Short-selling bans remind markets that there's still no plan to end the euro debt crisis

08/26/2011 9:21 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

As Isaac Newton, the Master of the Mint from 1699 to 1727, would have told European financial officials there is no action without a corresponding and opposite reaction.

So bans on short-selling in France, Italy, Spain, and Belgium, designed to protect wobbly European bank stocks, set off a selling panic in Germany yesterday, August 25, as traders sold German stocks short to hedge their European portfolios. The German DAX stock index dropped by as much as 4% during the day before recovering to post a 1.7% decline for the day.

European investors were apparently willing to look past a ban on shorting selected European bank stocks as long as they were convinced that the ban would be short-lived. But with financial officials in those countries announcing that the bans, which began about two weeks ago and cover about 60 stocks, would extend to the end of September traders looking to hedge the risk in their holdings of European stocks. Prevented from getting as much downside protection as they wanted in the French, Spanish, Italian, and Belgian markets, they moved to short German financials.

The move had a certain element of panic, too, since traders rushed to short the DAX just in case German financial officials decided to impose a short-selling ban too. Traders were already unsettled by German and French plans to impose a financial transactions tax.

It didn’t help the German market that early in the day traders started to hear rumors that Standard & Poor’s was about to downgrade Germany’s government debt.  In the event S&P, Moody’s Investors Service and Fitch Ratings all affirmed Germany’s AAA rating during the day.

There’s no evidence that bans on short-selling have much effect on stock prices. Bans imposed in 2008, for example, cut volumes (raising transaction cost) and pushed up the prices of the shares involved in the ban for just one-and-a-half weeks. The current bans have indeed reduced volatility in the bank stocks involved—trading volumes are just 75% of what they were before the ban—but after a brief pop shares prices have returned to their pre-ban levels.

What the bans do seem to be doing, however, is reminding traders and investors that European leaders still don’t have a plan for ending the euro debt crisis. In fact it looks like the EuroZone has taken a step backwards with German President Christian Wulff on Wednesday, August 24, questioning the legality of European Central Bank buying of Spanish and Italian bonds to support prices of that debt. Bans on short selling are band-aids and smack of desperation.\

Once we’re passed all the speculation about what Federal Reserve Chairman Ben Bernanke will or won’t say in Jackson Hole today I’m afraid the financial markets will go back to fretting about the apparently endless crisis in European financial markets.

 

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