Financial regulation goes in cycles. Some event occurs in which an abusive practice apparently harms the public. The government creates new regulations to prevent similar harm in the future. But ingenious financial firms attempt end runs around the new regulations.
Or, memories of the original abuse fade with time and enforcement is abandoned. Then, during a new crisis the old problem rears its ugly head. There are widespread calls for renewal of abandoned regulation.
This is happening right now. The stock market crash of 1929 touched off the most traumatic economic downturn in U.S. history. Congress identified practices thought to have contributed to the crash and banned them. But decades without similar problems induced complacency. Now that financial markets are in disarray, there are loud calls to revive abandoned regulations.
In the aftermath of 1929, Congress identified “short selling” as a cause of catastrophic stock prices declines. Short selling involves borrowing a share of stock, selling it in the hope that the price of the stock will go down and it will be possible to buy the same stock at a lower price when the time to return the borrowed share comes due.
Short selling creates a group of investors hoping that stock prices fall. Allegedly, the selling of borrowed shares in itself depresses the price of the stock, creating a self-fulfilling prophecy.
The more prices fall, the more short sellers benefit and the more such selling takes place. Short sellers thus contribute to dramatic market collapses.
One congressional response to 1929 was to create the Securities and Exchange Commission to limit harmful practices on financial markets. In 1938, the SEC instituted the “uptick rule” limiting short selling. Short selling was still allowed, but it had to be disclosed and a short sale of borrowed stock could only take place when the price of a company’s shares had experienced at least a minor increase or “uptick” on the ticker-tape price reporting system then in use.
Requiring an uptick meant that if the price of shares in any certain company declined steadily, short sellers could not jump in to take advantage of the decline and ride the stock down. The piling-on effect of short sellers ganging up on a beleaguered stock the way lions pounce on a wildebeest became harder to orchestrate.
There is little interest in short selling during a long-term rising market, however, and in July 2007, the SEC dropped the uptick rule. Now there is a clamor of voices calling for its reinstatement. Abusive short selling is alleged to have played a role in the demise of Bear Stearns and in sharp drops in the price of Lehman Brothers’ stock.
There was a long debate among researchers about whether the rule actually had any practical bite while it was in effect. But if Lehman or another major financial firm requires a bailout and short selling occurred, expect its reinstatement. A century ago, Peter Finley Dunne, a humorous commentator on U.S. politics, noted that “the Supreme Court follows the illiction returns.” So does the SEC.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.