Leave the Short-Sellers Alone

 | Aug 12, 2011 | 12:30 PM EDT  | Comments
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This commentary originally appeared on Real Money Pro on Aug. 12 at 8:45 a.m. EDT.

Four European countries are banning the short-selling of stocks in their markets to try to halt the precipitous plunge in value of troubled European banks, a step that some experts say could intensify fears and ratchet up risks of another financial crisis.

Belgium, France, Italy and Spain have decided to impose a temporary ban on short-selling, beginning on Friday, according to a statement from the European Securities and Markets Authority released Thursday evening, after markets had closed.... 

The ban on short-selling carries echoes of the 2008 financial crisis, when the Securities and Exchange Commission temporarily banned short sales in the U.S., a move that resulted in a brief rally but ultimately did little to arrest the market's free fall....

In France and Spain, the ban on short sales will last for 15 days, and will only apply to stocks in the financial sector, according to the Globe and Mail. Belgium will ban short sales on four financial stocks for an unknown period of time. It was unclear which stocks the Italian ban would affect, or for how long it would be in place.

A spokesman for the U.K. Financial Services Authority told Bloomberg that Britain has no plans to ban short sales.

-- The Huffington Post, "Italy, France, Spain, Belgium Ban Short-Selling in Order to Protect Markets"

Yesterday the U.S. stock market rallied, in part, on the announcement that several countries in Europe were imposing a ban on selected short-selling. (This morning, there are rumors of an even broader short-selling ban in Europe.

A September 2008 short-selling ban in the U.S. failed miserably (as the market's drop actually accelerated after it was instituted) and will likely fail in Europe now.

Such short-selling bans smack of desperation; they are artificial, interfere with natural market forces and are anti-free market (though typically instituted by free-market policymakers). Bans are ineffective Band-Aids that often raise red flags, may result in investors selling their longs (as bans make them nervous) and reduce the cushion of potentially latent buying from short positions put on.

As I have written recently, what should be clear in looking at the dismal U.S. and eurozone economic numbers in the first half of 2011 and in the falloff in confidence is that there is a pressing need for outside-the-box, creative, hard-hitting, thoughtful and pro-growth fiscal strategies. Our country needs (among other things) a series of Marshall Plans aimed at reviving the housing market (and denting the shadow inventory of unsold homes) and an aggressive fiscal strategy that will generate jobs growth. But, given the partisanship observed in the debt-ceiling and budget circus, how can investors be confident that these needs can be met, especially as we are closing in on the November 2012 elections?

Instead of hard-hitting solutions, we get short-selling bans.

It is almost laughable, but the poor state of our world's economic affairs makes it sad.

Back in the fall of 2008, I wrote the following op-ed in Financial Times about short-sellers and the blame game:

This Blame Game Is Short on Logic

After acquiring General Re in 1998, Warren Buffett, the veteran investor, learnt the hard way that "derivatives are like hell, easy to enter but almost impossible to exit."

Four years later, Mr Buffett, chairman of Berkshire Hathaway, argued that highly complex financial instruments and derivatives were time bombs and that these "financial weapons of mass destruction" might harm the economic system. His caution was prescient - like that of many others who have identified company frauds or diagnosed previous credit cycles gone wild. Yet most of these gloomy messengers have been ignored. Since Mr Buffett's warning, financial markets have imploded and policymakers have failed to address the abuses that created the crisis, from the excess leverage of banks to ratings agency failures.

Instead, public policy has become focused on a blame game aimed at restricting the short-selling of securities - especially of a financial kind. In July, Christopher Cox, chairman of the US Securities and Exchange Commission, announced a plan to curb improper (naked) short-selling. In doing so he has (de facto) attempted to limit the activity of short-sellers. Mr Cox seems to be implicitly blaming the shorts for the unprecedented fall of bank, government-sponsored agency and brokerage stocks over the past year - even though short-sellers were the very group that warned of the dangerous credit cycle and its consequences.

Short-selling runs deep in financial history. Perhaps the first case dates to 1609 when the Dutch trader, Isaac Le Maire, targeted the shares of the shipping company, Vereenigde Oostindische Compagnie (the Dutch East India Company). VOC was the first multinational corporation in history and had broad powers. Nonetheless, Le Maire, concerned about threats of attack by English ships, sold VOC's shares short. After learning about Le Maire's tactics, the stock exchange governing VOC's trading banned short-selling (although the ban was later revoked).

In the early 1630s, the Dutch economy fell into a depression following a speculative peak in the trading of tulips. Again, short-selling raised the ire of regulators, many of whom saw it as magnifying the effect on the Dutch economic downturn. As a result, England banned short-selling outright.

Almost 420 years later - in the late 1920s - short-sellers warned of the consequences of speculation. But in the aftermath of the Wall Street crash of 1929, many blamed them and the uptick rule - which banned short-selling on downticks - was instituted (and stayed in effect until 2007). More regulation governing short-selling came into force in 1940, with a ban on mutual funds from short-selling (though that law was lifted in 1997). In early 2005, the SEC again sought to restrict the practice.

Yet short-sellers have served as financial watchdogs, as many of their warnings have been spot on. The delusional dotcom boom in the late 1990s brought Cassandra-like utterings from the shortselling cabal that proved insightful but were largely ignored. After the subsequent 75 per cent collapse of the Nasdaq, a bull market in corporate fraud emerged and short-sellers such as David Rocker, founder of Rocker Partners, highlighted accounting problems at companies such as Sunbeam, Tyco and Lernout & Hauspie. Kynikos' Jim Chanos played a role in uncovering the largest fraud in history when his contrary-minded analysis warned of Enron's accounting shenanigans - which were emulated (but ignored by investors) in the banks' recent dalliance with structured investment vehicles.

By the middle of the decade the property cycle was in full bloom and David Tice of the Prudent Bear Fund warned of the dire ramifications of a downward spiral in home prices on the levered balanced sheets of Fannie Mae and Freddie Mac. Soon thereafter, Nouriel Roubini, the economist, voiced particularly pessimistic forecasts about the housing market's impact on credit.

Drawing a line between economic and market progress as against fantasy is a role taken by the few. Short-sellers provide an anchor of objectivity in an investment world populated by those more interested in rewards than in uncovering systemic risks. This week, Mr Cox said the SEC would announce new regulations to restrict short-selling. Instead of more regulation, the chairman and investors should begin listening to what short-sellers have to say about our economy and credit markets.

-- Doug Kass, Financial Times (August 21, 2008)

Weeks later, a short-selling ban on financial stocks was instituted in the U.S., and I wrote the following in mid-September:

"We believe that to err is human. To blame it on someone else is politics."

-- Hubert Humphrey

Several weeks ago, I wrote an op-ed column in the Financial Times that spelled out my view that short-sellers shouldn't be restricted in their activity and shouldn't be blamed for the abuses in lending, credit formation and in the growth of the unregulated derivative markets that got us into the mess that we are in today.

Indeed, history has shown -- EnronTyco (TYC), Sunbeam and so on -- that market participants should be attentive in listening to the analytical warnings of the short-selling community.

A few seem to be coming to their senses -- in certain cases from surprising corners. For example, here is an email exchange I had with Ben Stein (for whom I now have newfound respect) last night:

Ben Stein: I am bound to say after all this time that you understood this so much better than I did, especially the mentality on Wall Street that would lead to this that it is profoundly humbling.

Doug Kass: Thank you, Ben. My Grandma Koufax would call you a "mensch." My constant proddings were not meant to be ad hominem attacks against you but rather to deliver my analysis and underscore my sense of foreboding that was based on my analysis of the abuses and egregious risk taken in the credit, housing and derivatives markets.

Some observers, like Bloomberg's Michael Lewis get it.

Others recognize that the blame lies squarely on the shoulders of regulators, borrowers (and lenders), banks (did the shorts tell Citigroup's (C) Chuck Prince to "keep on dancing?"), brokerages (did the short-sellers OK obscene compensation packages in the "heads I win, tails I win" culture on Wall Street in which those monies earned were withdrawn out of the firms while levering their capital to 32-1?) and The Three Stooges of 21st Century Finance (who reside in the Administration, Treasury and Federal Reserve

 and proved, once again, to be reactive not proactive). All of these players gleefully and drunkenly drank from the bowl of credit excess over the past decade, believing in another new paradigm (and uninterrupted growth) for the housing and credit markets, but failed to have a vision of the dangers associated with their careless risk-taking and lack of due diligence. 

"If they can get you asking the wrong questions, they don't have to worry about answers."

-- Thomas Pynchon, Gravity's Rainbow 

From my perch, it seems far-fetched to blame short-sellers for the general lack of regulatory scrutiny and enforcement, the absence of risk controls and a continuum of reckless management decisions at the world's leading financial institutions (banks, brokers, hedge funds, private equity, etc.), all of which have combined to create a Black Swan event that has resulted in a credit market gone amok and a shadow banking system often under the radar of regulators.

Increasingly this week, however, all too many seem to be suggesting that the short-sellers are the root of all evil and are to blame for a plunge in share prices (especially of a financial-kind). Indeed, SEC Chairman Cox instituted new short-selling rules last night, which included a requirement to disclose daily short positions, and some institutional investors, like CalStrs' CIO Christopher Ailman, are not permitting their investment holdings to be loaned out to short-sellers, citing clear evidence that short-selling is the root cause of the decline in the shares of leading investment banks.

Here are some of my reasons why the current popular game of blaming short-sellers is misplaced:

* I simply can't accept the basic assertion that there is currently a great deal of naked short selling going on. Yesterday, I undertook an experiment and tried to borrow 250,000 shares of Morgan Stanley (MS) from my prime broker (one of the very institutions that is complaining about short-sellers!); it took less than three seconds. Every other financial on the SEC's list is readily available to borrow, so why the heck would anyone illegally short without a borrow?

 * Short interest in the publicly traded investment banks has dropped in the last month. (For example, Morgan Stanley's short interest has dropped by 3 million shares in the last month, to 45 million shares, and stands at a low 2.8 short interest ratio, and at only 4% of Morgan Stanley's float.) According to Short Alert, from early July to late August (the most recent data available), the short interest in the 34 companies classified as Investment Banking Brokerage by S&P dropped from 9.42% of all shares outstanding to only 7.55%, for a 20% decline. So not only are critics of short-selling wrong that shorting has increased, but it appears that covering by the short community served to provide stability to the markets.

* Fails-to-deliver from naked short-selling account for a small percentage of market capitalization, according to the Depository Trust and Clearing Corporation. Currently, fails are about 31,000 positions daily (including both new and aged fails) out of an average of 54 million new transactions processed every day by the National Securities Clearing Corporation. In dollars, fails-to-deliver-and-receive amount to only about 1.4% of the daily volume.

* Short-selling (or buying of protection) is now rampant in the credit default swaps area, an unregulated market that the very investment banks who are complaining about short-sellers pushing their shares down have argued to keep unregulated!

 * As to the rumor-mongering, one should not look at the short-sellers, we (or more precisely the SEC) should look at the very investment banks that are complaining the most loudly about short-sellers. Chinese Walls in brokerages have long fallen, as it is widely recognized that investment firms' proprietary desks are shorting each others' stocks (and pulling capital from each other), likely with information from their own investment banking arms. What if it turns out that Goldman Sachs (GS) was shorting Morgan Stanley and Morgan Stanley was shorting Goldman Sachs -- and that they both were shorting Fannie Mae (FNM), Freddie Mac (FRE) and American International Group (AIG).

 * Finally, where are the hedge funds making all this money shorting stocks (illegally)? The dedicated pool of short-sellers (which stands at about $5.5 billion, or about 9% the size of Fidelity's Magellan Fund) is simply too small to have a meaningful impact on the markets. Based on ISI data, most hedge funds tied to a long/shot strategy are relatively inactive, and many are liquidating out of fear of ever-greater losses and redemptions, which leaves us with the dominant quant funds that use algorithms, not fundamental security analysis or rumors, as their operating methodology. No doubt, some of these are shorting the weakness in financials based on their modeling.

 In summary, the blame game is counterintuitive to the facts (above) and seems motivated by investors' and financial managements' rationalizing their poor investment and business decisions, many of which have caused unnecessary pain for a lot of Wall Streeters who have become victims of their senior managers' misdeeds.

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