Many casual stock market observers know only one thing about the practice of short-selling: It’s a bet that a particular stock will soon decline in value. To bet in favor of someone else’s bad fortune carries a nefarious ring for many people. But there is nothing illegal about short-selling — at least in the United States. That phrase has been repeated frequently in the days since the Securities and Exchange Commission announced that it would impose at least temporary restrictions on certain methods of shorting the stock of 19 key financial institutions, including the government-sponsored mortgage firms, Fannie Mae and Freddie Mac. The rules were introduced after short-sellers were said to have helped drive down the shares of those and other major financial institutions. Knowledge at Wharton asked Wharton finance professors Marshall Blume and Franklin Allen to talk about these issues.

An edited transcript of the conversation appears below.

Knowledge at Wharton: Could you describe for us the mechanics of short selling?

Blume: Short selling is a very simple procedure. Normally, when you buy a stock, let’s say you buy it at $50; you make money if the stock goes up and you lose money if the stock goes down. So, if the stock goes from $50 to $60, you make $10. If it goes from $50 to $40, you lose $10. Well, a short sell reverses that. If the stock goes from $50 to $60, you lose $10 and visa versa — if it goes down, you make money.

Now, how does this work? It’s not really a very complicated process. Let’s say there’s a $50 stock and I think that it is going to go down to $40. What I do is, I borrow the stock from somebody and then I sell it. When I sell it, I have $50 in the bank; the stock then falls to $40, I buy it back at $40, give the stock back to the person from whom I borrowed it. And, that person still has one share, but I am $10 ahead [$50 less the $40]. 

Now, it’s important to realize that there are many other ways to make money when stocks go down. You can buy “puts.” I can buy a put at $50; and a put at $50 allows me to put the stock to the writer of the put, at any time, within say, three to six months or longer, depending upon the put. If the price goes down now to $40, I buy it at $40 and I put the stock to the writer of the put and make $10 — he’ll give me $50 and I just paid $40.

There are other ways too. For instance, I could do what is called a “swap.” A swap is basically, I swap my one return for another return. So, what I do is I say to a broker “I want to enter into a swap contract.” And, if the price goes down, they will pay me the amount that it goes down. If the price goes up, I will have to pay them. Now, of course, I have to give them something for this and it’s usually a short-term interest rate, plus a premium. And, there are many other ways to short stocks. I think that we lose focus when we say that we only can short stock by borrowing shares.

Knowledge at Wharton: The SEC’s new rules focus on the first of those – the borrowing of shares. Specifically, it prohibits what are known as “naked shorts” on the shares of those 19 firms. Can you tell us a little bit about naked shorts?

Blume: A naked short is sort of a pejorative term. A naked short means that I sell a stock and I don’t borrow it first. Now, if I do this within a day, there’s no real problem because I short the stock and then I buy it back — and there’s a “netting” — so I never have to deliver the stock.

What the SEC rule has said is, even if I want to short it for a day; I’ve got to borrow the stock first and then sell it — and then buy it back. Now, when you have liquid stocks – that’s not really a major concern; it’s very easy to borrow liquid stocks. When a stock is in short supply, then it’s hard; but here it’s just going to increase your transaction cost a little bit, to go short.

Knowledge at Wharton: As in any market bet there are upsides and downsides for short sellers. But, are there not also upsides and downsides for the companies that are the subjects of their bets?

Allen: I think there is a question of manipulation underlying all of these concerns that people have about short selling. Particularly for small companies. They can have a big problem if people simply go out and short sell their shares and drive the price down. And, that’s an example of trade manipulation — where people wonder if there is some information that these people have — and so that can cause problems for the company, particularly if they’re not doing very well anyway.

Among the bigger companies, the real problem is what’s known as “information based manipulation.” This is where you circulate rumors about something negative about the company and hopefully… in terms of making money, hopefully drive its price down and then close out the short. Now, that’s illegal. But, it’s very difficult for the SEC to prosecute those kinds of cases. And, I think that that is the thing that the SEC is currently most concerned about. That was why it was made difficult, back in the 1930s, when the SEC was founded; because there was some evidence then of that kind of information based manipulation.

Blume: Franklin, what would you say to the following: A person has a negative view on the stock; they sell the stock short and, then they call up their friends and say “I had a negative view on this stock and sold it short.” And then the other people then sell it short; helping to drive the price down. Is that market manipulation?

Allen: Some people would call that a “Bear Raid” and in that case it would be illegal if they did this with the intention of driving the price down. So, I think one has to be very careful as to how exactly one does this. But, you are quite right Marshall, there are many cases where, if you have a negative view and you talk with your friends… then that’s quite legal to do that. And, I think that there is a very fine line between those. I think it is very difficult to draw these lines — as to what’s legal and what’s illegal — and it’s very difficult for the SEC to prosecute any clearly illegal actions.

Knowledge at Wharton: Some people have said that the downfall of Bear Sterns and the swoons of Freddie Mac and Fannie Mae have been attributable, at least in part, to the activities of short sellers. What do you think about that theory?

Blume: Well, I think that certainly there are some views that these companies were overpriced, correctly so and they drove the price down more rapidly then they would have otherwise; but they drove it to a price that was not inappropriate.

Knowledge at Wharton: What are the stakes for these broader markets in which these bets were placed?

Allen: I think that in general, the weight of the academic evidence is that it has a good affect because it helps price discovery and it helps information get into prices much more quickly than is the case in countries where for example, it’s illegal to short stocks. So, I think that by and large, it’s a very good thing.

In the case of these financial crises, it’s a little bit more delicate, I think because there is an issue if there is manipulation, as I say, it’s illegal but it’s very difficult to prosecute. But, if people can successfully circulate rumors which are blatantly untrue; they have the potential to make a lot of money from doing that and little chance of being caught and going to jail. But, they could seriously disrupt the financial system.

The classic example, at the moment is Lehman; the chairman of Lehman thinks there are people out there trying to do that and he’s very concerned about that. And, it may well be that they have serious problems and Lehman could, for example, be forced to be sold. And, some people believe that this is what happened with Bear Stearns… that really this was just a form of manipulation and of course the SEC is looking into that. So, I think that they do have to be careful and they do have to check into this potential breaking of the law. But, it’s a delicate issue; more delicate than in general, I would say.

Knowledge at Wharton: What benefits might accrue from the new regulations?

Allen: I think that it won’t have much affect, in terms of stopping short sells. It will raise the transactions costs a little bit, as Marshall was indicating earlier. But, I think that this is part of a wider campaign that the SEC is involved in; which is to send a signal to the markets that they are concerned about short selling. And, I think that this is one way of them doing that.

So, whether or not it affects directly, a part from the slight increase in short sales, I think that it’s more that they want to signal to the market that they are worried about this. I think that they will aggressively pursue some of the hedge funds. If they find any emails, which suggest that there were false rumors being circulated…

Blume: I agree totally.

Allen: and this is all part of that campaign.

Knowledge at Wharton: Do you see any unintended consequences?

Blume: I don’t see any unintended consequences of this elimination of naked shorts for a particular group of stocks. It’s a minor change in the rules.

Allen: I would agree with that, yes.