The Blame Game Part I: Short-Sellers are Witches

witch We’re now into the blame game, and it seems obvious that a major chunk of the blame for the current mini-round of the ongoing financial crisis is being accorded to short-sellers.

Tonight we are hearing about new disclosure rules for short-sellers, new bans on short-selling certain financial stocks in certain jurisdictions, strong pushing for a reinstatement of the uptick rule, John McCain saying deranged things about naked short-selling, and pretty much everything else short of suggesting that short-sellers be tossed into creeks to see if they float. I’m sure that’s coming, of course.

As an aside, my current favorite smart-aleck comment on the crackdown came just now on Twitter from my friend Dick Costolo:

SEC expanding short-selling restrictions to prohibit yelling within 20 yards of a ticker symbol & exercising puts w/out saying "simon says"

The trouble is, blaming short-sellers works, as does, at least sometimes, banning short-selling. First, short-sellers are easy targets — people who want things to go down, especially things that you own, must be bad people. Blaming them gives you political, financial, and rhetorical power.

Second, to the extent that people are keeping money out of the market because they are petrified of short-sellers, convincing them that less short-selling is going on (even if it isn’t) is an easy way to get more capital back into the market. Granted, nothing has changed, but it’s a fun superstition, sort of like sacrificing the odd virgin into a nearby volcano. Or tossing a supposed witch into a shallow creek.

The trouble is, of course, short-selling remains important. They are usually the best-informed traders in an issue, as repeated studies have shown. Their ability to bring prices in line is lost, or at least muted, and that can make subsequent price moves even more wild.

At the same time, you can still make money from stocks going down, even in those issues that have had short-selling banned. I can still buy puts, or write calls on stocks, both of which are bets the stock will go down. And if I don’t like options I can buy something like the UltraShort ProShares Financials ETF, which goes up (down) twice as much as the Dow Jones Financials Index goes down (up). Inside said index is, of course, Morgan Stanley (at a 1.2% weight), Goldman Sachs (at a 2.3% weight), etc. I’m shorting the stocks that I’m not allowed to. Ooooh! (And this does raise a sort of zen question: If shorting financial stocks is wrong, does it follow that shorting the UltraShort Financial ETF is good? Just curious.)

This moment too shall pass. Eventually volatility will fall, banks will deleverage or merge or fail, and we will see the requisite studies showing that short-selling wasn’t the problem, plus that market quality deteriorated in stocks in which short-selling was banned. It’s as predictable as the politicians piling on. Too bad no-one cares in the rush to be seen having found someone to blame.