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The Unsung Heroes of the Financial Crisis
Last year, as the collapse of the housing bubble was threatening to turn Wall Street into a pre-industrial economy, many leading financial commentators were blaming short-sellers for the meltdown. They argued that the fundamentals of the financial industry were essentially sound. The only problem was that evil short-sellers had teamed up to push the price of the stock of Bear Stearns, Fannie Mae, Freddie Mac, AIG and the rest into the toilet. In response this outcry, the Securities and Exchange Commission actually took steps to limit the shorting of financial stocks.
As should be very clear in retrospect, the problem was not the shorts. The problem was that the clowns who ran these institutions somehow failed to see the largest asset bubble in the history of the world. As a result, they made huge bets that went bad, and drove their companies into bankruptcy.
The shorters were actually performing a valuable public service in calling attention to the bad financial state of these companies. At a time when Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson were insisting that everything was fine, and the bond rating agencies were blessing every piece of crap in sight with an investment grade rating, the shorters were telling the public that all hell was about to break loose. And of course, they were right.
There has been insufficient appreciation of the positive role that shorters played in this story. They were the ones that effectively brought the speculative party to an end. By dumping bonds and buying up credit default swaps on the sick financial giants’ debt, in addition to shorting their stock, the shorters made it impossible for these companies to continue their reckless ways.
Of course the shorters were not trying to perform a public service. They were trying to make money. However, in pursuing profits, they did what the Fed failed to do: they brought the dangerous inflation of a housing bubble to an end.
This is important to understand because shorting continues to be held in disrepute even though last year’s shorters have been entirely vindicated by events. Shorting is often confused with stock manipulation – deliberately trading in a way to move the market.
Stock manipulation is illegal and should be punished, but there is no reason to believe that it is any more prevalent on the short side than the long side. In other words, there is no reason to believe that big traders use short selling any more frequently to manipulate stock prices than they use buying to manipulate stock prices. This is just superstition. And an over-valued stock price is no more desirable than an under-valued stock price. Traders inflating a stock’s price through manipulation are doing every bit as much harm as those who depress the stock price through short-side manipulation.
When it comes to the economics of shorting, it is not just the image of shorters that is at issue. Part of the story of the bank rescues engineered by the Bernanke, Paulson, Geithner crew is that they have made shorting sick financial giants a dangerous exercise. By using the taxpayers’ dollars to keep these behemoths afloat, they have made a bet against Citigroup, Goldman and the rest far more risky.
As a result of the bailouts, if a trader recognizes that Goldman has filled its books with bad bets or that J.P. Morgan stands to take a beating on commercial real estate, she may still not want to short the company’s stocks because of the risk that Bernanke and Geithner will hand them the cash needed to make up their losses. This is another aspect of the moral hazard problem created by the rescue. It helps to undermine one of the few market mechanisms that could prevent or at least limit another dangerous bubble.
When the collapse of Lehman put the country’s financial system on edge, the government had two concerns. One was to keep the financial system operating in order to limit damage to the economy. The other was to protect the interests of the major banks and their top management. The country had no reason to protect the wealth and power of this clique: these were the people who brought us this disaster.
Unfortunately, the Fed and Treasury focused on protecting the major banks. As a result, the banks are still run by people who are immensely wealthy and, if anything, they are probably better situated to promote speculative bubbles in the future. And the market forces that could in principle rein in speculative excesses, like short-selling, are weaker than ever.
DEAN BAKER is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy.