That flaw is the inflation of the price of bad assets, out of the reach of the rest of the market. Whatever free market mechanism was left in the system for clearing out these bad assets is now gone. Only the taxpayer will buy them at these prices. And don't believe the part about a "reverse auction seeking the lowest price". Since when has anyone shopping with someone else's money haggled down to the lowest possible price? Especially when the purchase must be done in a hurry.
Well, I think I have identified a second fundamental flaw with potentially catastrophic consequences.
It lies in the banning of short selling. The SEC and Hank Paulson have placed the bet that the short sellers were driving down the financials, and that it was not just the shareholders liquidating out of fear. If they are wrong about the public's confidence in shares of the 799 financial institutions then the result could be catastrophic. Here's why:
A short seller is selling a stock he borrowed, but doesn't actually own, at current prices only to buy it back at a lower price. He causes two buys in the market. First is the person that buys the borrowed stock he sold, and the second buy is him buying it back at a lower price and then returning the borrowed stock to it's owner. In essence, he is betting on the price of the stock dropping and when it does he makes money. On the other hand, a long seller is an owner of the stock who just wants out. He is selling a stock he actually owns. He only causes one buy in the market because once he sells he is out. And as he sells, the stock is caught at the lower price by the short seller. So the short seller actually acts as a backstop against the panic selling of shareholders.
If you remove the short seller from the equation, then there will be no backstop if the actual shareholders get spooked by the market and decide to exit their positions.
Most short sellers place their bets because they actually believe a stock will go down based on fundamentals. In fact, most short sellers don't have the billions of dollars it would take to affect the market in a downward trajectory, so they must place their bets carefully. Some short sellers are doing it as a hedge against a long position they may have in the same company, perhaps in Preferred Shares with a fixed dividend. By shorting the common stock they can hedge their risk in the price of the preferreds.
The point is that legal short sellers provide a legitimate function in our current market setup. And by removing them wholesale from the marketplace creates a situation where the prices of stocks could theoretically freefall all the way to zero. That is where we are today.
This warning was issued by the editors at iTulip.com:
"Politicians forget that a short seller is a buyer albeit at a lower price. Take him away and in a market panic there are no buyers at all. A market can in theory then fall to zero. You've been warned."
Also, there were many short sellers that were completely wiped out on Friday. They will not be coming back to the trading floors because they are now bankrupt. I think the appropriate analogy is that all insects play an important role in nature. And if you completely eradicate one of them you will be overrun by the consequences. If you kill all the spiders, you will be overrun by the insects they once ate for lunch.
I'm going to post the entire message from the editors at iTulip because I think it contains a couple important messages:
Editor's addendum: On the short selling rules imposed today, two notes.
One, we extend our sympathy to Mike Morgan who we tried to warn against shorting financial stocks. This regime – we think it is fair to, at this point in time, to stop calling it an administration – knows no limits in the business of market controls.
Two, politicians forget that a short seller is a buyer albeit at a lower price. Take him away and in a market panic there are no buyers at all. A market can in theory then fall to zero. You've been warned.