The SEC's Second-Hand Socialism
by Michael S. Rozeff
by Michael S. Rozeff
Every day brings a new surprise or two from our home-grown financial central planners. Did they study some Soviet theorists? They didn't have to. They merely had to grow up in the American political, educational, and media system, our democracy being the disguised socialism-communism-fascism-plutocratic-kleptocracy that it is. They merely absorbed their socialism second-hand.
Once in power, which means once placed in the closed circle of power, our commissars act accordingly. People like Paulson and Bernanke and Cox can act in no other way, being the cowards and creatures of the system they are. They cannot withstand the pressures to conform and survive in the circle of power when combined with their own warped understanding.
What is that closed circle? It is the to-and-fro movement of money among: banker-investment banker-central banker-campaign contributor-lobbyist-Congressmen-regulators.
What hath the SEC (Securities and Exchange Commission) now wrought? It hath banned short-selling in 799 financial stocks until October 2, 2008. Such power! To be able to stop people from trading on a dime. And this in the supposed bastion of capitalism. What a terrible advertisement for capitalism and free markets, except that we don't have them. The next time someone speaks about the free market, or blames the free market for falling stock prices, remind them of this action. Isn't this what Murray Rothbard called "violent intervention" in the market? You bet it is. Murray, they are dreaming new dreams of interventions that you (and I) never conceived of.
An action like this deserves a few words, reactions that is, not many, even if I thought I had better things to do today.
The financial stocks have rallied sharply. But we do not know the size of the effect of the short-selling ban because simultaneously came the blockbuster news of a Resolution Trust type entity to bail out the banks. That possibility has driven up stock prices too. It will take a few careful studies to determine what effect the short-selling ban may have had on prices. But the theory of it is clear enough. And it can guide our understanding.
Short-sellers that have an impact on market prices are a specialized breed of investor. They work to discover negative information. They work to discover when stock prices are over-valuing a company's stock. They then borrow stock and sell it. By the usual market processes of price discovery, which are noisy and subject to volatility, that negative information may then get impounded in prices, showing up as lower prices if the short-sellers are on target in their assessments. Enron stock, for example, was in a declining mode for some months before its ultimate crash.
Banning short-sales is a partial closure of the market. The SEC, it goes without saying, has no natural right to do this. Such violence is uncalled for in a society that values freedom. Our leaders are upholding something vastly different than liberty, namely, a despicable old boy network, and they and their pals are the old boys.
The immediate effect of the news of such a ban is that traders anticipate that the flow of negative information will be dampened for a while. That's one conclusion. There are some ways out, however. One can sell short in a synthetic way. One can write a call option and buy a put option. Will the SEC also stop all options trading in the 799 stocks? So far, they have not. Short sellers can trade by writing calls and buying puts. However, this approach may not work well if the option prices have also been impacted adversely. That is possible because the call buyers and put sellers on the other side of the trade may want to sell short in order to even up their positions. In short, the SEC has thrown a monkey wrench into the options markets as well. Another possibility is that the short selling will go offshore. This will be slowed down by the cartel of offshore regulators who follow the SEC leadership. The United Kingdom has done some short-selling banning of its own.
If traders think that the negative news won't be developed and get into stock prices for a while, they will bid up prices. The existing short sellers then have an incentive to cover their short sales pronto. These two sets of buyers will tend to drive prices higher. We get a sharp short-covering bear market rally, induced by the SEC.
This causes great volatility in the market as prices jump sharply and later fall back. Since prices are rising above their equilibrium values, the odds are they will fall back. Those who hold the stocks long are given a chance to sell out, so that even without short-selling, a counteracting price pressure arises.
The short-selling ban no doubt results in some net price gain for a while. This means the SEC has succeeded in preventing the markets from reaching equilibrium for a while. When that period is slated to come to an end and short-selling is expected to resume, those who hold the stock long have a second chance to sell out and front-run short-sellers. They are merely selling stock they already own, so they do not violate the short-selling ban. The SEC hasn't gone that far yet as to close down the markets entirely.
The SEC ban changes the expectations of short-sellers. They now do not know when another such ban might occur. They face greater risk. They have a reduced incentive to investigate to find negative information and get it impounded into prices. They have a reduced incentive to sell short, even after the ban is lifted. They have an increased incentive to sell their research to companies that ordinarily hold long positions. But this avenue is not particularly attractive.
The result is that the SEC has reduced the market's efficiency. Stocks can go along at overpriced levels for longer periods of time, and then, wham, the bad news comes out in one lump sum, at which point the volatility rises sharply as the price collapses. This means that investors at large cannot be as sure as they once were that prices accurately reflect available information, especially negative information. They will require higher returns to compensate them for that added risk. They will also require higher returns to compensate for the added risk of regulatory interruption and interference in the stock market.
Meanwhile, will the SEC ban on short sales actually prevent the prices from attaining their equilibrium values at some point in the future? This is highly unlikely. It may take longer, but the market will learn how badly off these financial institutions are. For many of them, it knows already and the prices are now trading at artificially high levels.
The SEC is another New Deal monstrosity like Fannie Mae. In 1982, Roberta Karmel, who was an SEC commissioner, published Regulation by Prosecution.
Karmel, who was a Democrat, heavily criticized the SEC. In a paper that I published in 1990, I summarized her criticisms as follows:
- The SEC has a prosecutorial and legalistic orientation that conflicts with regulation designed to encourage commerce and business.
- The SEC has been unwilling to articulate clear law enforcement standards.
- The incentive structure of the SEC is perverse. It rewards the making of new rules and new enforcement work that are unwarranted.
- The SEC has displayed "historical intransigence in refusing to accept exemptions from registration as a legitimate part of the scheme of the federal securities laws."
- The SEC has opposed needed reforms in order to maintain its own freedom of action to expand securities regulation.
- The SEC has over-regulated the investment company industry.
- The agency structure shifts the focus of regulation from its center (the Legislature) to an agency that by itself is unable to accommodate major regulatory changes. Government becomes slower and less accountable to the needs of the electorate.
- The SEC has a tendency to be on the side of increased disclosure and to serve the constituencies who benefit from it.
- The SEC has stifled creativity and innovation in corporate disclosure.
- The SEC has displayed inattention and ignorance of the effects of its regulatory actions on small business capital formation.
- The SEC has imposed slow and burdensome review procedures for filings to raise capital on small business.
- There has been a serious curtailment of the private placement market through attention to legal positions rather than the economic impacts of policies on enterprises.
- There has been an unnecessary prevention of sales of letter stock (unregistered offerings of stocks already possessing a secondary market.)
- There has been too high a degree of restriction against new issues at the expense of eliminating the possibility of new ventures.
- The SEC has generated slow and uninformed treatment of companies in bankruptcy proceedings.
- The SEC shows a tendency to protect all investors against their own greed regardless of the cost.
- The SEC has a tendency to act against capital formation.
In sum, the SEC, according to Karmel, was anti-business and especially anti-small business.
It is now 2008 and 26 years have passed. We can now add many more items to Commissioner Karmel's list. The SEC has greatly expanded its regulation on insider trading, on national market exchange systems, and on disclosure. It has even butted into the pricing of stocks in pennies rather than eighths.
Now we find it banning short sales so as to support stock prices. If the U.S. had a claim to standing above your everyday banana republic, it is fast abandoning that claim. Our government is fast turning into a joke manned by clowns who aren't even funny. Does anyone take what they are doing seriously?
September 20, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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