Personal Finance

Return to Article

Stock Market Game Week in Review

The Stock Market Game Program

Suffice it to say there was a lot of news this week, but one of the bigger stories was about short-selling and the government's actions with respect to it.

Aggressive short-selling has been blamed for eroding the share prices of companies like Lehman Brothers, which last week was forced to file for bankruptcy, and Merrill Lynch(MER Quote), which felt it had no choice but to sell itself to Bank of America(BAC Quote).

Now, short-selling is not the only factor responsible for the crashing of the financial sector. Wall Street firms created a lot of their own problems by underwriting and loading up on securities linked to toxic mortgage loans.

But regulators felt that in order to prevent another big firm from going under and sending further tremors throughout the global financial system and economy, they needed to do two things: enforce rules against a kind of short-selling that is illegal, and temporarily halt short-selling in financial companies.

On Thursday, the Securities and Exchange Commission increased the penalties against illegal short-selling to include federal fraud charges. Then on Friday, in an emergency order, the SEC halted short-selling in the securities of 799 financial companies. The move will remain in place until Oct. 2, but could be extended, the SEC said.

So you and your students may be asking, what the heck is short-selling anyway? And more importantly, what's illegal short-selling? Both are complicated, but important to understand if you want to know what happened this week.

Simply put, short-selling is making a bet that a stock's price will fall. The practice is inherently risky but can be very profitable if you're right about a stock's price going down. It works like this: You borrow a certain number of shares of stock from your broker -- let's say 100 shares of a stock that's trading at $10. Once you borrow the stock, you sell it.

So now you have $1,000 of cash in your account and the buyer has the shares you borrowed from your broker. You are obligated to return the shares of stock to your broker in the future, not the $1,000 you received from selling the shares. So, if you sold the stock today for ten dollars and two weeks later the stock price drops to $5, you can buy back the 100 shares in the stock market for $500. You then return the 100 borrowed shares to your broker and keep a profit of $500.

Remember, you sold at $10 and bought at $5. It's "buy low, sell high" in reverse: Sell high, buy low. However, if the stock goes up, you'll eventually be forced to buy it back for more than you sold it. That's the risky part.

Illegal short-selling takes place at an institutional trading level. With illegal short-selling, also known as naked short-selling, the institution does not have and/or does not borrow the stock it is selling short. Essentially, a trader at an institution (brokerage, hedge fund, pension) has promised the buyer of the stock they are selling short (remember the first thing you do when you short sell is to sell) that they will borrow the stock and deliver it to the buyer within a reasonable period of time. Making the promise allows a trader to sell the stock before delivering the shares to the buyer. In an illegal short sale, you sell the stock on your promise and never deliver the stock to the buyer.

So you're selling something you don't have, which is illegal, no matter what you're selling. I can't sell you a car and never deliver it, especially if I never owned it in the first place. The practice violates a fundamental principle of capitalism.

If a trader is doing this intentionally (i.e., the trader knows his or her firm does not have the stock), the trader is not taking any risk and can manipulate the market by making large short-sale trades on imaginary shares of a targeted stock in an attempt to drive the price down precipitously. If many people are doing this at once, you will see a targeted stock drop like a rock.

In addition to increasing the penalties against this practice to include fraud charges, the SEC Thursday also vowed to investigate all "failure to deliver" notices. If your financial institution gets a failure to deliver notice, it means it never delivered the stock it promised to give to a buyer, as outlined above. There could be an "honest mistake" behind the failure to deliver or criminal behavior. But if no one (like, say, the SEC) ever asks you about it , the market starts to resemble a Wild West environment where anything goes.

Also announced this week, there will be an investigation by New York State Attorney General Andrew Cuomo to see whether false rumors were spread about the troubled investment banks. Spreading false rumors is also illegal. Additionally, the Feds announced they will create a special government entity to buy the distressed sub-prime mortgage debt that started this crisis more than a year ago.

Here in the financial district, we hope this is the beginning of the end to this cycle of crises and not the end of the beginning, but whatever the future brings there are lessons to be learned. The turmoil in the stock market we have seen this week presents an outstanding teachable moment to speak with your students about risk. The core lesson, "What is Risk?" is available in The Stock Market Game's Teacher Support Center. Also, there is a non-core lesson called "One Strategy for a Bear Market?" which explains short-selling and is also available in the Teacher Support Center.

To learn more about The Stock Market Game, visit www.stockmarketgame.org.