Short Sale Constraints, Dispersion of Opinion, and Market Quality: Evidence from the Short Sale Ban on U.S. Financial Stocks

The three-week ban on short selling during 2008 for nearly 800 U.S. financial stocks provides an opportunity to directly test how binding short sale constraints affect stock valuation. We focus on the relative valuation effects of the ban on stocks with higher vs. lower dispersion of investor opinion and stocks that experience greater vs. smaller deterioration in market quality. First, we find that the initiation of the ban is associated with abnormal price increases that continue even after the ban. Second, valuation increases are significantly more pronounced for stocks associated with greater dispersion of opinion. However, after the ban is removed, this dispersion effect disappears. Third, the ban is associated with large increases in relative quoted spreads and decreases in the average number of trades per day, consistent with a reduction in market quality. Finally, the banned stocks that face the greatest widening in their spread experience weaker abnormal stock performance during and after the ban. In summary, the dispersion-related findings support Miller’s (1977) argument that high dispersion stocks become overvalued under binding short sale constraints. The spread-related findings suggest that short sellers are viewed as informed investors. In the absence of short sellers, investors demand higher risk premiums to reflect the increased uncertainty about the stock’s value. From a policy standpoint, the actions of the Securities and Exchange Commission might have curbed excessive price declines for troubled firms without lasting differential valuation consequences for higher vs. lower dispersion stocks. However, these policy actions had severe market quality consequences. (JEL G12, G14, G18, G28) Short Sale Constraints, Dispersion of Opinion, and Market Quality

Personal financial planning

xix, 668 pages : illustrations ; 29 cm

The 2008 short sale ban: Liquidity, dispersion of opinion, and the cross-section of returns of US financial stocks

This study examines the cross-sectional impact of the 2008 short sale ban on the returns of US financial stocks. Motivated by the large cross-sectional variation in the extent to which banned stocks suffer an illiquidity shock, we hypothesize that stocks with larger liquidity declines are associated with poorer contemporaneous stock returns. The evidence supports this hypothesis and suggests that this effect is stronger for more liquid stocks, as predicted by Amihud and Mendelson (1986). Moreover, consistent with Miller's (1977) model, we report a valuation reversal whereby stocks with higher abnormal returns at the onset of the ban have lower abnormal returns at its removal. Our findings are robust when we control for firms most affected by TARP, include non-banned matched firms, and compare banned firms' stock returns with their bond returns. From a policy standpoint, the ban reduced valuations, ceteris paribus, of the stocks that were hardest hit by illiquidity.Short sale ban Liquidity Dispersion of opinion

Information uncertainty and auditor reputation

This paper explores the relationship between information uncertainty and auditor reputation revealed by the failure of Arthur Andersen (AA). AA's reputation deteriorated considerably when it announced on January 10, 2002, that it had shredded documents related to its audit of Enron. AA's demise was sealed on March 14, 2002, with its indictment for obstruction of justice. We find that on these dates the clients of AA and other Big Five auditors that are characterized by higher information uncertainty experience relatively larger share price declines compared to clients with lower information uncertainty. The findings suggest that the market relies more heavily on auditor reputation for higher information uncertainty firms, which implies that the value of an audit is greater when a firm is harder to value. Our results highlight the importance of information uncertainty in financial markets: where there is a shock to auditor reputation, firms with greater information uncertainty suffer the largest losses.Information uncertainty Auditor reputation Contagion Arthur Andersen