A Clear Announcement From Europe: “We Are Screwed.”

The European Parliament decided today to initiate a ban on short selling and selling of credit default swaps.  Their intention was to prevent the self-fulfilling prophesy of short selling from coming true.

Now, “naked” short-selling will be abolished, that is to say, hedge funds and the like will have to actually own the securities (like Italian sovereign debt or stock/debt from an Italian bank) to benefit from Italy’s financial demise.

For those of us that live above ground and are thus aware of Italy’s soaring bond yields, it’s easy to fear that Italy would follow the same downward spiral as Greece.  Things get dodgy, investors fear that the Greeks wouldn’t be able to pay back their debts.  They demand more for the risk, the price of borrowing goes up, and blammo.  It becomes even harder for Greece to pay up.

The Greek government, mind you, did it to themselves, but the shorts didn’t help.  That ban is intended to prevent that cycle, and at least salve the wound.

What this ban amounts to, however, is a giant kick me sign on the back.

Firstly, they just tried this medicine back in August, and it barely had a placebo effect. On August 12 of this year, France, Belgium, Italy, and Spain declared a temporary ban on short selling on financial stocks in an attempt to stop the daily terror on the markets.  What they got was generally a huge drop in trading volume on those stocks and a significant lack of liquidity.  Spanish and Italian financials outperformed the local indices, but the opposite happend for French and Belgian financials.

In the end, the ban made no difference whatsoever. This chart (via TABB Forum) compares the overal comparison of financials in several countries in late July (blue), the extremely volatile August 3-11 (red), and the period during the short selling ban (grey).

No discernible difference between the countries that had the short-selling ban and those that didn’t. The ban was like a bucket versus a wave against financials in every country. And again, the short selling ban didn’t leave French, Belgian, Spanish, or Italian financials any better off than their counterparts.

The US tried this in 2008 as well, and the SEC chief at the time, Christopher Cox, wishes that we hadn’t. After the fact he agreed that the short selling ban in the US sucked liquidity from the markets.  He told Reuters:


“If you know that you are doing everything you can to improve conditions for investors and markets … if you know that the team of professionals that is working on the mission is first-rate, that is ample comfort against what are sometimes hastily drawn conclusions by others.”

Good advice for the European parliament today.

Numerous academic papers on the US short-selling ban in 2008 conclude that the ban worsened intraday volatility,  robbed smaller companies of liquidity, and inflated the stocks of the companies that were rendered short-proof.

It must also further hurt the market’s confidence in the sovereign debt that it was supposed to protect.  This basically says ‘We can’t possibly think of anything that would dissuade investors from speculating on a pan-European default, so here are some rules.

Naked shorting with credit default swaps is like taking insurance on someone else’s house.  Nobody likes the guy that gets to do a victory lap when the creditworthiness of major European economies is reduced to junk.  But don’t shoot the messenger.  Short sellers can dull the spike on the upside and soften the blow when a bubble pops.  Shorts are usually the first ones to draw the market’s attention to some of the ballsiest rip-offs of all time (like Jim Chanos did for Enron.)

The Europeans can’t possibly be such poor students of history.  In all likelihood, they are doing this because, well, it looks like they are at least trying to do something.

(UPDATE:  Those bond yields, for Italy at least, actually got worse today.)


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