such an announcement would spell instant insolvency, it is not obvious how the shareholders gain by postponing the inevitable and allowing the company to fritter away more wealth by sputtering along.
However, this dynamic completely changes if there is a chance that the federal government will swoop in and buy up the bad assets well above the (current) market price. Investors are complaining about the lack of transparency regarding institutions' exposure to mortgage-backed securities, but this opaqueness of their balance sheets is itself exacerbated by the ever more generous assistance provided by the Fed and Treasury since the troubles began in August 2007. Rather than 'fessing up and taking their lumps, the most troubled firms decided to wait it out. And those firms that managed to hold on have just been rewarded with their cut of a $700 billion pot.
Turning from the narrow economics of moral hazard to the broader applications of public choice, we can conclude that the Paulson bailout will further politicize the financial markets. Whether or not their suspicions are true, many investors will now conclude that the path to success is to choose executives with political pull. Is it really just a coincidence that Goldman Sachs' competitors have fallen one by one and that Warren Buffett just decided to invest $5 billion in the firm after its former CEO proposed a massive transfer of tax dollars into the industry?
The ostensibly laissez-faire Bush Administration has proposed the biggest expansion of government authority since the New Deal. Foreign observers are understandably concluding that pure capitalism has failed, just as surely as the collapse of the Soviet Union proved the infeasibility of central planning. Ironically, it was interventionist policies that led to the crisis in the first place. The latest calls for a massive bailout, as well as the SEC's coordinated ban on short-selling of specific firms, will hurt the very financial stocks they are supposedly helping. The capital markets are now highly politicized, meaning that long-term real economic growth in the U.S. will suffer.
A put option on a stock gives the owner the right, but not the obligation, to sell shares of the stock at a prespecified price. Thus the put option becomes more valuable if the actual price of the stock falls. See the Wikipedia entry for more details.