I’m sure most of you are aware of the fact that on Friday the SEC effectively banned short selling of about 799 financial stocks. But I’m not sure whether or not people are actually aware of the unintended consequences of doing so. Everyone sees the headline of “Dow soars” and “Nasdaq rebounds”, but through their positive reactions to the SEC ruling, it is pretty evident that most people are in the dark in terms of what it actually means.

Two points stand out above the rest:

1. The rally really wasn’t a rally – it was just the fact that every short seller had to cover their position. If you look at the technicals of the trading and a chart of the trading, the rally was simply a “gap up” in the mornings. What this means is the rally wasn’t volume driven, it wasn’t as if a stock traded up to 70 from 50 slowly throughout the day. The opening bid of the biggest gainers was pretty much where it ended up for the day. It wasn’t as if people were “more willing” to buy and to “pay more” per share of stock as the news media would have you believe, but it was people were “less willing” to sell (primarily because it was now illegal in many cases).

2. The banning on short selling of financial stocks creates massive massive mis-pricing. Case in point: Merrill Lynch being acquired by Bank of America for .86 BAC shares per MER. Their respective closing prices were as follows: 37.48 BAC and 29.5 MER respectively. This means that (ignoring all time value of money arguments and built in risk), Merrill Lynch should be trading at $32.23 per share. That reflects roughly a 10% discount to which the deal was valued and agreed upon. This may not seem shocking, but it is considering the deal is expected to close within 4 months and there is little to no resistance to the deal since it has strong Fed and government backing. So what causes this?

Well, the quintessential arbitrage trade here would be to short Bank of America shares and to long Merrill Lynch, but oh wait, you can’t short Bank of America shares anymore! So the only thing would be to long Merrill Lynch, but all this would really do is potentially inflate an asset simply because it is pegged to another inflated asset… all in all, creating massive amounts of mispricing.

Are there ways around this? Sure, you could always buy put options on the asset and I suppose put options is the new short sell, but it’s clearly not as effective a means of hedging.

Yet again, this is simply another example of how the federal government is trying to have all the benefits of capitalism and trying to use government intervention to prevent any of the “necessary destruction” of capitalism from occurring. But, the essence of capitalism is the idea of creative destruction which “incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one” (Schumpeter).