The Lehman Brothers headquarters in New York in September, 2008.REUTERS/Chip East (UNITED STATES)
In the inglorious history of the financial markets, Napoleon stands out-not for his retreat from Russia, not for the Napoleonic Code, but for his hatred of a species of speculator known as the short seller. The emperor had no use for cynics who felt that his regime and its bonds faced a dim future, and who bet against him. Shorts were "enemies of the state," he reputedly said.
Short sellers borrow stock or other securities and then sell them, hoping to profit from a price decline by buying the same issuer's shares or securities in the market later for less to cover their borrowings. In the 200 or so years since Napoleon griped about shorts, he has been joined by dubious securities issuers from Boca Raton to Vancouver, as well as heads of some of the most overextended banks ever to belly-flop into insolvency.
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Enron's CEO Jeff Skilling blamed short sellers for his company's collapse in 2001. Bear Stearns CEO Alan Schwartz and Lehman Brothers CEO Richard Fuld also griped that shorts, not poor decisions by managers-heaven forbid-torpedoed their shares in 2008. Earlier this year, Citigroup CEO Vikram Pandit renewed the blame-the-shorts mantra. Looking back at his bank's near-death experience in 2008, Pandit said that fear overtook the markets, "and that's the tool that short sellers need to make money."
The problem with the anti-short crusade is that the shorts are rarely the cause of widespread fear and panic. The shorts like to portray themselves as truth tellers who expose excessive valuations, fundamental weaknesses and blatant fraud in companies.
Yet regulators often blame the shorts, rather than incompetent or corrupt managers of companies under siege, for market turmoil. One of the first steps the U.S. Securities and Exchange Commission (SEC) took during the market crash that started in September, 2008, was to temporarily ban short selling of nearly 1,000 financial stocks. That prompted New York short James Chanos, who is renowned for having exposed the rot at Enron, to joke that regulators were alternately asking him for advice and trying to put him out of business.
Fortunately, the anti-short tide seems to be turning a little. As the market bottomed and climbed in 2009, the traditional role of shorts as a stabilizing force became more apparent-after all, they eventually have to buy back the shares they borrow and sell. The crisis also reminded investors and regulators that shorts are often the most effective corporate watchdogs.
A recently published study by researchers at the University of Chicago and the University of Toronto examined 216 corporate fraud cases between 1996 and 2004. Shorts uncovered 14.5% of those frauds, not far behind the 17% that were exposed by whistleblowers within companies. And what about the SEC? It uncovered just 6.6% of the frauds.
Looking back, it's also now clear just how right the shorts were about the poor condition of U.S. banks and investment dealers before the 2008 financial crisis. A recent bankruptcy examiner's report shows that officials at Lehman Brothers created an off-balance sheet mechanism to shift liabilities off the books, concealing weaknesses caused by Lehman's own recklessness. As Michael Lewis correctly points out in his latest book, The Big Short, the problem is not that regulators allowed Lehman to fail, but that it was allowed to succeed.
In the months before Lehman collapsed in September, 2008, Fuld complained that the firm was being targeted by so-called naked shorting, in which traders put in sell orders for shares without even borrowing them first. A study by three University of Oklahoma researchers published in May, 2009, examined trading in several major U.S. financial stocks-including Lehman-before and after the SEC imposed a ban on naked shorting of those issues in late July and early August in 2008. It found "no evidence that stock price declines were caused by naked shorting."
The trouble was that U.S. regulators took the complaints from Lehman and other companies far too seriously. In fact, that SEC order actually hurt investors. A study by Arturo Bris, a professor at IMD business school in Switzerland, concluded that the order dampened trading in the stocks, which widened the spread between market bid and ask prices-a spread that investors have to cover. Erik R. Sirri, who ran the SEC's division of trading and markets during the crisis, recently conceded that the decision to restrict short selling was based on political considerations.
Yet the media still love a conspiracy, and they still pass on hysteria about shorts and the self-serving spin of CEOs like Skilling, Schwartz and Fuld. Those journalists often look very naive in retrospect. In March, 2009, long after details about just how bad Lehman's finances were before it collapsed had come to light, Bloomberg reporter Gary Matsumoto said that the firm's bankruptcy "might have been avoided if Wall Street had been prevented from practising one of its darkest arts." Writing in Rolling Stone last fall, after the academic studies of the 2008 collapse had been widely publicized, Matt Taibbi repeated the complaints that Bear Stearns and Lehman were destroyed by naked shorting.
That's the problem with anti-short hysteria. CEOs who have something to hide want regulators and the media to look elsewhere. The more attention that is focused on "dark arts" that are more myth than reality, the more likely it is that real wrongdoing will be overlooked.