Published November 5, 2009

Time to stop shooting the messenger

By OH BOON PING

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WHAT do you do when a messenger brings you bad news? You don't shoot him, because that is not going to change reality.

But that is precisely what some regulators have done when they try to artificially support market prices through measures such as a ban on naked shorts, said famed short-seller James Chanos at a hedge fund seminar last week. In the US, the authorities are now considering new rules to curb short-selling, while the Singapore Exchange now imposes penalties for naked short-selling of stocks.

In a short sale, an investor sells borrowed stock in anticipation of a price decline that will allow him to repurchase the shares at a lower price. But sceptics such as Mr Chanos have a point. Market participants typically go short on a stock if they believe that it is overvalued and the price will correct sooner or later.

Often, the victims are companies with weak fundamentals, or there are serious underlying problems in their business model. This can be seen in recent examples such as Bear Sterns and Lehman Brothers which saw their shares plunge after news broke of their heavy losses relating to the housing market.

In such cases, reason dictates that companies should try to clean up their books and regain market confidence with the help, if necessary, of the regulators. Only then will the share prices recover, while participants reverse their positions on the counters.

A ban on naked shorts or lowering the accounting bar so that companies can clear the hurdle does nothing to improve their fundamentals or restore investor confidence in the stocks.

True, critics may argue that just because a company is a target of short-sellers does not make it a fundamentally unsound business in the long run. But the fact remains that the short-term losses, as shown by the recent cases, are so severe that it is unlikely that stockholders would earn any cashflow from their investments for a very long time.

Therefore, from a valuation standpoint, the shares are nearly worthless, and the market prices merely reflect that reality. Not to mention that draconian measures by the regulators merely interfere with market efficiency.

In an efficient system, short selling helps to expose financial misconduct and align market prices with fundamental analysis. The role of a regulator should be to create a level playing field for all players in the financial industry and ensuring that they play by the rules.

Beyond that, any government intervention may distort market mechanisms, which cannot be beneficial in the long run. Fine, if there is market failure, but if the markets can get it wrong, what makes the authorities of any country think that they will get it right?

A third point concerns the effectiveness of such restrictions on naked shorts, since managers can in principle create a synthetic short via a series of option contracts.

As it is, over-the-counter markets are often less transparent than stock markets, and it is not clear if the authorities in every country can effectively enforce a ban on naked shorts.

Therefore, it is timely for stock exchanges around the world to rethink about this issue, especially when market conditions have stabilised while the world braces itself for an economic recovery next year or after.