Short Sellers are Not to Blame

Short selling (or selling stock now with the obligation to buy it back later) was widely blamed for the collapse and instability of financial markets during 2007 and 2008. The Lehman bankruptcy report would suggest otherwise.

I’ve come across more interesting revelations from the bankruptcy report released by the Southern District Court of Manhattan, this time surrounding the controversial issue of short sellers.
 
The report was written by Anton Valukas and is 2,200 pages long. Previously I wrote about the discovery of misleading accounting transactions called Repo 105s in this article.
 
Short selling (also called shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. At the basic level the short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as he will pay less to buy the assets than he received on selling them. If the rise rises, the seller will incur a loss. Shorting in essence entails entering into any derivative or other contract under which the investor profits from a fall in the value of an asset.
 
During the weeks leading up to the financial crisis, short-sellers were accused of spreading false rumors about the capital and liquidity positions of big investment banks, most notably Lehman Brothers, Morgan Stanley and Goldman Sachs. Former Lehman CEO Dick Fuld approached Christopher Cox several times to try and “curb” short-sellers from spreading “malicious” rumors and thereby driving the stock price of Lehman down. Fuld desperately wanted the government to ban short-sellers. Fuld’s persistent belief that short-sellers were responsible for the massive losses in the Lehman stock price is well chronicled in Too Big to Fail, by Andrew Ross Sorkin. Cox did eventually give in to pressure by banning short transactions in September 2008.
 
Returning to the above-mentioned report, there are some interesting factoids and perspectives on short selling. David Einhorn, of Greenlight Capital, gave an address at the Value Investor Conference on Lehman Brothers, where he challenged the firm’s accounting policies and valuation of illiquid assets. The report says:
 
“Before that presentation, Einhorn had corresponded with [Lehman CFO Erin Callan] in mid-May 2008, as part of what he described as fact-checking in advance of his presentation at the Ira Sohn Conference. Einhorn focused on four major issues in his correspondence with Callan and in his May 21, 2008 speech:
 
(1) Lehman’s disclosures regarding CDO exposure and related write‐downs;
 
(2) the difference between the amount of Level III assets disclosed in the Form 10‐Q filed in February 2008 and during Lehman’s first quarter 2008 earnings call;
 
(3) Lehman’s disclosure and valuation of its stake in KSK Energy;
 
(4) Lehman’s write downs of its CMBS assets.
 
On the day of Einhorn’s speech, Lehman’s stock closed down $2.44, with its highest volume of the entire month of May 2008. Einhorn’s criticism of Lehman and Callan is commonly cited as the reason for Callan’s replacement less than three weeks later.
 
Following the near collapse of Bear Stearns, Einhorn published a book, Fooling Some of the People All of the Time, which focused on [his years-long battle with Allied Capital Corp., a small, Washington-based lender that Einhorn accused of accounting and other misdeeds.]”.
 
Einhorn’s short, and many of the other shorts on Lehman’s stock, was based purely on fact and an overvaluation of key assets.
 
The report also has an interesting piece relating to the regulatory authority in charge of the issue:
 
“Thomas C. Baxter, Jr., General Counsel to the Federal Reserve Bank of New York, said that reading Einhorn’s book made him think that the FRBNY should pay more attention to short sellers’ concerns. However, Baxter did not reach that conclusion for the reason that Lehman would have wanted, namely to persuade the Government to regulate short sellers, but rather because it appeared to Baxter that Einhorn may have been shorting Lehman for good cause. Baxter was unable to say, however, whether anyone at the Federal Reserve followed up on Einhorn’s criticism of Lehman in his speech.”
 
In short (pardon the pun) there is nothing wrong with short sellers so long as their bets are made with sufficient research. Short sellers assist with price discovery in most cases and provide the market with pressure to value assets at close to intrinsic value.

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