Who are the Short Sellers?

The uptick rule has been a whipping boy in the market decline, but some skepticism is emerging as people examine the issue in detail.

Like Jim Cramer, Jack Risko has been criticizing short sellers and the uptick rule in particular. Supposedly they act like a pack to bring down a weak stock, and this is imperilling the financial system since big banks are currently weak.

I'm unconvinced that short sellers are not revealing the true value of overpriced banks and thereby legitimately contributing to price discovery. If short sellers are involved in a vicious circle, I'm unconvinced that it's a deliberate conspiracy; it could be emergent behavior that mimics conspiratorial actions.

But another interpretation altogether crossed my mind: the short-selling could be legitimate hedging.

IMHO the picture underlying option valuation is that the reward/risk ratios of a stock and its options should be the identical. Accordingly, under idealized conditions, you can construct a combination of stock and option such that the risks cancel each other out: this recipe leads to the Black-Scholes valuation equation.

Suppose you're a market maker who sells a put option on BankAmerica. You have taken the risk that the stock will be sold back to you at a higher price than the market will charge. To reduce that risk, you hedge by shorting the stock. The more the stock drops, the more you should short in order to minimize the risk. If the stock develops a strong downward trend, you the put seller will act so as to reinforce the trend, and you could become a participant in a vicious circle.

Moreover, it turns out that a "sophisticated" put shopper can dispense with the market maker altogether. If the market maker can cancel his risk by shorting the put and the stock, a put shopper can equivalize the risk of holding an unhedged put by trading like the market maker would. This is the notorious portfolio insurance that was a prime suspect in the 1987 crash.

Now consider that the financial system, expecially the big insitutions, are highly leveraged. Suppose it's June 2008 and you have bought a "diversified" package of concocted illiquid "AAA" securities from Wall Street. You are getting worried. How do you protect yourself against the decline of illiquid composite instruments that are so complicated that no one understands their details?--By shorting liquid instruments that are related as closely as possible to your holdings. You protect yourself against systemic risk by shorting the system. So you're ready to go: when trouble appears, you short the stocks of large-cap financial institutions.

The amount of money in these holdings is many times the net worth of the financial system, the potential for a vicious circle is compounded many times.

If I had a case, I'd rest it with a flourish now, but all I have is a plausibility argument so I'll mundanely stop.

My Dinocrat comment is here.

Addendum 20090806. Suppose the value of those illiquid securities is many times the value of the issuing institution, and people try to hedge with the value of the stock...