My Own Private IPO

I thought I would log in to say that I throroughly applaud the current crackdown on and investigation of the abuses of short selling (financial post). While the theory of short selling makes some sense. The sheer volume of shorts in this last year seem to indicate that there has been a fundamental transition in the role of shorts in the market.

A short is an interesting financial tool.

If an investor feels that a stock is way overvalued, they can sell shares of the stock. They then buy back the stock at a later date.

In theory this process can help reduce the high of artificial peaks by creating additional selling pressure. The buying back of shorts creates some buying value for the stock with the price is weak.

In the last several years, the market has seen a transformation in the thinking about shorts. Hedge funds have started taking extremely large short positions and holding the positions long term. As I understand the goal is to mitigate risks through complex derivative formulas. Regardless of the reason, the new style of shorting is simply creating a downward pressure.

When average Joe investor shorts a stock, they have to pay an interest fee on the stock they borrowed. This creates an incentive to buy back the stock. Hudge funds are both the payers and recipients of huge amounts of short interest. Imagine buying 100 shares of stock, borrowing the stock from yourself then shorting the stock. You pay interest to yourself, and the deal is a wash.

If a hedge fund takes a massive short position without the intention of buying back the stock, they are, in effect, issuing an IPO against another person's assets.

The new thinking about shorts (ie, holding shorts long term) has changed the dynamics of valuing assets. A company that would earn a 10x market capitalization might only get an 8x price per earning in a market where is is common for hedge funds to take a 20% short position on the stock of a healthy profitable company. This massive dilution of market capital dramatically diminishes the ability of companies to use the capitalization of the firm for future expansion.

Let's try a different angle at this. A short is a thing called a derivative. The value of a short is derived from the value of another security. A derivatives market can help in the process of valuing securities in the market.

The danger of a derivatives market happens when the derivatives themselves become the primary focus of the investors. Our hedge funds and insurance companies are doing programmatic trading designed to mitigate risk. This massive programmatic trading is divorcing securities from the underlying value and underlying risks. The market is in chaos because it has lost its ability to value assets.

When the tail weighs less than the dog, the tail can wag along and help the dog as it runs through fields. Once the tail weighs more than the dog, the K9 unit simply flops around on the ground, and the tail wags the dog.

Unfortunately, the free marketeers of the world have been arguing for unrestricted use of derivatives. My position is way out in left field. I recognize that if you want to have derivatives, the derivatives have to be regulated. My inner Libertarian tells me that a functional free market may not have derivatives at all.

There are many voices on the net at the moment denouncing the current efforts to regulate short selling. I realize that derivatives only exist because the derivatives are defined by a regulatory authority.