The Moral Hazard of Selling Short

17 May

If I bought a house for $200,000 and insured it for $1 million, that insurance policy would create a “moral hazard”.  I.e., the $1 million insurance policy against my $200,000 house being destroyed by fire would, in fact, provide an incentive for me to burn my house.  Why?  Because I could never hope to gain much more than $200,000 for selling the house, but I could instantly gain $1 million from burning it down.  A “moral hazard” is something done for a seemingly good reason (to protect against destruction by fire) that nevertheless creates an incentive to do wrong (cause the fire).

Gambling can create a moral hazard.  I.e., the object of gambling is to generate a monetary gain (a seemingly good reason) but the gambling process invites participants to cheat (a wrong).  When we gamble, we “bet” on the outcome of a future event.  If we play poker, each player “bets” some amount of money that by the time the hand is over, he alone will have the winning hand and will therefore “gain” all of the money in the pot.

The essential requirements for gambling are: 1) we bet (risk) something of value; 2) whether we gain or lose depends on some future event; 3) that future event has several possible outcomes which cannot be predicted at the time of the bet; 4) the actual outcome will be at least partially determined by random, unpredictable factors; 5) one or more opponents bet against us; and 6) the time when that future event will take place is fixed.

The problem with gambling is that, while the contest is supposedly based primarily on random chance, gambling is always about predicting the future.  As a result, there is a time delay between the moment when a bet/prediction is made, and the moment when the predicted event actually takes place.  That “delay” provides opportunity for the cunning to influence or even control the seemingly “random” outcome of the future event.

Simply put, gambling on future events creates both an incentive and opportunity for opponents to cheat and “fix” the game.  Gambling on future events thus creates a moral hazard—an incentive to violate the “rules of the game” and do wrong now in order to insure a later gain.

Classical devices used to influence or control future events are marked cards, loaded dice, roulette wheels with magnets to control where the ball lands—and short sales in the futures markets.

Investments—Going “long”

If I buy IBM stock, I gamble/risk my wealth based on my belief that the price of IBM is going up.  When I bet the price of stock is going up, I’m “going long”.   If I bet right, I win and gain a profit.  If I’m wrong, I lose some of my investment.

But whether I win or lose depends on my patience.  When I invest (go long), I control the time period between the date when I buy the stock and the date of the “future event” when I sell that stock.  Today, I might invest in a stock worth $50 per share that will be worth only $40 a share next December.  If I agree to sell next December, I will lose $10/share.  But if I hang onto the stock and don’t sell until the following April when the stock sells for $60/share, I’ll have generated a $10/share profit.  If I hold a stock long enough, it’s likely to at least generate a nominal profit.

In traditional investments (going long), there’s no opponent who has a direct interest in seeing the investor lose.  If I “invest” (go long) in IBM stock, my investment generates no identifiable opponents who are also competing to win the same money I’ve invested in IBM.  No one has a personal incentive to see me lose.  More, because I control the timing of the final sale of my stock, I almost can’t lose unless I consent to do so by agreeing to sell at a loss.   There is virtually no moral hazard (incentive to do wrong) in “going long”.

Ideally, traditional investing is a win-win situation.  When I risk/invest my money in a corporation’s stock, the corporation “wins” by using my money to buy needed equipment to generate more profits and those increased profits cause the value of my stock to rise.  The corporation wins and I win. Win-win.

Even the community at large tends to win if I invest wisely.  I.e., if my investment causes IBM to generate more profits, some of those profits will help to enrich IBM employees in the form of higher wages and then “trickle down” into the general community in the form of increased purchases of cars, computers and flat-screen TVs.  Ideally, everyone can win based on wise investments.

Futures—going “short”

Wikipedia describes “short selling” as:

“. . . the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from [bets on] a decline in the price of the asset between the time of sale and the time of repurchase, as the seller will pay less to buy the assets in future than the seller received on selling them.”

“Shorting” works like this:  If you believe the future price of a security will go down, you can go “short” (bet) and ostensibly sell stock you don’t own at today’s price to some purported buyer (who is betting that the price of the stock will go up).  For a commission, your broker will “effectively borrow” shares from another client’s account or from the broker’s own account, and then “effectively lend” those shares to you to sell short to the new “buyer”. It’s all done with smoke and mirrors; no stock certificates are issued, no paper changes hands, no lender is identified by name.  A short sale is as much a pure bookkeeping entry as making book on the next horse race at Santa Anita.

Every futures trade is a “bet” wherein one party bets that the price of a stock or commodity will be up on some future date and another party bets the price on that date will be down.  There are always two parties to the future’s “bet”.  One party normally goes “short” by selling stock he borrows—but doesn’t actually own.

Right there—in selling something you don’t actually own—you can see that there’s something shady going on in short sales.  How th’ Hell can anyone “sell” something they don’t actually own?  If I contracted with a third party to sell him your house, wouldn’t that be a criminal act?

Well, Wall Street explains that short sales in the futures market are kosher because the seller first borrows the stock before he sells it.

Really?  OK—so suppose you loaned me your car to drive to town to buy some milk.  Would that loan entitle me to sell your car?  No.  Nevertheless, when it comes to futures trading, it’s legal to sell that which you don’t own. (Do you need a PhD in economics or philosophy to see that there’s something very suspicious about selling short?)

Every short sale results in a win-loss.  One party wins; the other loses.  Both futures trading and shooting craps create identical moral hazards.  Unlike investing (which creates no identifiable opponent), the opposing bettors in short selling have an incentive and opportunity to cheat by fixing the seemingly unpredictable future event.

Increasing the Supply

When someone “shorts” (sells) a security he doesn’t actually own, the apparent supply of that security is seemingly increased.  According to Art Kamlet:

“When you short a stock you’re essentially creating a new shareholder. The person from whom the broker borrowed the shares on the short seller’s behalf justifiably considers himself to be the true shareholder. The person who bought the shares from the short seller (borrower) also considers himself to be the true shareholder. But what happens with the dividend and the corporation vote? The corporation surely won’t pay out dividends to both of these purported shareholders, nor will it let both of them vote.”

More, shorting not only “creates a new shareholder,” it also creates the appearance of new stock.  That is, if an actual stock owner had 100 shares and a new borrower/short-seller also claimed to have sold the same 100 shares to a “new shareholder,” the market might seemingly reflect the presence of 200 shares rather than the actual 100.  Think about that.  Shorting could falsely increase the apparent supply of whatever security was being “shorted”.

If “shorting” increased the apparent number of shares available then, under the rules of Supply & Demand, shorting could, all by itself, tend to increase the apparent supply of shares and thereby tend to reduce their price.  If so, “shorting” would tend to be self-fulfilling in that the more a particular security was shorted, the more its apparent supply would increase, and the faster the security’s price might fall.  Thus, shorting might not simply constitute an innocent “bet” that the price of a security would fall; shorting might actually cause the price to fall.

This possibility is consistent with the claims by GATA (Gold Anti-Trust Action Committee) that the gold futures markets have been manipulated for over a decade—primarily by means of short sales.  Major financial institutions that “short” gold are purportedly selling gold that they don’t actually own and may not even exist.  These sales are nothing but bookkeeping entries.  By means of short sales of non-existent gold, these financial institutions are increasing the apparent supply of gold and thereby suppressing gold’s price.

Thus, short sales don’t merely create an incentive for “moral hazard,” they are a “moral hazard” in that they tend to improperly influence and “fix” the future events on which people are “betting”.  I.e., the more a particular security is shorted, the lower its price should go.

The fact that the price of gold has continued to rise despite massive shorting is testimony to the massive demand for gold.  If the shorting ever stops, the price of gold should skyrocket.

Ted Butler estimates that the current net short position on gold is probably over 30 million ounces . . . of which at least 90% is held by the ‘8 or less’ bullion banks (the manipulators).  Let’s suppose that 2/3rds of those 30 million ounces are non-existent, short-sale, “paper” gold.  What would happen to the global price of gold if it were admitted that the current supply is overstated by 20 million ounces?  And there’s a real chance that 90% of those 30 million ounces are mere “paper” (non-existent, fictional) gold.

What do you suppose will happen to the price of gold if the world discovers that the reported supply has been hugely exaggerated by means of short sales?  A: The price should skyrocket.

Conspiracy Theories

Gold isn’t the only investment that’s been subjected to the moral hazard of selling short.  Short sale conspiracy theories are numerous and sometimes horrific:

•  After the 911 attacks on the World Trade Center, it was reported that some unidentified persons made enormous short sales of airline stocks just days before the attacks.  These reports imply that some very wealthy individuals or institutions had advance knowledge that the 911 attacks were going to take place and sought to profit from those attacks with short sales.  Thus, short sales can create an incentive to not merely fix the markets directly, but also to cause bloody external events that would indirectly influence or “fix” the markets.

•  “Derivatives” are nothing but bets.  When you hold a derivative, you hold no interest in the actual stock, currency, or house that’s trading up or down.  In terms of mortgage derivatives, investors are simply “betting” on whether mortgagors will or will not make their mortgage payments.  If you “short” a mortgage derivative, you’re betting that the mortgagor will not make his mortgage payments.   The current economic crisis was precipitated by price declines of “derivatives” based on sub-prime mortgages.  Note that those who shorted mortgage derivatives had an incentive (profit) to cause sub-prime borrowers to default.   Given that incentive and the enormous amount of money involved, it’s conceivable that the sub-prime mortgage crisis didn’t simply “happen,” but may have been precipitated (and perhaps even designed) in order to fail and generate huge profits though short sales.

•  Goldman Sachs reportedly created and sold derivatives based on the Greek government’s debt—and also “shorted” those same derivatives to apparently ensure those derivative failed.  If so, Goldman created and sold a product that was designed to fail in order to profit by shorting derivatives they knew would fail—or that they knew could be caused to fail.

•  It’s rumored couple of days before the British Petroleum offshore drilling platform exploded in the Gulf of Mexico,  “Fab” Fabrice Tourre (the only Goldman Sachs executive expressly named in the earlier SEC indictment) emailed his girl friend to say he’d shorted oil industry stock and if anything adverse happened in the Gulf he’d become even more “fabulously” wealthy.  Implication:  the opportunity to “short” oil stocks may have created an incentive to cause the still unexplained industrial and environmental catastrophe.

The Game is Rigged

Selling short creates a moral hazard—an incentive to do wrong.  Selling short provides an opportunity to manipulate markets and an incentive to precipitate tragedies.

So long as short selling exists, you can bet the futures markets are rigged and shouldn’t be relied on except to reveal long term trends.  The price of gold might vary by $200 this month.  It might be up $50 this morning and down $20 this afternoon.  So what?  Given the moral hazard inherent in futures trading, it’s virtually certain that those markets are at least strongly influenced (fixed) in the short run.

But over the long run, the influence wanes, fundamentals control and the truth will (eventually) out.  If you want to follow the futures market results don’t bother with the daily, weekly or even monthly changes.  Look to trends that are quarterly, yearly or longer.

Despite a decade of short sale manipulation, the price of gold has been up about 17% a year for that decade.  Now, there’s a trend you can believe in.

At arm’s length and within The United States of America,

Alfred Adask


Posted by on May 17, 2010 in Economy, Moral Hazard, Short Selling


4 responses to “The Moral Hazard of Selling Short

  1. Tony

    May 17, 2010 at 12:43 PM

    Thanks for the information, Al.

    One thing that really hits me (besides all the craziness about effectively creating shares of stuck that don’t really exist) is the insanity around permitting investment in failure.

    What kind of countries/economic systems would allow types of investment that profit from failure? The morality implicit in that is bleak.

    Not that I needed any more evidence of the present moral state of things!

    Thanks again…


  2. Charles Torello

    June 1, 2010 at 2:04 PM

    In a short sale, there is still a buyer, no? In the gold markets, where it seems very likely there are huge supplies of paper gold, who is the one still buying such? And, are the banks and nations of the world oblivious to this racket? Why is there not more of a furor (or is there a furor?) about demanding actual physical possession of the gold?

    • adask

      June 1, 2010 at 2:19 PM

      The “world” does not complain because:
      1) Up until recently, people (other than “gold bugs”) were making “money” (actually, “legal tender”) off the paper-gold racket. Treason doth never prosper, for if it prosper, none dare call it treason.
      2) The system has depended and relied on the ILLUSION created by short sales of non-existent gold to hold down the price of gold and thereby support the apparent value of the paper dollar.
      But–the world is changing. People are started to demand actual delivery of the gold promised in the short sales rather than merely accept a check. Short sales (of gold, at least) are bound to diminish dramatically. As they do, the price of gold should start to rise with more energy and velocity.
      The system is beginning to crack.


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