Potent Weapon for Mutual Destruction of Capital: Short Selling

March 23, 2010

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

March 22, 2010

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid and Richard J. Durbin

Honorable Chairman, House Oversight and Government Affairs Committee

Honorable Chairman, Financial Crisis Enquiry Commission

Sub:     Constitutional rules to run capital markets and to organize regulators[1]

Dear President Obama,

Violation of religious tenets is slated in the scripts as sin.  The notion of sins allowed self-governance of people in every religion.  But wisdom then dawned on “We the People,” to script a common set of tenets (Constitution) for self-governance by transcending race, religion, color or origin. The Constitution is now sacred, to be upheld by every citizen. 

Any transgression of the Constitution is a punishable crime, not simply an absolvable sin. Yet, rules adopted by government agencies have surreptitiously transgressed the Constitution that “We the People” recognize, if at all, only after losing the wherewithal needed to campaign for reform.  The transgressing Robber Barons by then control even the elected representatives of “We the People” to perpetuate a virtual dictatorship. 

This memo outlines some crucial rules for running the capital markets and organizing the government agencies, in order to restore the constitutional rights of “We the People.”

1.                 Make speculative short selling illegal

A short seller sells a stock he does not own and promises to deliver the stock to the buyer by borrowing the same from an existing owner.  If the price falls, the short seller can buy the stock at the lower price to return it to the lender.  The profit of the short seller is the difference between the selling price and the buying price.  If the security is not borrowed for delivery to the buyer, the short sale remains naked.  The Security and Exchange Commission (SEC) allows naked short sales for 3 days, does not penalize such naked positions for 13 days, and simply prohibits an increase in the naked positions if a broker-dealer fails to deliver in 13 days. 

1.1    Short selling amounts to unconstitutional usurpation of private property

An ordinary short seller can speculate and may lose or gain because he cannot control the price move.  But a mega short seller can strategically speculate by trading a very large number of shares of a stock to rig its price downward in order to profit from the falling price.  A mega short seller can be a bank or a private hedge fund run by a bank’s executives with easy access to federally insured deposits and FDIC guaranteed debts of the bank. 

Speculative short selling can significantly increase the supply and lower the price of a security.  This is unconstitutional because the true owners are forced to take an artificially lower value of their holdings than possible without the increased supply of the security triggered by short selling.  Speculative short selling thus amounts to surreptitious, unconstitutional usurpation of private property.  Creation of unauthorized shares through short selling also violates the prevailing company act. Speculative short selling should, therefore, be banned. 

1.2    Short selling triggers financial meltdowns, depressions and unemployment

Mega short selling can cause depressions, massive unemployment and even anarchy. 

For example, JP Morgan and Chase could follow the current SEC rule to short sell nearly one billion shares of Washington Mutual in 2008.   By massively increasing the supply of outstanding shares, without authorization by the Board of Directors of WaMu, JPM could (a) decimate the market price of WaMu common shares, (b) force the rating agencies to downgrade WaMu, (c) make it impossible for WaMu to raise more capital, (d) scare the FDIC to seize WaMu to transfer $300 billion of WaMu assets to JPM for $1.9 billion in a weekend, even if WaMu was solvent and well capitalized according to OTS and could have received TARP funds and discount funds from the Federal Reserve. 

The SEC imposed a ban on short selling of most financial firms except WaMu during those dark days.  This raises a question about whether the SEC is at the beck and call of mega short sellers, and whether it devises rules constitutionally to serve the best interest of “We the People.”     

Whether or not JPM did anything illegal under the current SEC regime is for the courts to determine.  The point is that the SEC rule on short selling is unconstitutional because it deprives thousands of legitimate owners of property (stocks, bonds and preferred stocks) of their possessions.  Such deprivation leads to unemployment and financial depression.  Unfair seizure of property leads to mistrust in banking, financial markets and governance.   

1.3    Short selling to control Congress and people

Mega short selling can facilitate a bank to use its FDIC guaranteed debt and federally insured deposits to take over or eliminate rival banks.   It can allow a few firms to take control of the economy, people and Congress, as happened during the Great Depression.  Short selling has exacerbated the Great Recession and can still lead the economy to Great Depression II. 

Short selling has made JPM too big to fail because of its massive outstanding short positions.

Will the taxpayers cover the huge short positions of tottering mega banks which cannot avail of fresh bailout funds under the newly proposed law?  

Elimination of rival firms through short selling may have pushed business entrepreneurs from USA to overseas.

1.4    Short selling destroys home mortgage market

Short selling could destroy the home mortgage debt market during the Great Recession. 

For example, a large bank like Goldman Sachs could buy the best rated mortgage debts from several mortgage banks to securitize as mortgage backed securities (MBS).  Goldman Sachs could then sell the MBS to other investors like Bear Stern and Merrill Lynch. 

JPM can then short sell massive quantities of the same category of MBS without being required to borrow the securities under the SEC rule.  The market could then have an artificially increased quantity of outstanding MBS.  This could drive down the MBS values at Bear Stern and Merrill Lynch, making these investment banks fall.  Such failures could scare the regulators and Congress to offer inducements in terms of billions of dollars of fresh taxpayer funds to rescue the failed investment banks. 

The mega short sellers could thus acquire the best rated mortgage loans cheaply by depriving the owners of Bear Sterns and Merrill Lynch.  Consolidation could then allow the short sellers to resort to predatory lending.   

Here is a numerical example.  Suppose that JPM acquires $100 mortgage loans, made to zero risk borrowers, at par.  JPM then creates mortgage backed securities (MBS) based on these loans, gets the MBS rated as AAA and then short sells the same at par to Bear Sterns.  This should be enticing to Bear Sterns because it buys the MBS at no premium.  Now JPM short sells another $100 of the same AAA-rated MBS to Merrill Lynch.  JPM thus makes $200 from the MBS sold to the two investment banks.  Neither Bear Sterns nor Merrill Lynch holds the original mortgage loans underlying the MBS.  Only JPM holds the original mortgage loans and receives annual payments (at say 6% per year) from the borrowers of those loans.  JPM has paid $100 to the mortgage borrowers, but makes $200 upfront from two investment banks or a net of $100 upfront.  JPM pays annually $12 to the investment banks and receives from the mortgage borrowers $6.  This amounts to a net annual payment of $6 by JPM. 

The short sale thus generates for JPM a net cash inflow of $100 upfront and a net annual cash outflow of $6.  This appears fair and unproblematic. 

But then JPM short sells the same AAA-rated MBS for $90 with a promise to make the same annual payment of $6 to other investors.  This looks unprofitable to JPM and attractive to buyers.  But it can be strategic for JPM and devastating to others including the economy.  The short sale at reduced price depresses the equity capital of both Bear Sterns and Merrill Lynch by 10% of all their MBS holdings. 

If Bear Sterns borrows from JPM to buy the MBS, it is doomed by JPM.  This is possible due to legality of short selling under the SEC rule. 

Speculative short selling thus allows JPM to take over Bear Sterns to control the mortgage market and unleash predatory lending.  Such developments during the Great Depression led the Congress to create Fannie Mae and Freddie Mac to contain predatory lending. 

Speculative short selling facilitates predatory lending.  The short selling rule of the SEC makes JPM’s actions in the above example legal.  But this rule is unconstitutional because it facilitates usurpation of (a) property that belongs to owners of Bear Sterns and (b) incomes of home mortgage holders through usurious interest rates that a consolidated bank can set predatorily. 

The name of JPM in the above example is incidental.  JPM can be replaced by any other bank in this example to arrive at the same conclusion that the SEC rule is unconstitutional and should be banned. 

1.5  Short selling destroys housing sector

Rampant speculative short selling devastated the economy during the Great Depression.  The SEC learnt nothing from it or is simply pretending ignorance.  Speculative short selling made the financial firms the most vulnerable during the Great Recession, as it did during the Great Depression.  The SEC went haywire during 2009 about short selling that it first banned selectively and then lifted. 

The academic studies based on data during the SEC ban and after the ban argue that speculative short selling does not increase price volatility.  But the SEC ban was not extended to all firms and it excluded financial firms like Washington Mutual.  The academic study obviously did not consider stock prices of specific companies like WaMu, Bear Sterns, Merrill Lynch and Lehman Brothers that had perished by the time SEC introduced its ban on short selling.  No study is necessary to establish that the stock prices of these firms were wildly swinging during 2008.  It was due to speculative short selling.  The short sellers can be formally established only by examining the confidential trading books of the market makers and clearing houses.

Speculators bought huge quantities of Credit Default Swaps (CDS)-which are put options on MBS-and simultaneously short sold MBS as well as other debt and equity securities issued by mortgage banks.  The led to a rapid decline in prices of mortgage bank securities.  It then prompted the rating agencies to lower their ratings.  Rating downgrades curtailed the availability of funds to many mortgage banks.  This destroyed the ability of mortgage banks to finance homes.  Many mortgage banks folded and home prices scaled down. 

The top rated home mortgage borrowers continue to pay their mortgage payments at higher rates of interests artificially set by the shenanigans of the banks and hedge funds.  These home owners cannot avail of the lower rates of interest on the new money created on their back by the Federal Reserve.  The new cheap funds injected to banks have perhaps gone to private hedge funds.  Many home owners with decimated prices of their homes are resorting to strategic defaults. 

It is so eerie that the replacement cost of many homes, as quoted by home insurers, is significantly higher (sometimes 200% more) than the assessed values based on declining prices caused by strategic defaults. 

Speculative short selling of MBS has thus exacerbated the home mortgage crisis.

1.6  Short selling destroys international relations

Speculative short selling led to bitter relations with China and Russia in 2008. 

A top strategist, advising the Chinese government, warned on September 5, 2008 about an end to the international financial system, if not end of the world, if the US government did not honor the tacitly guaranteed Fannie and Freddie debt.  China warned after worrying about the spurt in speculative short positions on Fannie and Freddie securities including common stock.  Speculative short selling thus pushed the U.S. to the brink of a financial war with China and Russia.  It then forced the Treasury Secretary to the White House bunker to push Fannie and Freddie into conservatorship.  The Federal Reserve had to swap the Chinese and Russian debt holdings for guaranteed deposits in the Federal Reserve Bank of New York for about $600 billion.

The speculative short sellers were the same banks who first short sold the taxpayers by originating subprime mortgage loans including liar loans and transferring the loans to Fannie and Freddie.  They then short sold Fannie and Freddie securities and lobbied for dismantling the GSEs, which were created to alleviate the woes of the Great Depression and were critical during the Great Recession. 

The speculative short selling was almost poised to create anarchy domestically through Great Depression II and internationally by straining relations with China and Russia. 

Every banking and nonbanking firm must have acted in its self interest while selling securities short.  The speculative short selling rule granted by the SEC appeared to help a bank boost its profits temporarily.  But mutual short selling of each other’s holdings forced most banks to their collective ruin and pushed the fate of a great nation to the brink of disaster.  Speculative short selling thus strikes the heart of the nation as well as society, in addition to causing unconstitutional plunder of hard earned savings of households.  After discovering its deadly force in 2001, I have articulated it in memos and papers since 2003 to plead with the Congress for a universal ban on speculative short selling.

1.7  Non-speculative short selling should remain legal

Short selling is not always speculative.  Non-speculative short selling does not artificially raise the supply of securities.  It is needed for hedging. 

For example, farmers short sell forward contracts at the time of plantation to deliver their crop at the time of harvest for a forward price set at the time of plantation.  Farmers will plant only if the forward price exceeds the cost of plantation and harvest.  If the forward price is less than the cost of production, the farmer will avoid plantation and avert the potential agony of becoming bankrupt. 

We have similar examples for exporters who need to short sell forward foreign exchange contracts to hedge their future foreign currency earnings. 

Oil exporting countries often short sell forward contracts to deliver crude oil to the importing countries. 

Portfolio managers often buy put options to hedge their portfolios.  Option specialists write (short sell) options and hedge their risk exposure by trading in the common stock on which the options are written.  This is necessary to run their brokerage business that earns them commission.  Short selling of securities for such hedging is non-speculative and should not be banned. 

Non-speculative short selling is needed to protect/hedge basic business operations.  Non-speculative short selling does not artificially increase the supply of securities because the short positions are usually covered. 

2.                 Form Government Agency to Clear Markets

The market clearing institution is a network though which millions of trades crisscross to effect transfers from sellers to buyers. It is like the network of highways through which hundreds of cars ply from various origins to their destinations.  If the network of highways is controlled privately, there will be so much robbery that the government will be unable to control.  The market clearing houses (for all securities) must be brought under the domain of a new government clearing house to monitor rampant short selling by the current private clearing houses.     

3.                  Enact Safe Banking Policy

Safe Banking Policy was discussed in detail in my memo of March 7, 2010, with minimum capital requirements for both Safe Banks and Universal Banks.[2]  The Safe Banking policy will automatically avoid lending of taxpayer insured deposits to private hedge funds and contain the huge short selling activity in the capital markets.  This policy will amount to an elimination of current system of deposit insurance, which is the main source of moral hazard instituted by the Robber Barons during the Great Depression after people lost their trust in the banks and chose to keep their cash under the pillows and to hold gold as investments.  The Robber Barons feared for their own survival without the support of the indebted people who were the source of the accumulated (wealth) credit of the Barons.    

4.                  Consolidate regulators 

In a Safe Banking Policy regime, bank regulators will have limited roles due to unneeded interference in banks. 

The bank regulators from the current FDIC should merge with their counterparts from the OCC, OTS and Federal Reserve Board and the nonbank regulators of SEC and CFTC.  This will consolidate all the bank and nonbank regulators into a single agency to effectively coordinate monitoring of all firms for their (i) accounting statements, (ii) security and derivative trades, and (iii) mutually annihilating speculative short selling of each other’s securities. 

Without a consolidated regulatory agency, any coordinated authoritative analysis and monitoring will be impossible.  The currently floated idea of a consortium of the current regulators-who have badly failed to perform their duties by willy-nilly pandering to the wishes of the firms they regulated and thus caused the Great Recession-is bound to fail because it defies the first principle of management, which advocates that one can discharge one’s responsibility only by having the authority to do so.  The consortium idea cannot duly vest the absolute authority in the Treasury Department, over the currently independent regulators, to make it responsible or answerable to the Congress and people of the U.S.  If such absolute authority is vested in the Treasury Department, it will be the effectively consolidated regulator that I am proposing.    

The Treasury Department should obviously be the consolidated regulator answerable to the President and Congress.  The constitutional system of U.S. behooves the elected leaders, not appointed regulators or bureaucrats, to be answerable to the people.   

5.                 Restructure Responsibility of the Federal Reserve Board

The Federal Reserve should remain responsible for monetary policy and other policies to (a) enhance national competitiveness, (b) raise the value of dollar, (c) reduce the cost of capital for businesses and households, (d) preserve the free market economy with the least possible interference of the government in businesses, (f) maintain low price volatility in commodities, assets and financial securities, and (e) measure and enhance prosperity of American households.   

Growth in net assets is a measure of prosperity that appears to be the common longing of “We the People.”  Federal Reserve’s research and policy should be consistent with the common longing of people.  This will ensure consistency with the goals of the newly proposed Consumer Finance Oversight Agency. 

All the voting governors of the Federal Reserve should be nominated by the President and confirmed by the Congress. 

6.                  Ban running of hedge funds by the CEOs and Directors of banks

          and mutual fund companies or by their proxy relatives

This is necessary to avert unconstitutional usurpation of savings of mutual fund investors, to reinforce trust in mutual fund investment and in capital markets.  Such trust is necessary to enhance prosperity and stability of “We the People.”

7.                  Make shareholders’ say on bank and nonbank executive pays and

perquisites binding

This is necessary to align executives’ interests with the long term value and survival of firms.  This is necessary to enhance prosperity of investors and to preserve stable jobs for households.  

8.                 Concluding Arguments

The concluding argument can be made with a question:

How many Americans will vote for a system that guarantees the best health care, the best food and the best housing as long as they live, but with a condition that they will have nothing left to bequeath to their posterity? 

The answer is that no American will vote for such a system because it amounts to a sophisticated form of slavery that transcends race, color, religion and origin. 

We have abandoned slavery, legislatively.  But the dramatic rise in the percent of people with little savings proves that our system fosters slavery in a sophisticated way, despite the legislations.  It is due to the pre-Civil War capital market rules and practices that have continued thus far.  These rules facilitate usurpation of most of the savings of the vast majority by those who control the repertoires of American wealth-the banks, brokerages and clearing houses. This is why most Americans (rich and poor alike) want to reform the rules governing banks and capital markets. 

The Americans know that the repertoires of their hard earned savings are continually being looted via the existing rules of governance.  They saw in you the integrity needed to reform these rules.  They tilted overwhelmingly towards you when the capital markets crashed in 2008.  Their support swung with the market crash, indicating that they expected you to reform banks and capital markets.  They developed some skepticism when they did not see your administration accord priority to their wishes.  They then rendered upset losses to your party in Virginia, New Jersey and Massachusetts.

The debate on protecting consumers is moot because every American is a capitalist entrepreneur who does not relish mercy, like the Great Depression era doles of breads after losing job and hard-earned savings due to the unconstitutional rules.  Scientists have found that obesity increases with stress.  The source of American stress is their fear of unexpected loss in their employment and hard earned savings.

The bankers and hedge funds are now locked in mutually opposing short and long positions in financial securities, which are like financial bombs aimed at annihilating capitals of each other.  Banks have lent the taxpayer insured funds to private hedge funds and are squeezing the latter for margin debt collection.  Hedge funds have won or lost depending on their relationship with banks vis-à-vis banks’ own private hedge funds run by bank executives.  The fortune of all these hedge funds depends on the ability of their banks to muster large taxpayer-insured deposits and government bailout. There was a fight among major banks to acquire deposits of Washington Mutual, Wachovia and many other failed banks.  The deposits are needed to fund their hedge funds. 

Vulnerable hedge funds include university endowments and pension plans.  So the rich, the mighty, and the genius are all scared.  Speculative short selling has risked everyone’s hard earned savings or the dignity of labor.  It is important that we secure the system from mutual destruction of the value of accumulated labor. 

Capital market reforms must enhance mutual trust.  This is possible only if we can preserve the accumulated value of labor stored in banks and capital markets through reformed rules of governance.

With profound regards,

Sankarshan Acharya



[1]The basic ideas of this memo are from my book “Prosperity: Optimal Governance, Banking, Capital Markets, Global Trade and Exchange Rate,” published by Citizens Publishing. 

[2] http://pro-prosperity.com/Mythology%20of%20Market%20Discipline%20Unraveled%20by%20Market%20Crash.html