Spain, Italy Reinstate Short-Selling Bans Amidst Market Turmoil

Spain and Italy banned short-selling on all stocks and equity derivatives Monday, as domestic stock indexes plummeted on fears that Spain would need a full sovereign bailout. Spain's Ibex fell 5 percent ahead of the news but since rallied back only 2 percent. Italian shares saw a similar reversal.

Banning short-selling is a last ditch response by politicians to buy time and attempt to delay the European Debt Crisis from destroying the euro. By banning short-selling, politicians are looking to backstop ailing banks and other financial institutions. Basic accounting teaches investors that the balance sheet is made of three parts, on one side are assets and the other side liabilities and equity. Banks are naturally leveraged to generate profits, so there are more liabilities than equity.

As banks borrow more to increase asset holdings, they become more and more susceptible to market risk. If the value of the assets fall, the losses are written off to the equity account first. Spanish banks are very leveraged, so small losses on assets (in this case Spanish bonds) can wipe out equity. By banning short-selling, the politicians are effectively making it so Spanish stocks cannot reflect the true value of the stocks of the banks, which are the largest source of equity for most banks.

There could be negative implications to this sort of action. Last year, European leaders banned short-selling across the continent, only to see liquidity in financial markets dry up. The freezing of credit markets due to the lack of liquidity led to the ECB needing to launch emergency crisis actions that included the Longer-Term Refinancing Operations (LTRO's). These loans to banks soaked up lots of the good collateral that remained in the market, driving down yields on safe government bonds that could be used as collateral.

Should this repeat, investors could prepare for it by watching credit spreads. First, government bond yields would be important to watch, as the ECB could re-launch the Securities Market Program (SMP) where it buys sovereign bonds directly on the open market. Also, the Ted Spread, which measures the difference in borrowing costs for the U.S. government and corporate borrowers, could signal further LTRO's. In 2011, when the ECB launched the first two LTRO's, the Ted Spread widened significantly and thus further widening could signal more action. Lastly, the FRA-OIS spread is a broad measure of health in the banking system. It measures the ability of European banks to borrow dollars cheaply. As it widens, it signals that banks are having trouble accessing dollar funding and liquidity is drying up.