Pros and Cons of Short Selling

http://www.washingtonpost.com/wp-dyn/content/article/2010/11/30/AR2010113007755.html?hpid=news-col-blog

Very insightful article by Richard Pearlstein, who is one of the better writer on the financial markets who is able to find a platform in the Washington Post. He used one of the more successful and more public spirited hedge fund operators for his analysis. He agrees that short selling can make some contributions but he points out several of the fallacies of short selling, and he raises the question raised in an earlier post by John Cassidy about the social value of certain financial markets, and especially about the relationship between that value and the outsized compensation of many participants.

Pearlstein agrees that shorts and longs are equivalent but he argues that shorts do not create value for the company that is sold short. He then asks, rhetorically, whether value creation is the purpose of markets.

He then describes how influential short sellers can impact a market by spreading negative information about firms that have been sold short. The information may be true or false but it can affect the market and produce large profits for the short seller in either case.

Some short sellers, especially of derivatives like credit default swaps, argue that they add liquidity to markets. Many believe that liquidity is good thing for markets. That is, the easier it is to sell an asset the better it is for the market. That is true to a point but supposedly liquid markets can dry up very quickly in panics. When everyone tries to sell an asset at the same time the number of sellers are greater than the number of buyers and the once liquid market freezes.

Pearlstein comes down particularly hard on the credit default swap (CDS) market. In this market one can make money by purchasing insurance against the default on an asset that one does not own. For example, if one believes that Greece will default on its sovereign debt one can purchase insurance against that default even if one does not hold a Greek bond. If the market comes to believe that the probability of default has increased for Greek bonds, the price of insurance against default increases and the holder of the CDS can earn a profit by selling CDS at the higher price. This is a sum zero game. For every winner there are an equal number of losers. Social value in sum zero games is nil. The billions of dollars wagered in this market produce no social value but the winners can earn billions of dollars. Moreover, the market for the side bets on CDS's distorts the market for the real asset since the change in CDS prices influences the prices that purchasers are willing to pay for the bonds. We have also learned that when the sentiment in a market changes the subsequent meltdown in the value of underlying asset will be magnified. The notional value of the CDS market is in trillions and many times larger than the market for bonds.