QUESTION: I have read that the recent turmoil in the markets has been in part caused by short selling. Can you explain what this means?
ANSWER: They say that a week is a long time in politics, after the events in recent weeks it can be even longer in the financial markets.
In two weeks we have seen over 100 years of banking brought to an abrupt end for Lehman Brothers, the takeover of another bastion of Wall Street — Merrill Lynch, by Bank of America and the American government coming to the rescue of one of the world's largest life offices AIG. The Russian stock exchange was closed due to the mayhem being felt on Russian shares, and finally, closer to home the unthinkable a year ago has happened within 48 hours — Lloyds TSB stepped in to take on the mighty HBOS.
Billions, and talk of trillions, have been pumped into the financial markets all around the world, as governments try to stabilise global finances.
Some are even pointing to the fact that modern day capitalism has been shaken to the core. It is hard to believe that we have ended up in such a position.
As the fall out continues and people, companies and governments count the cost of the last 12 months, naturally people will try and apportion blame for all of these events.
The credit crunch recently celebrated, if that is the correct word, its first year anniversary.
At the heart of it all, is the downturn in the US housing market and the fact that for years, individuals were allowed to take on mortgages and credit without the means to ever repay the interest never mind the capital.
This led to major write downs and losses being suffered by the banks and finance houses, many of whom couldn't even quantify the extent of their losses.
Then there is the issue which you refer to, shorting. This has become commonplace in financial markets, with fund managers even specialising in this form of investment.
Shorting effectively happens when someone sells shares they don't own in the hope that when the time comes to buy the shares, they will have fallen from the price they were originally sold at. The difference between what they were sold for and what they are subsequently bought at is in effect the profit an individual can make. There has been and continues to be a great ethical debate about this form of investment.
The key risk, however, as we have seen with the likes of HBOS, is that in order to drive a share price down that has been "shorted" rumours are sometimes circulated in the market to help drive its price even lower. Hence we see wide fluctuations in a share price that is normally fairly consistent and in line with the general market.
The Government, via the Financial Services Authority, has intervened in this form of speculation and has now drawn up a list of financial service companies that cannot be sold short. This is a temporary measure but it is expected in the days and weeks that lie ahead the FSA will draw up rules and guidelines that will regulate the whole area of short selling.
Meantime, the debate rages on as to those who see the FSA ban as a welcome intervention, to those who see it as another form of meddling in what should be a free market left to normal market forces.
Raymond Mulligan is managing director of Johnston Campbell, a company of independent financial advisers regulated by the Financial Services Authority. For further information, please contact email@example.com or (028) 9022-1010