Angered by the recent drubbing of his company’s share price, Morgan Stanley CEO John Mack made a stinging assertion and a solemn vow in September. “Short-sellers are driving our stock down,” Mack wrote in a memo to Morgan Stanley employees. “The management committee and I are taking every step possible to stop this irresponsible action.”
Mack’s vitriol echoed the sentiment expressed by another beleaguered investment banking titan, longtime Lehman Brothers CEO Richard Fuld. In April, Fuld told shareholders that he was out for revenge: “I will hurt the shorts — and that is my goal.”
Yet Lehman and Fuld are history, Morgan Stanley is a holding bank fighting for survival, and short-sellers — though they have been temporarily reined in by regulators — have yet to be vanquished.
The dominolike fall of some of the biggest firms in finance — and the widespread assertion that short-sellers were partly to blame for their demise — led to what was probably a politically inevitable move by the Securities and Exchange Commission on September 19, just two days after Mack sent his memo. The agency not only resurrected a temporary restriction imposed this summer on the shorting of 19 “systemically important” financial stocks but also widened the ban to include 950 companies.
“The emergency order temporarily banning short-selling of financial stocks will restore equilibrium to markets,” SEC chairman Christopher Cox said at the time.
The effectiveness of the ban, which expired three days after President George W. Bush signed the $700 billion financial bailout legislation into law on October 3, is clearly in question. The Dow Jones industrial average plummeted more than 2,000 points during the two and a half weeks the short-selling restrictions were in place, continuing an increasingly stunning yearlong slide in which the Dow had lost a third of its value by early October.
Short-sellers — who sell borrowed securities in the hope of profiting by buying them back later at a lower price — are under assault nearly everywhere. Australia, Canada, France, Germany, Italy, the Netherlands, Portugal, Taiwan and the U.K. have placed restrictions on the practice, imposing bans lasting from weeks to months. The prohibitions in Australia and Italy apply to all stocks, not just financial ones, and in the U.K. the Financial Services Authority has hinted that short-sellers will face permanent restrictions once the current ban expires in January.
For hedge fund managers, perhaps the most blood-chilling component of the rush to exterminate short-selling was the SEC’s initial demand that hedge funds be required to publicly disclose substantial short positions that they already held in any of the officially protected financial services stocks. The agency backed down after hedge fund managers complained that the rule could kill the $1.9 trillion industry, arguing that to force such disclosure would be tantamount to asking a poker player to show his cards midway through a hand. But the SEC on October 16 extended to August 1, 2009, a temporary rule requiring major short-sellers to report their positions to the government, and the sense remains that as the U.S. economy slides deeper into recession, the regulators, financiers and politicians who would bury short-sellers once and for all are marshaling forces to finish the job.
Any investor who shorts — and there are many, both in the hedge fund industry and outside it — must now consider the possibility of life without shorting. Asked to describe the impact such a change would create, Dick Del Bello, a senior partner at New York–based hedge fund administrator Conifer Securities, puts it this way: “There are a lot of players who’ve just been dealt out of the game.”
That is because the heart of the hedge fund industry — even if it seems to go without saying — is hedging, which, put another way, is playing long bets against short ones. Though even the most ardent defenders of shorting won’t deny the harmful effects of naked shorting (the practice of selling a stock short without first borrowing it or having arranged to borrow it), most are clearly alarmed at the regulatory rush to judgment and warn of the long-term damage to the markets that could occur in the absence of short-selling.
In a speech in July to members of the Managed Funds Association — the main voice in Washington for the hedge fund industry — Richard Baker, the group’s president and CEO, defended short-sellers as one of the forces that keep the markets honest. “Short-selling is an essential risk management tool and a critical component of ensuring market stability, not a contributor to market volatility,” argued Baker, a former Republican congressman from Louisiana.
Robert McDonald, a professor of finance at the Kellogg School of Management at Northwestern University, says the SEC is behaving more like a bully than a wise regulator.
“The SEC’s focus on short sales reminds one of the adage that when your only tool is a hammer, every problem resembles a nail,” McDonald explains. “If short sales are forbidden, investors with unfavorable information about a firm cannot express their information by trading.”
McDonald is among those who argue that short-sellers ultimately have a buoyant effect on markets. Without short-sellers, investors may be less willing to pay as high a price for a good stock. “They will assume, correctly, that bearish opinions have been suppressed, and the price they will willingly pay for the stock will be reduced,” McDonald says. “So a short-sale restriction may even lower the price by causing investors to discount high-quality stocks.”
Ari Bergmann, lead portfolio manager for Cedarhurst, New York–based hedge fund Penso Capital Markets, agrees that curtailing short activity is counterproductive. “By banning shorts, you’re not solving the problem — you’re just delaying it,” he says.
Andrew Feldstein, CEO and chief investment officer at New York–based BlueMountain Capital Management, a $5.6 billion private investment firm, smells a witch-hunt. “Having a philosophical problem with short-sellers is one thing, but we need to figure out solutions that are different from the extreme measures that have been taken,” Feldstein says. “If the SEC thinks there has been market manipulation and that the law has been violated, they have the tools to go after the perpetrators. But this approach is clearly different.”
The current call to control short-selling is only the latest in a series of efforts by the SEC to repair the problems that its critics say it helped create. Regulation SHO, enacted by the agency in early 2005, sought to curb naked short-selling through the inclusion of a “threshold security list,” which tracked potential stock-delivery violations involving numerous companies that were said to have been targeted by short-sellers. The rule, by most estimates, was largely ineffective.
Two years later the SEC abolished the 73-year-old uptick rule, which barred short sharks from moving in until a stock’s price had first moved up. With shares of major financial firms suddenly in free fall this summer, the SEC in July did an about-face and ordered a three-week suspension of shorting in the shares of Fannie Mae, Freddie Mac, Lehman Brothers and 16 other financial issues. The action was to no avail, though, as those stocks and the markets in general continued to plummet.
With the latest crackdown, in which the SEC reimposed and expanded its summer ban, regulators have a daunting task. They are trying to appease the chorus of corporations and other critics who place much of the blame for the market meltdown on short-sellers. And they are in the position now of having to defend a ban on short-selling even as markets have tanked while short-sellers have been sidelined.
Still, the SEC and its overseas counterparts are likely to continue to try to keep short-sellers on a short leash. In the U.K., where the campaign against short-selling began, Prime Minister Gordon Brown announced in September the FSA’s intention to extend portions of the ban beyond January. “When a group of people are exploiting a difficult economic situation,” he said, “it is right to stop it.”
But even if short-selling as hedge funds now know it were to be outlawed permanently, there are viable and legal ways around it — although none are as easy or cost-effective as selling borrowed securities. “Investors can buy puts, sell calls and short futures, effectively shorting the stock by using a derivatives market maker as a surrogate,” says Kellogg finance professor McDonald.
Put and call options and futures all trade on exchanges. Investors can also use over-the-counter derivatives, which for the most part fly beneath the SEC’s radar. Equity swap contracts — which allow investors to profit if a company’s share price falters — are one route.
Another is the use of credit default swaps, whereby investors in essence buy insurance protection on companies with questionable fundamentals. Should the company slip and its credit spread increase, investors profit. (Traders using credit default swaps may currently be creating downward pressure on big stocks like General Electric Co., a late addition to the untouchables list, which saw its five-year CDS spreads balloon to 626 basis points in early October — a threefold increase in less than a month — as its stock dropped by more than 20 percent.)
But using derivatives to short has a pronounced downside: It adds a middleman to the equation, which increases investment costs. Aaron Gerdeman, a product manager for New York–based research firm SunGard Astec Analytics, says the higher price of doing business would be painfully evident. “There’s no getting around the fact that short-selling is the most efficient mechanism to express negative sentiment toward certain asset value,” Gerdeman argues. “If the regulations force investors into alternative mechanisms that are more costly, that inefficiency will make itself plain to the market.”
Worse, those products that trade on the largely unregulated over-the-counter markets could cause even more headaches for the general markets — much as credit default swaps have already done this year — notes Susan Chaplinsky, a corporate finance professor at the University of Virginia’s Darden School of Business. “We’re seeing the net effect of that trend now with credit default swaps and collateralized debt obligations,” Chaplinsky says. “The bottom line is that it’s just not a very good solution.”
Add to that the fact that SEC chairman Cox has signaled that credit default swaps are next on the hit list. Noting that the $54.6 trillion CDS market is unregulated, Cox has asked Congress to pass a law establishing “the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets.”
Hedge funds also have the backing of enormous wealth: The pension programs of corporations, governments and major foundations and endowments in the U.S. and Europe are among the biggest investors in hedge funds. To threaten short-selling is to threaten the vast flow of institutional assets.
Perhaps the solution lies in the little-talked-about notion of a built-in circuit breaker that would stop short-sellers if downward momentum on a stock were to reach a certain velocity. Though the idea has received scant attention and hasn’t been widely discussed, it hardly seems beyond the pale. NYSE Euronext on October 1 said it was considering just such a rule to put the brakes on stocks that are in free fall; the exchange would place an intraday ban on trading the stocks in question and restrict short-selling on them for perhaps several days after that.
Such a move, of course, would be a radical step by the stock exchanges — as would any attempt to limit trading — but the mere fact that the action was proposed by such a high-profile intermediary is a sign that it may have legs.
