The UK’s Financial Services Authority (FSA) today announced certain types of short selling on financial institutions are banned. However, everybody seems to be taking it as granted that short selling is the cause of the current turmoil. How, exactly, is there a proposed connection between short selling and the collapse of a bank? How does repeatedly buying and selling shares actually cause the price to fall?
Surely the short sellers have good reason to believe that the price will fall, and absent collusion on their part, the price drop has more to do with the problems of the target bank, no? Otherwise, is it a trust issue? Other traders see people repeatedly selling shares, think “they must know something”, and then get in on it?
Further, central banks today “injected” $180bn of liquidity into the markets in a co-ordinated effort, funded by the Federal Reserve. What does it mean to “inject liquidity” into the market, in this sense?
I know next to nothing about what happens on the markets, heh.
I don’t know about the short-selling issue, but injecting liquidity generally means that investors (or in this case the Fed itself) loans a lot of money to troubled banks and traders, so they can cover their obligations and not go bankrupt. In exchange, the lenders demand a high level of control over the borrower, e.g. replacing management or securing the loan against a majority of the company’s assets.
The recent AIG calamity, for instance, involved the Federal Reserve providing a two-year $85 billion line of credit to AIG, at a rather high interest rate, secured by AIG shares.
BTW, here is an excellent post from the NY Times which explains the current crisis and bail-outs in detail, with very clear language. It’s a long post and I still need to re-read a couple parts to fully understand the whole thing, but it cleared up a great deal for me.
Yes, that’s a good post, but it still doesn’t address my question. Why does short selling reduce the price of a stock? Further, it’s my understanding that to short sell, the trader needs to borrow stock from a company for a fee (is this correct?). Given what was happening, why did people continue to loan out their stocks to short sellers? It’s my understanding that a load of companies started to refuse to loan shares to short sellers, but by then it was too late.
Supply and demand. If there’s more demand for short selling, it will become harder to short sell, as represented by the drop in the share price. (I’m sure it can be looked at from the point of view of the long holders, but it’s hurting my brain )
It’s my understanding that many small holders hold their stocks from their broker “in common”, which among other things lets their brokers loan out the shares, so the brokers technically are loaning out other people’s shares. They let the brokers do this because it makes it easier to buy and sell their shares if the broker has plenipotentiary power with them. I might be wrong about this (only saw it once in a column several years ago) but it always struck me as wrong that the broker gets the money for loaning out other people’s shares.
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