The housing bubble, and the dot-com bubble before that, continue to provide fodder for consternation. But according to William B. Tayler, assistant professor of accounting at Emory University’s Goizueta Business School, neither bubble posed a surprise to some professional traders. He notes they should have conceded an anomaly in the market was occurring, adjusting their trading strategies accordingly. But he questions. “If most agreed there was a bubble, why did it persist for as long as it did?”

Indeed the efforts to establish some sort of discipline and fix anomalies in the market can be difficult to craft, admits Tayler. The decision to temporarily halt rampant short-selling on financial firms in the fall of 2008 during the zenith of the financial crisis only helped to delay inevitable market corrections, he reasons. From September 19, 2008 to October 2, 2008, the Securities and Exchange Commission (SEC) placed a temporary ban on short-selling of 799 financial stocks during the height of the financial and housing crisis.

The SEC officially weakened margin requirements in 2007, making short-selling much more possible. (On December 12, 2006, the SEC approved a new method of calculating margin requirements for options trading in brokerage accounts. These new rules took effect on April 2, 2007, giving broker-dealers greater flexibility in setting those requirements.) The SEC held two roundtable discussions on securities lending and short-selling on September 29 and 30, 2009. On the second day of the roundtable discussions, SEC Chairman Mary L. Schapiro led a panel of speakers from the academic, finance, non-profit and governmental realm to discuss the possibility of a “hard locate” requirement to prevent naked short-selling, as well as “means to foster short selling transparency” for investors and regulators.

Tayler and co-authors address this timely subject in a research paper titled “Margin Trading, Overpricing, and Synchronization Risk”. In the paper, Tayler and co-authors Sanjeev Bhojraj, faculty director of the Parker Center and an associate professor of accounting at the Johnson Graduate School of Management at Cornell University, and Robert J. Bloomfield, the Nicholas H. Noyes professor of management and a professor of accounting also at the Johnson Graduate School of Management at Cornell University, take a critical look at short-selling, exploring how the weakening of margin restrictions to allow for more short-selling can drive up and further exacerbate overpricing in the market. The paper was published in May 2009 by The Review of Financial Studies.

Specifically, the authors conclude that the relaxation of margin requirements result in an increase in “aggressive short-selling.” Tayler and his co-authors also state that “relaxing margin restrictions can also interfere with the ability of arbitrageurs to converge to equilibrium prices when arbitrageurs cannot predict other arbitrageurs’ trading strategies.” Previous researchers in the field label or define this scenario as “synchronization risk.” When synchronization risk is great, the authors note that weak or relaxed margin restrictions worsen overpricing in the market.

For the purposes of the research, the authors use a set of “smart money” traders, who have finite capital, but also the ability “to borrow money and shares at an interest rate of 0 percent, as long as they maintain an adequate ratio of equity to assets.” The human participants in the study serve as these “smart money” traders, while a robot model acts as a “sentiment trader” reacting as an “irrationally bullish group.” As with real margin requirements in trading, the researchers establish that the study participants, in this case the “traders,” are forced to close out their position if their “equity/assets ratio falls below a pre-specified level.”

According to the paper, “the experiments were held at the Business Simulation Laboratory at the Johnson Graduate School of Management at Cornell University, and the participants were graduate and undergraduate students from a variety of programs at Cornell University.” The participants electronically traded a bundle of fictitious stocks using different scenarios setting loose or tight margin restrictions, with the researchers testing their results in two separate experiments. The computer trading screen offered continuous updates on a trader’s “cash balance, share exposure, average cost or revenue per share in inventory, realized and unrealized gains, and their current equity ratio. The screen also reported the current market price and the number of shares bought and sold by them and by the market.”

As expected, the two experiments indicate that the human or “smart-money” traders quickly buy stocks up in the beginning, front-running the “sentiment” trader to the trade, but then they choose to delay arbitrage. The trio determines that the “smart-money traders” know that they can earn “greater profits by front-running the sentiment trader and delaying arbitrage of price errors than they earn in equilibrium,” says Tayler.

With large amounts of capital and tight margin restrictions, the competitive pressures quickly drive prices to some sort of equilibrium. But with less capital and “loose margin restrictions”, a bubble-and-crash scenario happens because of front-running and delayed arbitrage. The traders tend to “short-sell aggressively to exploit deviations from equilibrium; this short-selling exposes them to margin risk if they sell too long before others sell.” The trio concludes relaxed margin restrictions inevitably increase stock prices, since the traders can more easily front-run with the additional cash they possess under weaker margin restrictions. However, they do face greater margin risk.

Tayler believes that the current research makes it clear that disciplining the market is certainly difficult. He relates that even in the midst of a major bubble, and even with the knowledge that a bubble is occurring, professional arbitragers should be ready to correct market mispricing. But the reaction of these arbs can be all over the map, with some getting in too early and others waiting to trade once the bubble begins to deflate. Says Tayler, “What they don’t know is whether all the other arbitragers know there’s a bubble. Or, perhaps they believe the other arbitragers know about the bubble, but they’re not sure other arbitragers are willing to get in and trade against it just yet. There’s a huge synchronization problem.”

If one trader jumps in too early, they inevitably will “get killed,” Tayler says. “If they jump in too late, they don’t make as much money as they could have made. So arbitragers delay, and jump in when the bubble starts to burst.” Despite some of the problems with short-selling, Tayler does note that short-selling eventually helps to discipline prices, especially against bullish forces, but that it is not “ a perfect inoculation against bubble formation”.