Get Shorty!

It looks as if the initial positive reaction to the Greek bailout package agreed by the EU on Thursday evening could run out of steam by the time markets reopen on Monday. After a spot of prudent short-covering, traders and analysts seem to be coming to the view that the deal is no more than a stopgap, leaving the fundamental problems untouched. Rising bond yields in Spain and Italy late on Friday suggest that traders will not immediately try to test the EU's resolve regarding Greece itself, but will instead turn their attentions to trying to identify and undermine the next weak sister.

The key weapon in doing this will, as usual, be short selling, especially by hedge funds. Financial institutions always defend this practice, arguing that it provides a mechanism for identifying underlying problems quickly and bringing them to a head. As I've suggested in these pages in the past, this is akin to claiming that the school sneak, the kid who rats out his schoolmates for smoking behind the bike sheds, is a major contributor to school discipline. It's not as if the hedgies can claim any special expertise that has allowed them to figure out there is too much sovereign debt in some Eurozone countries. Everybody knows that. The bizarre part is that nobody seems seriously inclined to curb the short sellers, even though the costs, if they succeed in bringing down another debtor, will be borne by the same taxpayers that picked up the tab last time.

Michael Lewis's "The Big Short" (see last month's "Summer reading list 2011" post) painted a knockabout picture of a bunch of geeky oddballs making money by shorting asset backed bonds. However, the role of short selling in the runup to the financial crisis was pernicious. The most egregious example was provided by Goldman Sachs, who reportedly allowed a known short-seller to select ropey assets as collateral for one of their ABS deals, ensuring profits for the short seller as soon as the deal came to market. There may be no scope for that sort of skulduggery with Spanish or Italian bonds, but there's no reason to suppose that the short sellers will be any more scrupulous in their dealings.

The irony is that the hedge funds doing the short selling generally carry far more leverage than Italy or Spain do. Neither of those countries is in anything like as much trouble as Greece. The hedgies are unapologetic about trying to bring the sovereign debtors to their knees. It's long past time for regulators to return the favour.