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The 'Naked' Truth -- Short sellers are unsung financial heroes

At the peak of the real estate boom, there was one group of individuals who said the bubble was about to pop. They pointed to overvalued land and bad underwriting of loans. And they bet their own money on their beliefs. Who are these unsung prophets of the subprime bust: the much-maligned short-sellers, whom both Britain, as Iain Murray reported yesterday, and now the U.S. Securities and Exchange Commission temporarily want to ban in an effort to keep the share price of financials from going further down.

On Thursday, John McCain foolishly called for the ouster of SEC Chairman Chris Cox because Cox hadn't cracked down on so-called "naked" short sellers and supposedly "kept in place trading rules that let speculators and hedge funds turn our markets into a casino."

McCain would have been on better ground asking for Cox's ouster based on his refusal to push for reform of the growth-killing and counterproductive Sarbanes-Oxley accounting mandates and for opposing CEI's lawsuit against the law's unconstitutional Public Company Accounting Oversight Board. The "naked" short-selling McCain was referring to -- which doesn't mean that someone is shorting a stock disrobed at their computer, but refers to when someone trades with shares that aren't there -- is already illegal. (Although the SEC steps recently taken to prevent it could have costly effects on broker-dealers who would have to redesign their computer systems. More on that in another blog post.)

But later that evening, Cox would apparently prove the even bigger fool by reportedly telling Congress that the SEC was going to temporarily ban all short selling! According to the Associated Press, "Cox told the lawmakers the SEC may put in a temporary emergency ban on all short-selling -- not just the aggressive forms it already has targeted, according to a person familiar with the matter. The ban might apply to stocks of selected financial companies, to all financial companies or even possibly to all public companies."

If ever there were a case "killing the messenger," this would be it. As a commentator on CNBC's "Fast Money," pointed out Thursday night, a successful short seller isn't someone who falsely shouts fire in a theater; it's instead the person who first notices the theater is on fire.

Yes short sellers reap great reward but they take great risk. Through a series of agreements, they borrow shares to sell and buy back and pocket the difference if the stock goes down. But if they're wrong and the price goes up, they have to "cover" and pay the difference. In the meantime, they are sending he market and the economy valuable signals about stocks that may be overvalued.

As James Surowiecki observes in his brilliant book, The Wisdom of Crowds, if the price of a stock “represents a weighted average of investors' judgments, it's more likely to be accurate if those investors aren't all cut from the same cloth”.

The real question policy makers should ask about shorts is why weren't there more of them during the subprime boom? If more fund managers had shorted, more investors would have profited or at least been able to hedge their risks. More importantly, the bubble would not likely have accelerated as fast as it did, because of the check shorts provide on irrational exuberence. As Surowiecki writes, a market with few shorts increases vastly the chances that if a price “gets out of whack, it will really get out of whack."

But as I noted in an article I wrote for the Economist.com debate on regulation, mutual funds for ordinary investors face more government restrictions on shorting than do hedge funds available only to the superwealthy. The justification is to protect ordinary folks from the risks of shorting, but in this case once again it is proved that protection from risk can lead to greater risks -- for individual investors and the system.

In fact, the European Union has been going in the right direction with its UCITS 3 (Undertaking for Collective Investments in Transferable Securities) directive greatly liberalises the ability of retail portfolio managers to utilise shorting strategies in funds for ordinary investors. The US should follow suit.

In the meantime, getting rid of the valuable and time-honored market mechanism of shorting will have little if any effect at restoring confidence. If the SEC says financial companies are so fragile that they need to protected from any negative feedback, why would anyone invest in them or loan them money in the first place?