Matt Taibbi's recent column criticizing Goldman Sachs' supposed failure to comply with short sale regulation rests upon the erroneous premise that naked short selling artificially depresses stock prices and thereby robs companies of growth opportunities and shareholders of wealth.
A naked short sale takes place when the short seller "fails to deliver" the shorted stock to the buyer because the seller did not borrow the shares in the first place. From Taibbi's perspective,
naked short-selling [is] a kind of high-finance counterfeiting that, especially prior to the introduction of new regulations in 2008, short-sellers could use to artificially depress the value of the stocks they’ve bet against.
Contrary to Taibbi's claim, however, there is virtually no evidence that naked short selling depresses stock prices, "artificially" or otherwise. Academic studies find that naked short sales do not cause price reductions and in fact are made in response to overvalued stocks.
Below are snippets from the abstracts of some recent academic studies:
- a 2009 study by Veljko Fotak, Vikas Raman, and Pradeep K. Yadav:
We empirically investigate the impact of naked short-selling on market quality, and find that naked shorting leads to significant reduction in positive pricing errors, the volatility of stock price returns, bid-ask spreads, and pricing error volatility. We study naked shorting surrounding the demise of financial institutions hardest hit by the financial crisis in 2008 and find no evidence that stock price declines were caused by naked shorting. We also find that naked short-selling intensifies after rather than before credit downgrade announcements during the 2008 financial crisis. In general, we find that naked short sellers respond to public news and intensify their activity after price declines rather than triggering these price declines.
- a 2010 dissertation chapter by Stanford's Elizabeth Stone (page 88):
This paper evaluates the validity of the claim that naked shorting leads to negative excess returns by creating additional selling pressure. ... I find no evidence that stocks subject to naked short selling experience negative excess returns. Rather, I find evidence that these stocks outperform on the day the trades occur. Naked short sellers appear to target stocks that outperform during the trading day and cover existing fails on days when the stocks underperform....The analysis presented in this paper finds that naked short selling is not systematically associated with negative excess returns.
- a 2011 study by Warren Bailey and Lin Zheng:
Using NYSE transactions records, we study short selling during the recent financial crisis....We conclude that short sales did not contribute substantially to stock price declines, and constraining short-selling is unwarranted.
- a 2012 article by Thomas Boulton and Marcus V. Braga-Alves:
Contrary to recent claims that naked short sellers are momentum traders who drive down stock prices, we find that returns are typically positive just prior to periods of increased naked short selling that result in persistent fails and that returns generally remain positive for several weeks afterwards.
Taibbi's column certainly makes for some interesting reading. But when it comes to giving readers an accurate picture of the impact of naked shorting, it's what he's writing that fails to deliver.
