When the Fed stepped in to ensure an orderly collapse of insurance giant AIG, it meant bad news for many short-sellers. The problem isn't for short-sellers of AIG stock. They should do fine as the stock is likely to have little value post-intervention. However, there may have been short-sellers who bet that some of AIG's big creditors were about to take a hit. These short-sellers may rack up big losses as a result of the Fed's actions. We could perhaps say that the short-sellers should take into account the possibility of Fed interventions when they place their bets. However, this does create an asymmetric situation in which those betting that stocks will rise need have no fear that the Fed will intervene to take away their profits, while those placing short bets must have this concern. This will bias traders away from taking short positions even when a proper assessment of fundamentals may justify a short position. If this sounds like a far-fetched concern, it shouldn't. The economy has just suffered from the rise and demise of two enormous asset bubbles, one in stock and one in housing. Think of how much better off the country would have been if short-sellers had nailed Pets.com and other Internet darlings before they became hugely over-valued. In the case of the housing bubble, imagine that short-sellers had crashed Citigroup and Merrill Lynch when they first started pushing complex mortgage derivatives filled with junk. We need not feel sorry for the short-traders. They are speculating and should know the risks. However, we obviously have a serious problem with financial bubbles and one force that could act as a corrective (absent action from the Fed) would be short-sellers. If the Fed's policy creates a bias against short-selling then it is yet another factor helping to promote asset bubbles.
--Dean Baker
