Don’t Blame The Shorts

Blaming short sellers shows history is repeating itself

ROBERT SLOAN, MANAGING PARTNER, S3 PARTNERS

To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without a free press. There would be no one to criticise and restrain the false optimism that always leads to disaster.
– Bernard Baruch, financier, statement before the Committee on Rules of the US House of Representatives, 1917

October 2009 marked the 80th anniversary of the stock market crash of 1929, which led to a financial and economic wasteland from which the United States and much of the world only emerged after World War II through the institution of the Marshall Plan. The Temporary National Economic Committee of 1937 showed that despite all the fiscal stimuli implemented by the US government to try to jumpstart the economy—namely, the measures introduced in Roosevelt’s New Deal—the lingering effect of the Depression remained. These days, it seems impossible to separate our understanding of the Depression and World War II. The war was an elixir to the Depression, and, more significantly, the atrocities of World War II overshadowed the domestic catastrophe inflicted by the trauma of 1929. There were breadlines, unemployment, and starvation, but American domestic life was spared the horrors of fascism.

The Depression occupies a lower ground, as it did then, when viewed from the lofty Churchillian promises that “blood, toil, tears, and sweat” would lead to the “broad, sunlit uplands” of peace, peace in his time. From the high ground of Churchill’s rhetoric, the Depression could be seen as less important, less consequential. Its historical wave lapped on the shore and was overcome by a much larger one. It is useful to recall that America has elected a number of presidents who fought in World War II, but no candidate that solely defined himself as a survivor of the Depression has held the highest office in the land. The narrative of Depression-era survival is stirring, but it was not the resonant narrative of a generation. Freedom of movement, expression, and belief—the victory of democracy over tyranny—were more important than any economic ill. Even though we were miserable, so our historical memory tells us, what came after it made the suffering well worthwhile. In hindsight, our basic need to be free was more important than our need to be rich.

Parallels to the depression
Given the recent collapse of the American economy, there are many parallels to the Depression—not all of which are obvious. The similarities could lead to a major reinterpretation of that period of economic history precisely because of the way the credit crisis has transpired. It would seem that the current mess on Wall Street has provincial roots in the Depression. Just as the makers of the economic bubbles of the 1920s were either too old or too young to have fought in World War I, the bankers and executives who presided over this postmillennial mess were either too old or too young to serve in Vietnam (the two wars fought in the Persian Gulf do not apply to the comparison, as we now have a volunteer service). The danger for current Wall Street power brokers is that the Great Crash may be reinterpreted as having been caused not by great economic factors such as Smoot-Hawley or the rise in interest rates, but by a group of counterfeiters and hucksters. It was Wall Street and Wall Street alone that was responsible for the easy leverage of both eras, the purchase of stocks and real estate in the 1920s or, more recently, the boom in real estate and debt-laden leveraged buyouts that enriched the new owners. But we will let history do the redefining and correcting.

Short sellers function as the police officers to markets—the editors—the very checks and balances our forefathers envisioned. The shorts are a disinfectant, shedding light where there is only corporate darkness. In many ways they are the inheritors of the rights of dissent and the rights of minority interests that the founders fought for and designed with such intricate detail. What has happened over the last year is the economic equivalent of Tiananmen Square. I will not argue that the right to short sell is the equivalent of a sole freedom marcher’s denying a tank’s advance or an Iranian’s willingness to give his or her life so that others enjoy the inalienable rights that ourfounders expressed for the world. But I will say that, in the same way that governments want to discourage dissent and keep their power, corporations have the natural inclination to keep the ranks in file, which has prompted them to engage in a war on shorting.

Controlling the message without a filter is what governments want—it is the central nervous system of any political campaign—and can be an important business strategy for any corporation. When big business becomes so big that it can operate hand in hand with Washington, what is good for business is good for government, and vice versa. In a related sense, what is bad for business is deemed worth using the arms and levers of Washington to police.

Financial protesters
The reason that shorting taps into our inalienable rights is that short sellers are financial protesters. Very much like the press, shorts should have the right to ask any question they want. I do not believe that it is a coincidence that a war on shorting coincided with a war on sources for news stories. The press lets out a pretty loud yelp when a reporter goes to jail for protecting sources, preserving the rights defined by the First Amendment. Yet, ironically, the very people who defend the free press—including some of the world’s finest journalists and editors at the New York Times—also run story after story evidencing a very negative slant against shorts.

In part, short sellers are the 60 Minutes of the capital markets. They are the investigative reporters who show up at your warehouse and ask if you are dumping toxins into the river, or worse, exporting your bad and mercury-filled computers to China. This is why management hates them so much and wants to do everything it can to get rid of them.

The reason American capital markets are the best in the world is that we have the best information. In many countries, the government is less trustworthy, and there is less capital flow because of the manner in which information is disseminated. Japan is still coping with the fact that it kept altering the number of bad loans the country had in the early 1990s. Every number the Japanese government released was supposed to be final—until the next final number was announced. The government manipulated the information, and now, 15 years later, a significant chunk of the population remains inclined to second-guess the government’s official statistics.

Shorting encourages transparency
By discouraging shorting, this essential transparency—ironically the same transparency that the Obama administration keeps calling for—becomes completely unattainable. In a world where information is incredibly accessible, where it is often a point-and-click or a wiki-site away, there is now a war on accuracy that starts with a war on shorting. We have confused accessibility with accuracy and consequently are making it easier—despite all the public scrutiny on compensation and bonuses—for companies to manipulate earnings, lie about their balance sheets, and distort their overall financial health. It appears we are doing this because the creation of a scapegoat is a successful political tool. But what boggles the mind of any speculator with an understanding of history is that we are repeating a pattern that has never borne prosperity.

During the height of the panic that ensued after the collapse of Lehman Brothers, two things became clear to market participants. First, the firms that were the backbone of the financial system were incredibly interconnected. The idea behind letting Lehman fail was to prove that there was no such thing as being “too big to fail,” that regulators and central bankers were determined to show that taking big bets with shareholder money did not end in an exchange of shareholder interests with those of taxpayers. By letting a big firm fail, the regulators figured that they were sending a message that there was no free lunch for Wall Street. They were also saying to the global banks around the world that“we will not bail out your bad bets.” Second, the regulators believed that there was enough financial strength in the system to withstand a failure of one major bank.

But the regulators went a step further—they went out and blamed the shorts, restarting what the Senate Banking and Currency Committee put to rest some 80 years earlier. In the immediate aftermath of the failure of Lehman, shorts came under attack from all sorts of people. The attack was global: liberal and conservative politicians, clergyman of all faiths, trade unions, and bank CEOs.

So what did the global regulators and heads of state do in the aftermath of the mortgage debacle? Gordon Brown—a politician in need of an uptick—along with the British Chancellor of the Exchequer, attacked shorting in no uncertain terms at the annual Labour party conference. The British Prime Minister told the conference that the rights of homeowners come before the rights of a “few hedge funds.”

Other European political leaders followed suit. Prime Minister Silvio Berlusconi of Italy called for a ban on “speculative attacks” on Italy’s banks. Peer Steinbrück, the German finance minister, piled on as he wanted all “purely speculative short selling” done away with. As events from the 1930s were repeating themselves, the larger economic and difficult regulatory issues were taking a backseat to easy political talking points that could be made by assigning immediate blame to those who could not defend themselves.

Hedge funds: press shy
Hedge funds and the proprietary trading desks that obtain liquidity by shorting stocks are incredibly press shy because the people who give them money to manage, either investors or the management of the big banks, are hypersensitive to negative press. There is an old adage in the hedge fund industry that says that headline risk is death. This is because the people giving them money provide that capital on a short-term basis, and a transaction that makes controversy is particularly unpalatable.

“I think the hedge funds would have lost the debate anyway, but given that no one turned up, there was no chance of winning the debate,” says one of the United Kingdom’s largest hedge fund managers, who declined to be named. Dozens of other managers expressed similar sentiments. After the crash, the British press quickly labelled hedge funds “spivs” and “speculators,” and few wanted to go public to defend shorting since politicians and regulators were trailing in the media’s wake.

Following suit, most of the world’s largest stock markets introduced temporary restrictions on short selling—some, like the United States, suspended shorting on 15% of the NYSE companies. The number of companies that applied for protection was very high. In the United States, almost 1,000 companies applied to be exempt under the SEC emergency order to ban short sales of financial companies.

But then a funny thing happened. All sorts of firms were calling themselves “financials,” even though they had already raised money from the public in all sorts of ways by calling themselves “nonfinancials.” Health-care companies, information technology companies, and manufacturers, as well as Ford and IBM, all wanted to be exempt from shorting, alongside insurers and banks. This is why shorting is such an emotional and important issue. Companies need to produce quarterly earnings, and the ways in which they sometimes go about fulfilling that need collides with the investors’ right to know the true financial conditions of the companies. But when these truths are exposed by the shorts, a constituency that can easily have points scored against it in the eyes of people who don’t fully understand its function, their merits are lost. Perhaps the most poignant maligning of shorting came from England and the archbishops of York and Canterbury, the top Anglican clerics who called on the government to ban short selling and not lose their nerve as “they look to identify more targets.” Chaucer, who noted a tradition of corruption in the churches as far back as the 14th century, would no doubt have laughed at the irony of the Archbishop of Canterbury calling short sellers “asset strippers and bank robbers.”

Duplicitous behaviour
But some very duplicitous behaviour by the critics of shorting came out during the height of the financial crisis. The very critics of shorting by the Church of England were found to have profited from their hedge fund investments—some of whom had shorted stocks as a key point of their strategy. The Liberal Democrats in the United Kingdom were found to have their largest contributor be a hedge fund; members of Parliament had invested in hedge funds as well.

Wall Street CEOs were telling their employees and shareholders that the only thing wrong with their firms was the market’s irrational view of them. They believed that fear, rumours, and short selling were reasons that stock prices were falling. Liquidity issues of banks that had borrowed money in the short term only to buy assets in the long term were not addressed. The wholesale funding that supported and then could not support the entire earnings stream of Wall Street firms was being explained by huge numbers that could have quickly disappeared. The amount of credit lines and funding available to the firms was not the same as core capital. Firms knew that the flaw in borrowing short and lending long was exposed, so they did what they always do: they attacked the people they could attack and moved the attention of the debate away from themselves.

What these CEOs also did not realize was that in attacking the shorts and publicly naming them as the main reason for the falling of their stock prices, they were exacerbating their own demise. The hedge funds assets that were held in the prime broker departments of the very same banks having funding problems became nervous that their clients and their own money could find its way into a bankruptcy, resembling what happened at Lehman Brothers Europe. The resultant widening of the credit default spread was caused as much by managers wanting to protect themselves against the failures of the banks that held all their money as anything else.

History repeats itself
Wall Street lobbied Washington for a ban and got one. But then a funny thing happened—history repeated itself. Just as it was in 1937 when the SEC introduced an uptick rule, people had forgotten how shorting was so interconnected with the instruments of the capital markets—a mirror image of how institutions were interconnected to one another. After introducing the uptick rule in 1937, regulators started to get complaints that market makers could not do their jobs. They could not provide liquidity at a price, so regulators made consecutive—not concurrent—one-off exceptions. As a result, the SEC gave an exemption to shorting instruments, where the long position was convertible into the underlying stock, like warrant and convertible bonds, and for general market-making activities. Just as it was some 70 years later in 2008, the ban was total at first. There were no “exempted short positions taken as a hedge against holdings of convertible bonds, which can convert into equity. It also allowed shorting by market makers—special traders who match buyers and sellers—and index arbitrageurs, who ensure index futures contracts trade in line with the underlying stocks.” Wall Street was powerful enough to shut down the very markets that it would later tap to raise needed capital in the future—such as the preferred stock and convertible bond markets—all because it believed shorting was hurting it. In fact, the ban turned out to be very expensive, as it undoubtedly increased the cost for the capital that needed to be raised in the middle of the crisis.

The regulatory moves effectively put many hedge funds whose sole focus was buying convertible bonds out of business. “The market shutdown was blasted by the industry for destroyingthe hedge-fund-dominated convertibles market by refusing to exempt hedges against convertible bonds or convertible preferred stock…The reason people like us are willing to lend money or invest money in these companies is because we can hedge the underlying risk of the company,” fumed the head of one of the largest hedge funds in the United States. “The market is now completely shot as a way for companies to go out and raise capital.” In other words, one of the market’s best providers of liquidity was being undermined.

The Financial Services Authority, the UK regulator, understood the connectivity of shorting to the rest of the market, but the US regulators did not and only repealed parts of the ban after it became apparent that many other markets—other than the stock market—were dependent on being able to hedge the underlying bonds or preferred stock. But by that time, the ban was on—stocks rose ferociously and caused tremendous losses for the very people that the country needed at that time to lend money (buy bonds) from the very banks who wanted the ban. The buyers, most of them Americans, would have stepped in instead of having foreigners own a substantial part of the banking system. In an odd way we have said that banks are too important to fail, but not important enough that the matter of who owns them is a political or national security issue. To call this a short-sighted strategy is an understatement. No one was thinking of the unintended consequences at the time. There was only the transfer of wealth, from funds and firms that were the victims of the short-sale squeeze on banks to the banks and former investment banks that needed their share prices bolstered.

Good vs band shorting
The ban also effectively identified good versus bad short selling. Short selling that helps companies raise capital is “good.” If companies can issue debt in the form of convertible, corporate, preferred stock, or distressed debt, and if the owner wants to hedge the risk of holding the debt by shorting some of the common stock against it, that is morally good. But if someone takes a bet against a company in the form of shorting its common shares, that is morally dubious or “bad.” “The Church of England makes this distinction itself in defending its use of currency hedging for its vast investment portfolio, a practice that could be described as shorting entire countries,” (an article in the Financial Times noted).

Aside from the role shorting plays for companies raising capital, there were further unintended consequences immediately after the ban. The biggest impact was that people could not get their money out of the equity markets as fast or as cheaply as they could before the ban. Liquidity—getting your money when you want it—cost a lot more after the ban. Was that supposed to be the point?

According to Credit Suisse, the cost of trading rose sharply in stocks that can no longer be shorted, as bid-offer spreads – the difference between buying and selling prices at any moment – widened “substantially.” The reason was simple: volume plunged as hedge funds stopped taking long positions that they could not hedge with short positions in other stocks.

Volumes plunge
Analysts at Sandler O’Neill calculated that volumes of trades on US exchanges fell 41% after the ban, with volumes in stocks that can no longer be shorted down 49.6%, while for those that can still be shorted it was down 37.7%. At the same time—as is normal when liquidity dries up—volatility increased sharply, making shares rise or fall faster.

The problem here is that the computer-driven hedge funds that make up 30–40% of trading on the world’s major stock exchanges have cut back, as they cannot risk trading without short positions to protect them from overall market movements. The regulators appeared to believe that this was a price worth paying for bolstering financial share prices while the US’s $700 billion bail-out plan was put together.

The short-selling ban was instituted because the falling of a bank’s stock price—even though it is the most junior piece of paper in the capital structure—was deemed to be the most important piece of financial information in worldwide financial circles. Callum McCarthy, as chairman of the FSA, said that the UK watchdog had brought in the ban because it was concerned with “incoherence” in bank shares. He said “movements in equity prices can be translated into uncertainty in the minds of those who place deposits with those institutions with consequent financial stability issues,” echoing worries that plunging shares can cause a run on a bank.

The SEC raised the issue of rumour-mongering by short sellers, where a trader bets against a stock and then spreads false rumours to push down the price. This is already illegal, of course, and it is the nasty rumour that overwhelmingly contributes to the black eye worn by the profession. “This kind of manipulative activity is particularly problematic in the midst of a loss in market confidence,” the SEC said. “For example, in the context of a credit crisis where financial institutions face liquidity challenges but are otherwise solvent, a decrease in their share price induced by short selling may lead to further credit tightening for these entities, possibly resulting in loss of confidence in these institutions.”

Therein lies the problem that we all face. Short selling is one of the integral forks in the road for how we are going to regulate banking in the future. The Brady Commission, though full of many interesting recommendations (one of them was to combine all regulators, something the Obama administration had considered), focused solely on why the crash of 1987 happened, and on very specific trading practices, not on all of Wall Street. The country was willing to give President Ronald Reagan and his team a pass, since most of the country believed that Washington, and not Wall Street, was the cause of economic problems.

In 1907 the Pujo Committee underscored the country’s unease with the management of the laissez-faire banking system, which was created by Andrew Jackson’s refusal to renew the Second Bank of the United States. The committee took shape to counteract how deeply entrenched Wall Street had become in Washington. The National Monetary Commission was led by a Republican senator from Rhode Island, Nelson Aldrich, who was a good friend of Wall Street, but the recommendations went nowhere because Wall Street understood K Street before there even was a K Street. They “fared well in the Washington arena.” So Wall Street was able to schmooze its way out of regulatory harm and scrutiny because it was such a powerful oligopoly.
The Pujo Committee’s work was followed by a time in which business was seen as controllable because of the newly perceived relationship between government and big business in the 1920s. With the successful passing of the Clayton Act, which strengthened antitrust regulation, and the establishment of the FTC to enforce the Clayton Act, Stanley Buder, in his Capitalizing on Change: A Social History of American Business, contends that the average American finally saw the federal government as an effective “watchdog” on business, and the progressive initiatives “dampened anti–big business sentiment by seemingly offering protection from large corporations.”

The FTC was considered the watchdog over capitalism and big corporations. So when the crash happened, Washington’s road map was an easy one to regulate Wall Street. The Pecora Commission, recognizing how entrenched Wall Street had become, decided to show the world what some of the guys were up to. It was clear that the opprobrium directed at the bankers was just. The double dealing, insider trading, and manipulation of the stock market were seen for what they were: an insider’s game. Matthew Chauncey Brush was asked during his testimony after Whitney to the Senate’s Banking and Currency Committee in 1932, “Have theygot rackets like Al Capone up there?”

Bankers skewered
Mr. Brush answered, “Al Capone is a piker compared to that racket.” Brush had replied in a way that captured the power and the criminality that many felt Wall Street had committed. Pecora used the doings of Wall Street to reintroduce proper legislation. I think he brilliantly realised that even though he did not preside over the shortsale hearing, the effect was to soften Wall Street up. The bankers that followed the prominent Wall Street bears were shown up for rigging the game. They were documented under oath, and he skewered them—rightly.

Just as in 1932, the investigations into shorting and rumormongering—still ongoing through the summer of 2009—are the opening bell. Wall Street complained and got action on something that is very hard to prove: what was the motivation of the seller at the time of sale? Professor Marshall Blume of the Wharton School poses a hypothetical question: “A person has a negative view on the stock; they sell the stock short, and then they call up their friends and say, ‘I had a negative view on this stock and sold it short.’ And then other people then sell it short; helping to drive the price down. Is that market manipulation?”

What Blume describes is perfectly legal, whereas spreading the same information with the intent to drive the stock price down is illegal. Of course, determining one’s intent is a difficult, if not impossible, task.

Wall Street bought some time and deflected the blame of the credit crisis onto short sellers based upon the definition of what the intent was at the time of sale—very tricky ground. If someone did purposely and abusively spread false rumours, the law is pretty clear about what should happen to that person. History has repeatedly demonstrated that there has never been a case of consequence when it comes to proving intent as it pertains to short selling or naked short selling. Something tells me that the Wall Street executives should brush up on Pecora and understand the vitriol that America has historically held for Wall Street.

First amendment issues
If there is a litigation of a major player in the money management world who disseminated his belief that the shares of a major financial institution would fall based on his research, then I believe that you have a classic case of First Amendment issues: right to freedom of speech, right to peaceful assembly, right to protest. The case would try to prove that the research was given out with the intent to drive down the shares of the banks and brokers. It will be hard to prove because the numbers are on the side of the shorts. Wall Street firms, despite their protestations to the contrary, were not as well funded as they stated. It is simple: a firm may have had $40 billion in equity capital and $500 billion in debt, but it had over $2 trillion of CDS exposure that it had written to other firms and clients. Once the market thought that the firm could not pay off a significant majority of the $2 trillion in promises to pay what it owed other firms, the core capital of debt and the firm’s equity valuations were not near enough to cover its obligations. Every jury will understand that $2 trillion is a bigger number than $500 or so billion—this $2 trillion number would be on top of the souring mortgage, residential, and commercial bonds on the firm’s books.

As I already stated, short sellers are financial protesters. As much as the government hates leaks to the media and unexpected front-page stories in the Washington Post or New York Times, corporations view short sellers as snitches, people who prevent them from controlling the spin on their own companies. Shorts are an interference, or an outright block to the message they want played to the public. If you are the government, it is the CNN watcher, the buyer of newspapers, and the online news browser who get your story. If you are Wall Street, it is the buyers of stocks and bonds. There is one difference, however: politicians do not have to sign a piece of paper that is legally binding to attest to the accuracy of what they say. Corporations do. If they are public, they have to attest to the accuracy of their public statements and filings. It is why we have the best information and best capital markets in the world. What are the suspenders to the belt of possible civil and criminal litigation? Short selling.

At the very beginning of the credit crisis, I was fascinated by how the crisis quickly morphed into a Main Street versus Wall Street argument. Did Wall Street cause the panic? Wasn’t it those greedy bankers who caused all these problems? No one in the media bothered to try to explain how the fracas between Wall Street and Main Street reached its boiling point. This is one of the reasons that I decided to write Don’t Blame The Shorts – Why Short Sellers Are Always Blamed For Market Crashes and How History is Repeating Itself.

All my friends on Wall Street said that it was a ridiculous argument. Main Street is Wall Street; they are the same; there is no difference. They were completely—even as smart as some of them are—unaware of the anger that was brewing in the country over the paychecks and self-appointed entitlement—“my business is more important than your business, so I need government money more than you do”—mentality. There was just this very strange feeling that the credit crisis had actually revealed that some of the most basic assumptions we had made about one another were wrong. Wall Street felt that since it runs the most important businesses in town—after all, what is more important than credit—we were all in this together. Main Street felt differently.

In this crisis, my appreciation for American history and for the founding of this country was renewed. For all the stories, books, articles, and blogs that I read while researching this book, I was fascinated that not one of them actually addressed the issue of why Main Street feels the way it does about Wall Street. I had a hunch that there was something in the nation’s founding that could explain not only why we feel the way we do but also how our feelings take on different vehicles over time. There are very real historical antecedents that show we are doing nothing but repeating what our founding fathers did so many years ago.

Robert Sloan is the managing partner of S3 Partners, a firm that manages the global balance sheets of leading hedge funds. This is excerpted from his new book Don’t Blame The Shorts (McGraw Hill)