DON’T BLAME THE SHORTS

WHY SHORT SELLERS ARE ALWAYS BLAMED FOR MARKET CRASHES AND HOW HISTORY IS REPEATING ITSELFBy ROBERT SLOAN

The McGraw-Hill Companies, Inc.

Copyright © 2010 Robert Sloan
All right reserved.
ISBN: 978-0-07-163686-5

Contents

Chapter One

The Great Debate 1790–1800

To establish the concept of the “security of transfer,” Hamilton was willing, if necessary, to reward mercenary scoundrels and penalize patriotic citizens.

—Ron Chernow

Before we turn to the founding fathers, a few points must be made about the very nature of short selling.

Unique among financial transactions, short selling can be viewed as deeply personal, as an attack on one’s own personal possessions. In 2001, when questioned about his company’s unusual accounting procedures, then-Enron COO Jeffrey Skilling famously replied to a noted short seller, “Well, thank you very much, we appreciate that. . . Asshole.” What’s striking isn’t Skilling’s lack of compunction, but the fact that he had no reaction to investors who owned Enron stock and decided to sell it. In the end, of course, the short was right to suspect that Enron’s books were a sham and considerably misleading.

Short selling has aroused such strong emotions that analyzing the practice dispassionately can be nearly impossible, especially since it is often misunderstood outside Wall Street. No one has any animus toward the commodities speculator who shorts wheat or oil. The person who shorts oil is a hero in this country because he wants the price to go down. But he who shorts an oil company is a villain because he wants the oil company’s fortune to sour. He who shorts a corrupt energy company is only vindicated when that company’s smoke-and-mirrors act has come to light. No one mentions George Soros’s role in breaking the British pound by shorting the currency in 1992 as a reason to disqualify him from playing a very serious role in American politics. It is only the shorting of stocks that prompts such harsh—and strong—emotions.

The history of short sellers actually dates back to the early seventeenth century, when the very first European trade markets were born. More important, the controversy over short selling goes back just as far. The Dutch East India Company filed complaints against the Amsterdam Stock Exchange over large profits made by short sellers in 1609, which led to the first regulations on short selling the following year. By the end of the seventeenth century, Amsterdam had issued a decree levying taxes on short-sale transactions. Two Dutch pamphlets on short selling from 1688, written respectively by lawyers Nicholas Muys van Holy and Joseph de la Vega, survive to this day. One, aptly titled “Confusión de Confusiones,” shows how mysterious and misunderstood the practice was from its very inception.

In a strange trial-and-error pattern that spanned two centuries, markets all over the West experimented with short-selling restrictions before ultimately removing them. In 1733, Sir John Barnard, a member of the British Parliament who attacked moneyed interests, introduced an act that banned naked short selling. However, the act was honored more in breach than in observance—despite heavy penalties of up to the equivalent of $500—and it was subsequently repealed in 1860. In France, Napoleon’s finance minister passionately lobbied the emperor on short selling’s behalf but to no avail. Much like President Hoover would a century later, Napoleon couched his decision to ban the practice in patriotic terms, calling short sellers “enemies of the state.” Years later, however, recognizing the ban’s futility, Napoleon repealed the legislation. In the United States, New York prohibited short sales in 1812, only to remove the ban in 1858, when “short selling occurred with abandon.” In 1896 the Berlin Boerse forbade short selling, but reversed track by 1909. In a strange trial-and-error pattern, markets all over the world tested short-selling restrictions and ultimately removed them.

Writing in the New York Times, J. Edward Meeker, the New York Stock Exchange’s staff economist during the 1920s and 1930s, summarized the history of short selling with a prescience that echoes true today. “The popular misunderstanding and prejudice against short selling of securities is not new,” wrote Meeker. “As long as stock exchanges of the world have existed, the short sale has been bitterly condemned, but invariably endorsed after thorough investigation or painful experience, as a vital and indispensable factor in the maintenance of free securities markets everywhere.”

Why had short selling been bitterly condemned, and why does it remain so today? The problem has always been, as it is now, a murky moral issue engulfing the transaction: How can a regulator possibly determine the motivation of the individual speculator? If prices fall day after day while confidence in the marketplace plummets, is it justifiable for the bear speculator to push values still lower by selling short? Is the seller motivated by righteousness or personal gain?

But these questions obscure a few important facts. First, it is the short sellers’ job to hunt for fraud, inconsistency, and bad business models and to offset the risk of positions already held. Second, their profits are the proof that a company’s management is not giving its shareholders an accurate picture. Third, success also requires a considerable amount of risk. Shorting is not selling those stocks that are overpriced, and getting the gearing and position weighting right. The short must endure many days, sometimes years, of being wrong before he or she is proven right. A hedge fund manager who can take a view on the markets only as long as he has use of the money—usually three months or less—must be committed and very right. The market bias and the short-term nature of his capital beg for the short to be squeezed out of his position. It runs against the human condition to accept constant daily negative feedback, the stock going up with your exposure as well, and interpret that as a positive.

The best analogy of how shorting works is in Frank Partnoy’s book, Infectious Greed:

Another limitation on arbitrage was the difficulty of taking a position that would increase in value when the stock went down. The basic problem was that, although it was easy to bet in favor of a particular stock, it was difficult and expensive to bet against it by shorting stock. Moreover, put options often were unavailable, too expensive, or expired too soon.

Partnoy goes on to compare the stock market to a pari-mutuel betting window at a racetrack:

It was simple to bet on a horse: you walked up to a window and bought a ticket. But how could you bet against a horse? You could try to find someone in the stands who wanted to bet on the horse, and bet with them. But that was time-consuming, and—unlike the cashier standing at the pari-mutuel window—you couldn’t be assured that a random person you found would pay if she lost. Or you could do something more complicated: find someone who already had bet on the horse, borrow their ticket, and sell that ticket so someone else, promising to pay the person if the horse won, in which case she would give you the ticket, which you then would return to the first person, along with a fee. This second plan had problems, too. Not only did it have several complex steps, but a random person betting on the horse might not be persuaded that you would pay if she won.

Most investors short stock by borrowing the shares from their brokers and selling the borrowed shares to other investors with the promise of buying back the stock and returning it to the brokers in the future.

In the 1930s, regulators in this country made shorting more difficult to execute, which is exactly why hedge fund managers get paid so handsomely: anyone who can run the gauntlet of all the upward price bias built into how we regulate short sales is rewarded handsomely by investors. So handsomely, in fact, that it has redefined wealth as we know it. (This wealth seems to be another reason why the public distrusts short sellers.) The ability to short and to buy securities on margin (use leverage) are the main differences between a hedge fund and a mutual fund. Shorting is the main justification for the compensation models that hedge funds enjoy.

Which brings us back to Enron. Even if short sellers are correct in their positions on the value of a company, they remain a walking target on account of their own wealth and their influence on the wealth of others. Then as now, Wall Street firms that short in their proprietary trading (and profit from the liquidity and fat profit margins from executing and clearing short trades for their clients) blamed the shorts for their ills in the fall of 2008. CEOs blamed short sellers for spreading rumors about their firms and demanded their arrest. CFOs blamed short sellers for distorting their conference calls and the market valuations of assets on their balance sheets. In doing so, they adopted the populist rhetoric as old as the country itself: that shorting was un-American.

However, short selling is as American as can be. From its very beginning, the country has had an uneasy relationship with speculation and the compensation that comes with it. Many felt in 1790, as many do now, that compensation made through financial speculation is unjust, and short selling is the most unjust of all. When our country began, there were arguments over compensation and the transfer of security rights, debates that turned out to be the forebearer for how we now feel about shorting.

Hamilton, Jefferson, and the Fight Over Assumption

In the early days of our republic the economic foundation of the country was in disarray. The debt of the federal government was vast, as was that of the states, each of which had its own currency, not to mention debt and tariff laws. Some states were creditworthy, some were not, and most paid the soldiers who had helped win the Revolutionary War merely in IOUs.

In 1790, in order to steady the economy, Treasury Secretary Alexander Hamilton consolidated these IOUs, and other state debt, under the federal government. The move was called “assumption,” and Hamilton planned to pay for it by introducing a debt scheme funded by new taxes and the use of western land as collateral. Before Hamilton’s plan was enacted, skillful investors and speculators—some very close to Hamilton—began purchasing these depressed instruments from soldiers and other debt holders, creating the widespread appearance of arbitrage. The states’ debt and IOUs were trading at very large discounts to par, some as low as 15 cents on the dollar.

A vast fortune might be made if investors could locate state creditors and purchase their claims at a discount. Senator Robert Morris, considered by some to be the wealthiest man in America, sent agents scurrying to the western region of his home state, Pennsylvania, to buy up cheap paper from unsuspecting citizens. Congressman James Wadsworth sent two ships to South Carolina for the same purpose. The result was that before assumption took place, or even before many people knew about Hamilton’s plan, a significant number of soldiers and other holders of state debt had unloaded it at a steep discount to New York speculators. Better to receive some money, the soldiers and debt holders thought, than none at all. To the debt holders, the speculators seemed to be gambling that the federal government would step in and assume this debt.

Actually, for many of these speculators it wasn’t much of a gamble. They knew the new government was about to approve assumption, and the speculators—which included political leaders—took advantage of their inside knowledge that the federal government would guarantee the repayment of that debt.

This issue about assumption set the stage for a more than 200-year ideological split over how the country’s financial interests should be run. The battle determined how southern and, later, western interests would look upon their eastern brethren.

Assumption created a twofold quandary: should speculators profit from the arbitrage opportunity that the government presented to it? Or should the original soldiers be compensated for their losses? Hamilton decided that for the greater good, the speculators should be allowed to profit. The establishment of the good credit standing of the United States was more important than the vexing issue of who should profit. The government should stand behind the transferability of bonds, no matter if the purchase occurred recently, as it had with some speculators, or much earlier, as it was with many who had faith in the new government from its earliest days.

Hamilton believed in a strong executive branch. He understood that the creation of a single unit of account upon which a national currency could be established, the right to taxation, and the right to issue debt would not only unify the country but would also give the federal government the centralized power it needed to function. But that meant there would be a very hard choice—as the philosopher Thomas Hobbes argued—about how to assure that contracts would become the underpinning of a society. Contracts had to be honored, and the buyers and sellers had to accept the consequences of their actions. The protection of property rights was at the heart of any future economic structure.

Even when reports showed that many speculators were buying up cheap state debt that would become valuable under assumption, Hamilton held his nose. He maintained that the original holders got liquidity when they wanted it, and that was compensation enough, even though their military service made them more patriotic than the speculators. At stake now was a new kind of patriotism: Hamilton thought that speculators should be rewarded for showing faith in the financing structure of the new country.

Hamilton stole the moral high ground from opponents and established the legal and moral basis for securities trading in America: the notion that securities are freely transferable and that buyers assume all rights to profits or losses in transactions. The knowledge that government could not interfere retroactively with a financial transaction was so vital … as to outweigh any short-term expediency. To establish the concept of the “security of transfer,” Hamilton was willing, if necessary, to reward mercenary scoundrels and penalize patriotic citizens.

Hamilton realized that the use of federal money to solidify the central government’s ability to function was an important issue in the creation of the country. He “knew that bondholders would feel a stake in preserving any government that owed them money. If the federal government, not the states, owed the money, creditors would shift their main allegiance to the central government.”

On the issue of assumption, Hamilton understood that if Congress approved his plan, it would give the federal government and not the states the ability to centralize taxation, unify import tariffs, and create credit for the new republic. But these centralized powers also alerted the opposition, in this case the landed interests near the Potomac. Those northern Virginia farmers had long been land rich, cash poor, and incessantly in debt to their British creditors. As Jefferson said, the Virginia planter was a “species of property annexed to certain mercantile houses in London.”

The high interest charged by the British banks led many—including Jefferson—to make a stark choice: purchase slaves to service the debt by producing tobacco and other cash crops, or sell their land. Jefferson, like many, remained in steep debt to the British until his death in 1826.

The issue of assumption was the first step in centralizing power, which many Americans, especially Jefferson, feared. Jefferson was the counterargument to Hamilton’s Federalist bent. Jefferson saw the aggregation and centralization of the government as something that could lead to monarchy and betray the ideals of the Revolution. There were great paradoxes when it came to the views of both men. Jefferson was against the notion of federal government, as he feared the expansion of executive power, and at the same time was pro free trade, yet antispeculation. Hamilton saw the benefits of the Bank of England model where a good credit standing could be used to make a country more powerful. Hamilton wanted to centralize the methods for revenue collection. He was mercantilist in trade, but was very pro financial speculation. These polemic views established how we would feel about the concentration of financial power and how financial power and government power would become intertwined in fundamental constitutional issues that would define the limits of states’ rights and expand federal authority.

So as Hamilton used the Bank of England as a model to create the First Bank of the United States, his enemies did not trust a British system that they perceived worked with the monarchy at the expense of the English legislature. Many of Hamilton’s enemies also owed money to England, a foreign power that had significant influence over their personal lives. As a result, when Hamilton proposed that speculators keep the gains from the IOUs and state debt, which they could redeem at a healthy profit in the new, better credit of the republic, there was a natural negative reaction to the move. So, at the formation of the nation’s credit standing, Hamilton made sure that contracts were honored and that the resulting uproar did not result in a redistribution of wealth from the new owner of U.S. debt back to the original holder of the IOUs.

We can argue whether the financial tools that Hamilton employed to fund assumption were understood in the House and Senate, but his strategy undeniably had two important results: it split the financial and political capitals of the country, and—just as significantly—it split the interests of the country into banks versus borrowers.

(Continues…)

Excerpted from DON’T BLAME THE SHORTSby ROBERT SLOAN Copyright © 2010 by Robert Sloan. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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