Over at Equitable Growth: In relatively short order after John Paulson and company figured out how to sell mortgage finance short--howto collect the money from selling MBS to addled investors without having to first finance the construction of five-bedroom houses with swimming pools in the desert between Los Angeles and Albuquerque--the housing bubble reached its peak.
It seems at least plausible that if Paulson and company had been in business in 2004 the bad bets of MBS buyers would have gone into the pockets of short sellers rather than being wasted financing the construction of houses people really do not want to live it. And it seems at least plausible that if the supply of MBS had not been limited by housing construction, the price peaks would have been lower, the losses when MBS prices returned to fundamentals would have been less, and that even with all of the portfolio and risk-management dysfunction in the too-big-to-fail money-center banks and all the regulatory dysfunction at the Federal Reserve the bubble collapse would not have taken down our too-big-to-fail money-center banks, and we would not be in our current mess. READ MOAR
We do not like short-selling during the panic of the crisis during the panic and the crisis because then is when we want to bail-in people. In the panic and the crisis short-selling is the reverse: an enabler of and a force multiplier for destabilizing positive-feedback trading. But before the panic and the crisis short-selling is a valuable curb on enthusiasm, and a valuable stabilizing mechanism.
And the excellent Noah Smith brings refreshments in the form of empirical evidence from the hard-working and thoughtful Ringgenberg et al.:
Noah Smith: Don't Shortchange Short Sellers: "'Short Selling Risk', by Matthew Ringgenberg, Adam Reed, and Joseph Engelberg...
...look at how short-selling actually works in real life... and figure out what the costs of shorting really are.... The... risk of high fees.... Dealers generally have the ability to recall a stock loan at any time.... That’s another big risk, and it happens about 2 percent of the time. So... over-optimistic longs get to set the price.... There has been a lot of controversy over short-selling. People are afraid that shorts can foment panic, driving down stock prices by making it look as if there has been a piece of bad news, then buying at the dip and earning a double profit when the artificial panic fades.... On the other hand, plenty of finance professors view shorts as society’s best hope of killing asset bubbles before they get too big.... Ringgenberg et al. find... stocks for which shorting costs are higher experience less short selling, and have lower returns going forward. Other profs have found that short-selling risks tend to increase the time it takes stocks to incorporate new information into the price....
Shorts seem bad because they profit from stocks going down. But if shorts are bad, then so are risk managers. If shorts are bad, then so is anyone who shoots down an idea in a board meeting. Shorts are the leash that markets put on asset bubbles. We should be helping them do their job.