By Sebastian Mallaby
Monday, July 21, 2008
Until just recently, policymakers were doing well in the financial crisis. Congress passed a timely and well-crafted stimulus. Bear Stearns was rescued, averting market chaos. The Fed cut interest rates aggressively, reasonably fearing a collapse of the economy more than a collapse of the dollar.
But now Washington is losing it. The most vivid illustration comes from the Securities and Exchange Commission, which first failed to oversee the financial institutions under its purview -- and now wants to stop the markets from doing their part.
Starting today, the SEC is clamping down on short selling, which is a way for market watchdogs to telegraph trouble. Short sellers dig around in company balance sheets. When they come across a problem, they borrow shares in the offending company and sell them. This pushes down the share price, alerting others to trouble.
Short sellers have always been unpopular. Everyone likes optimists; pessimists tend to be despised. People who think companies are undervalued, buy their stock and then make speeches on their terrific prospects may be inflating a dangerous bubble -- but they are just being red-blooded Americans. On the other hand, people who think a company is overvalued, short its stock and publicly explain their reasons may be preventing a bubble from inflating -- but they are rumor-mongers and conspirators.
Needless to say, this double standard is dumb. Despite popular myth, the strength of the American economy does not lie in boundless optimism. It lies in optimism spiked with honesty. Optimism drives entrepreneurs to start new companies. Honesty allows venture capitalists to filter out crackpots. Economies need a balance of boosters and skeptics to be healthy. When the boosters take over, you get frauds like Enron, farces like the dot-com bubble and tragedies like families who can't afford their home payments.
When the mortgage bubble burst last summer, there was much earnest speechifying on how not to be Japan. The Japanese, you will remember, reacted to their property bust by throwing honesty out the window. Banks didn't own up to the full extent of their losses, and the government propped up stock prices. The result was that Japan's recovery was a decade in coming. The United States, it was argued, would be altogether more forthright. Banks would acknowledge problems, fix them and move on.
One year later, the Japanese urge is growing strong. For perfectly sound reasons, the economy is not yet out of the woods: Real estate prices are still falling, and years of reckless borrowing by finance companies and households still have to be worked off. But rather than be honest about these problems, people are pointing fingers at imagined villains.
The finger-pointing began with the Bear Stearns failure. Bear was sound, its boosters say; short sellers killed it off. Well, if traders did collude to drive down the stock price, they can and should be prosecuted. But without offering any evidence of collusion, the boss of J.P. Morgan stated recently on television, "This is even worse than insider trading. This is deliberate and malicious destruction of value and people's lives."
The finger-pointing continued with the near-failure of Lehman Brothers, another large investment bank. Lehman's boss brazenly declared in April that the firm had put the worst news behind it, and investors were lured into injecting fresh capital before Lehman fessed up to a huge loss. But Lehman's boss has gotten away with that because nobody objects to boosters. Instead there has been outrage about the short sellers who disputed Lehman's numbers -- and were right.
Now the finger-pointing has climaxed with Fannie Mae and Freddie Mac. The shares of those housing-finance companies plummeted two weeks ago for a very good reason: If you valued their books in a way that reflected the decline in house prices, they were worth about zero. Ah, but never mind such details. Blame the short sellers.
Enter the SEC chairman, Christopher Cox. Steamrolling his own staff and departing from prepared testimony to Congress last week, Cox declared that he would suspend "naked shorting" of 19 financial stocks. By this he meant that short sellers would have to borrow stocks before they sell them rather than when the sale is settled three days later.
It's true that naked shorting is a problem. If people sell stocks and then fail to deliver them to buyers, you are left with a mess. But the SEC issued a good rule three years ago to deal with that. Cox is ignoring his own agency's achievement and inventing a fictitious technical issue, all because he wants to be on the right side of the anti-short witch hunt.
Wall Street is already tense; it needs gratuitous disruption like a hole in the head. Cox's unconsidered populism has forced dealers to recode complex trading systems on virtually no notice. If the machinery misfires this week, we know whom to blame. But the really scary thing is what this promises for later. We are a long way from the end of this financial crisis. What will Washington do next?