Big Bad News Ban

We’d love for things to go well.  So we’d love people to think that things are going well.  So we want folks to hear news about how things are going well.  But sometimes people hear bad news, about how things are going bad.  Gee – why don’t we fix this by banning bad news?  Then people will only hear good things, and so only good things will happen, right?

This argument is transparently stupid to most everyone, at least when they think of “bad news” as appearing in newspapers or TV shows.  Sadly, that insight seems to disappear when it comes to financial bad news communicated via short sales.  Making for this bad news:

The [US] Securities and Exchange Commission enacted new restrictions on short selling on Wednesday aimed at restoring investor confidence by preventing speculators from pouncing on stocks already in a tailspin.

The rules, which were approved in a 3 to 2 party-line vote, come as the agency has faced intense pressure from lawmakers and investors to crack down on the practice, which some on Wall Street have blamed for crashing the stock values of major financial companies during the 2008 market crisis. …

The new restrictions, which will take eight months to put into effect, only affect stocks that have declined at least 10 percent since the previous day. At that point, short sellers essentially will have to pay a small premium to bet against a stock.

Anyone who believes that stocks which have fallen at least 10% in a day are an unappreciated good buy are free to grab that free money they think is lying on the sidewalk.  Clearly most folks don’t do this, and so don’t believe this, implying that short sales that push stock prices down on average give reliable bad news: this stock is worse than you thought.

Taxing short sales is an attempt to ban this bad news, to trick people into thinking those companies are doing better than they are.  After all, we all know that the financial crisis was not caused by banks making bad loans, it was caused by short sellers telling people that banks had made bad loans — if only we’d killed the messenger, we wouldn’t be in this mess, right?

Related posts.

Added 9p: A “self-fulfilling bad news” argument can apply to restaurant or movie reviews as well.  In fact, they can apply to most bad news.  For example, if a review says a restaurant is bad, fewer people go there, so they replace their expensive good chef with a cheap bad one, etc.  So should we band negative restaurant reviews?  Should we ban all bad news?

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  • bruce

    Do youi think Emmanual Todd is right about US financial statements being systematically ballyhooed?

    I mean, to where even the pros can’t see what’s relatively valuable.

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  • nazgulnarsil

    it depresses me that I knew what this post would be about from the title. I don’t see any indication that this idiocy is being immediately ridiculed for what it is by the right people. thus it will continue.

  • http://entitledtoanopinion.wordpress.com TGGP

    I think this post is also related, though perhaps to a lesser extent.

  • James Daniel Miller

    Former U.S. Treasury Secretary Henry Paulson in his new book On the Brink wrote how during the crisis some short sellers were trying to take down some of the big investment banks. He never explained the mechanism by which this could happen but I suspect this might have been possible if short sellers convinced enough hedge funds to suddenly withdraw their funds from an investment bank and so cause a “run on the bank”.

    Analogously, I bet you wouldn’t want someone to take out a big short position on your life even though the short position would provide you with information about your life expectancy.

  • Peter

    James,

    I’m about to get really technical and jargon-y here, so if you don’t know these terms…well you won’t understand this.

    The mechanism was called a bear raid, and it utilized the credit default swap (CDS) market to undermine a bank’s credibility. A hedge fund or group of funds would take a big short position against a bank, say, Lehman. Usually they were at least a couple billion short against the bank. Once they had established the position (usually over a longer timeframe), they would try to cause a run against Lehman via buying some CDS assurances.

    Let’s say a CDS against a Lehman mortgage-backed security (MBS) was going at 4% face value. The hedge fund would go to the CDS desk at somewhere like AIG and buy a small amount of insurance at above that rate. Say 6%. AIG would be happy to do the deal, since it looks like 2% of free profit to them. But then what happens is that every trader of bank stocks sees a little blip saying that insuring a Lehman MBS is now going at 6%. Repeat this a few times, and suddenly the “going” rate is like 20-30%. Now people start to worry, and sell shares, as well as precipitating a run against Lehman.

    The raiders don’t actually care if there’s a run against Lehman or not, they just want the share price to plummet. But the way they pushed it down did cause a run.

    • http://ahappinessexperiment.wordpress.com/ Bock

      Peter, I follow the theory but do we know this really happened? It has the ring of urban-financial-legend to it. However, if it is true, it sounds like Moldbug wins the debate.

  • http://timtyler.org/ Tim Tyler

    Shorting restrictions are not *really* bans on news! There are other communications channels beside share prices!

    • Buck Farmer

      No. But it’s basically a wage control on journalists.

      Before they could make a killing by reporting through the price mechanism…now they can only make a much smaller wage selling the story to CNBC.

      Net result…fewer stories? Accuracy?

  • http://hanson.gmu.edu Robin Hanson

    Tim, I didn’t say it was a ban on all forms of news. Even when governments forbid newspaper reports that put them in a negative light, they don’t necessarily ban verbal rumors to that effect.

    Peter, in such a scenario you could make the opposite transactions and make the bank look better, and profit while doing so, right?

    • http://timtyler.org/ Tim Tyler

      I think it is helpful to distinguish between “stock prices” and “news”. Stock prices are one thing, news is something else. Yes, stock price changes do sometimes carry some news-related signals, but to call them “news” seems to be rather misleading.

      In the case under discussion, taxing certain stock sales seems likely to prove extremely ineffective at preventing the spread of bad news – the actual news will spread pretty effectively in other channels.

  • Allen

    The market can stay irrational longer than you can stay solvent.

    It would seem to me that whether this extra tax is a good idea is entirely a function of whether it is true that bears were attempting to create a self-fulfilling prophecy.

    If they did in fact do what Peter says, then it seems that the extra tax is justified.

    At some point, making a counter-bet against the bears is no longer a bet on the fundamentals of the company being shorted, but instead a bet on the ability of the bears to fulfill their prophecy.

    Further, if the tax creates confidence among investors that the sort of manipulation alleged will not take place and thus increases their willingness to participate in financial markets, then maybe that good outweighs the loss of information?

    It would seem like the only way to answer the question would be to try it and see…since we don’t have a good model of human behavior to use in making predictions like this.

    • nazgulnarsil

      *At some point, making a counter-bet against the bears is no longer a bet on the fundamentals of the company being shorted, but instead a bet on the ability of the bears to fulfill their prophecy.*

      that’s how markets always work. you’re betting that the market is mispricing something, doesn’t matter what the mechanism is.

  • Buck Farmer

    I am upset to see this, but I’d be even more upset if I was in the hedge fund industry. The short-selling bans ruined them during the last quarter of 2008.

    Regarding Peter’s example:

    This looks like a case of illegal collusion among competing parties…i.e. the hedge funds get together and essentially fix the price of a security or its derivatives through explicit (but secret) policy.

    …or something actually was fundamentally wrong with Lehman and this mechanism incentivized people that knew or believed it to make that knowledge known through prices.

    If you think it is a pure case of price manipulation, I have to ask, “Why Lehman? Why not another company. Are the differentiating factors relevant to the price Lehman ‘should’ trade at?”

  • Grant

    To be fair, some people think bad financial news is a positive feedback loop which causes lower stock prices, more bad financial news, lower prices, etc. I’m not trying to defend bans on short selling, but I don’t think the newspaper or TV analogy is accurate.

    Oddly no one is advocating regulating prices which rise 10% or more in a day? I suppose prices tend to drop faster than they rise, but then the 10% point should just be reached less often.

    How could we test this empirically? The idea behind the ban is that shorting may produce more volatile price movement in the short or medium term, i.e. “the market can stay irrational longer than you can stay solvent”. Could we compare the volatility of two markets in an experiment, one which allows shorting and one which does not? Or maybe Vernon Smith has already done this?

  • http://hanson.gmu.edu Robin Hanson

    I just added to the post.

  • http://rationalmechanisms.com DWCrmcm

    The free market is a psychopath – gratuitously indifferent to anything but its own gain. Value has little to do with the stock market.
    The rise in wealth is a technological phenomenon. With the advance of technology unpredictability falls.
    I know little about economics but I like to think a I have rude grasp of complexity.
    The game has changed. Leverage is meaningless when the fulcrum becomes unhinged. When the fulcrum rolls around the relationship of the value at either end of the [url=http://rationalmechanisms.com/lexicon#chase]Chase©[/url] is meaningless.

  • http://entitledtoanopinion.wordpress.com TGGP

    Folks also want to restrict good news they disagree with.

  • http://www.rationalmechanisms.com Richard Silliker

    >implying that short sales that push stock prices down on average give reliable bad news:

    How do you know the news is reliable?

    • psych

      News is sometimes false, so therefore ban (bad) news?!?

      • http://www.rationalmechanisms.com Richard Silliker

        That does not answer my question. However, I will try to answer your question.

        I do not feel that any news should be banned. However There must be reciprocity.

  • Allen

    Actually, it seems like you are scare mongering with your melodramatic charge of a “ban” on bad news. The article says:

    “…short sellers essentially will have to pay a small premium to bet against a stock. They’ll have to pay a slightly higher price for transactions than investors who are simply looking to buy shares or sell shares they already own.”

    With the justification being:

    “officials are looking to assure investors that when stocks fall, they are not falling simply because of the tactics of sophisticated traders looking to make a quick buck, but because investors believe that the shares are worth less than they are priced.”

    It seems reasonable that if sophisticated traders are manipulating an aspect of the existing system to make money in ways that is harmful to companies and to people who invest in companies, and thus to the system itself…then the system should be adjusted.

    Further, the proposed fix seems quite modest. It isn’t a “ban”.

    I don’t see the problem, unless the charge that traders are actually doing this is false.

    Assuming traders are gaming the system, do you have a better fix? Or do you reject the premise that there is in fact manipulation?

    • Proper Dave

      I agree, “banning of bad news” puhleeze.
      At “worst” this is some (very mild) speculation tax.

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  • http://www.johnson.cornell.edu/faculty/profiles/bl Robert Bloomfield

    There are structural problems with short sales that go beyond their information content. First, short sales require margin trading, which can result in liquidity problems and related volatility. Second, people with short positions can have an incentive to reduce economic opportunities and growth.

    Both of these reasons have been invoked to justify the restrictions on short sales that are already in place. This change merely tweaks the details–it is not a ban, but more importantly the existing restrictions were already substantial.

  • Lo Statuz

    This may be an example of the slack Bryan Caplan talks about. People demand that the regulators do something, so they do as little as politically possible.

  • http://hanson.gmu.edu Robin Hanson

    Folks, the only way that selling short can hurt anything is by creating the impression that things are bad, i.e., by communicating bad news. But realize that any reporter who can get reward for reporting bad news has an incentive to create bad news by making things bad. Why ban bad news via short sales but not bad news via newspapers?

    • Tim Tyler

      Perhaps searching for “Black Tuesday: The World’s Largest Insider Trading Scam” might help here…?

  • Jeremy

    There are lots of ways short sales can hurt things, one obvious example is that they can create a problem where there isn’t one. A stock price is a sort of vote of confidence. A low stock price, caused or encouraged by shorts, could lead to a lack of financing options which could cause bankruptcy.

    I don’t understand why this is such a big deal to you though. Is there a new tax on buying puts, selling calls, or futures or options on futures? People that actually own the stock can drive down the price too.

    Also a tax is not a ban. A tax on short sales is not a tax or a ban on news.

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  • Chad

    The idea of “Bad News” has a greater implication here. I believe that the media doesn’t inform but instills fear into viewers. Most of the top stories are on death, destruction, financial hardships etc…

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