Demonic Short Sellers

by: Felix Salmon November 25, 2008 | about stocks: C / MS    
Felix Salmon

Felix Salmon

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Jim Surowiecki says, quite rightly, that short selling can cause viciously self-fulfilling downward spirals, especially in financial stocks. But reading the WSJ's long and alarmist tale of what happened to Morgan Stanley (MS) in September, I'm more convinced than ever that short-sellers, be they in the stock market or the CDS market, are not the cause of current problems.

I'm with Jim Chanos on the subject of the WSJ story: He writes that

The WSJ piece, despite its sensationalist headlines, actually confirms what we have been telling Washington for some time now. That is, that most of the "short activity" in the banks/brokerages, was to hedge embedded long exposure to these institutions, often by other banks/brokerages! These were NOT "bear raids", but prudent fiduciary-related decisions made by these entities to protect their capital/investors. An important story to the Financial Crisis narrative so far.

The bulk of the WSJ story concerns the activity of September 17, which precipitated the SEC's short-selling ban. But then, at the very end, comes the kicker:

The cost of insuring its debt has come back down from its peak, but its stock remains in the doldrums. On Friday, it was trading at $10.05 a share in 4 p.m. composite trading on the New York Stock Exchange -- less than half of the $21.75 close on Sept. 17.

Even now, after yesterday's massive rally and a further uptick this morning, Morgan Stanley stock is trading at less than $15 a share. Clearly the stock price is not being driven down by manipulative speculators taking advantage of an illiquid CDS market to sour sentiment. Robert Teitelman says that the WSJ story tells the tale of "the hellish tangle of unforeseen consequences of certain derivative instruments" -- yes, he's jumping on the CDS demonization bandwagon as well.

In fact it tells a much simpler tale: Morgan Stanley's counterparties were forced to buy CDS protection to hedge their exposure to the bank, and Morgan Stanley's hedge-fund clients withdrew a lot of money, not in a bear-raid attempt to kill it off, but because prudence demanded that they do so, and also because they were understandably upset about John Mack's role in getting the short-selling ban put in place. That ban devastated many hedge-fund relative-value and convertible-arbitrage strategies and caused a lot of anger in the hedge-fund community.

Short sellers are known by many names: Right now, the WSJ seems to like to think of them as "speculators", which carries a tinge of opprobrium. But they're also known as "noise traders" and "liquidity providers": the people who ensure that there's so much volume in the stock that bid-offer spreads are very narrow and large trades don't move the market very much. Check out the biggest single short-selling trade named in the article:

Third Point, after seeing the surge in swaps prices, made a substantial bearish bet, selling short about 100,000 Morgan Stanley shares, trading records indicate. Third Point quickly closed out that position for a profit of less than $10 million, says one person familiar with the trading.

In other words, as Morgan Stanley shares were reaching their intraday lows, Third Point was buying, rather than piling on and selling more. And in general, as any stock-market trader will tell you, large short interest tends to drive stock prices up, not down.

So yes, it's possible that those demonic short-sellers were responsible for the fall not only in Morgan Stanley's share price, but also in Citi's (C) at the end of last week. But it's also possible that it was just old-fashioned sellers, who weren't selling short but were rather selling down their existing long positions. And it's also possible that it wasn't selling at all, but simply a lack of buyers willing to place bets on a fragile institution with a possible leadership vacuum. We simply don't know -- which is why it's silly to assume that short-sellers were to blame.

Disclosure: No positions.

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This article has 10 comments:

  •  
    Nov 25 12:12 PM
    A name for short sellers: price discoverers, market liquidity facilitators, how about vandals.

    Old African Saying: "The tick burrowed into the backside of the lion imagines himself to be the King of the Beasts."
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  •  
    Nov 25 12:20 PM
    A lot of people talk about the evil short trade and those who engage in them. However, many people see derivatives as a speculative game where you roll the dice and hope your numbers turn up, rather than a tool traders and institutions use to mitigate risk.

    I have a basic grasp of derivatives namely options and futures. When studying up on them I noted a very strong resemblance of puts to my auto insurance policy. In both cases I pay a premium for a time limited policy. In the case of my auto policy if a deer jumps out and totals my car I sell the car at its pre-wreck value to the insurance company, if I have a stock and it crashes then I sell the puts and at least get something back.
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  •  
    Nov 25 02:03 PM
    The real problem with the CDS market is that buyers don't need to have an insurable interest when buying or selling a CDS. In the bad old days of individual insurance, this lack of insurable interest lead to speculators buying life insurance on some unsuspecting soul, then hiring someone else to do in the insured so that the policy ownere could collect.

    Kind of like what seems ot be going on in the CDS space today, except that buyers of CDS coverage don't need to hire intermediaries to kill the insured. All they need to do is give away stories for free to the media who will happilly help kill any organization in return for eyeballs.

    A CDS is not de facto a bad thing, but without transparency and a clear insurable inteerest, the CDS marklet is driving lots of unintended and perhaps quite evil consequences.
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  •  
    Nov 25 02:31 PM
    Same is true with almost any form of financial instrument. A person goes short on a particular item and then feeds rumors to the media, if the media is gullible enough the stories get out and the shorter makes money.

    Any financial instrument can be used for legitimate business financial practices or for rank speculation. Heck even the simple and straight-forward practice of buying stock with cash and holding it until the price goes up can be reduced to rank speculation. The difference being most people understand the practice.
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  •  
    Nov 25 03:08 PM
    Hence the need for complete transparencey, particulary with respect to statements about the market or individual companies. When a noted hedge or mutual fund manager publlically opines that comapny A is (a) a great investment, or (b) is headed for the crapper, the opiner should be required to disclosue whether they are long or short the company, including the impact of CDS positions.

    Financial media should be required to disclose their sources and source exposure to the comapny on which they are providing data. Period.
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  •  
    Nov 25 03:20 PM
    Shorting is a necessary part of the market,but Chanos, Einhorn and others seem to always skirt the issue of naked shorting.It is illegal,but our lame duck SEC does nothing.It no doubt brings down companies.It was made illegal for that reason among others.When a group of hedge funds oficers can get together and throw darts at names on a wall and then go after that company whether there is any problems with that company or not.If you short twice as many shares as are outstanding,it doesn't take a genious to figure that this company is going down.Hurts honest investors,retirees.Nak... shorter are crooks,yet all you hear about is how bad ALD treated Einhorn.Did anyone bring up his naked shorting of ALD?If they lose money on bad bets,we shouldn't shed any tears.
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  •  
    Nov 25 03:47 PM
    The volume of short selling in any stock is so small that it couldn't drive prices very far down in any event. It is a red herring used by politicians to manipulate public opinion via scapegoating.

    The prime drivers of any stock price are new buyers and existing holders who sell. That is where the volume of trading originates that moves the markets.
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  •  
    Nov 25 05:34 PM
    If you can prove your assertion (show your sources and work) I would be more inclined to believe you were on the up and up. Instead I think you are just one more short seller trying to change the subject.
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  •  
    Nov 25 07:31 PM
    CDS is a form of insurance and should be regulated as such: 1) there should be a requirement of insurable interest for the reasons mentioned by Research123...2) those who sell CDS protection should be required to meet minimum capital requirements, like any other insurance company.

    The CDS industry defends itself on the grounds that what they do is a zero sum game. In reality, it draws in funds from legitimate investors, who are impoverished by the effects of manipulative CDS trading. To buy CDS which is not supported by an insurable interest is equivalent to naked short-selling of the bonds involved.

    Legitimate investors eventually became cowed by the power of short-selling when augmented by CDS manipulation and developed the habit of running for cover as soon as the attack started.
    Reply | Link to Comment
  •  
    Nov 26 02:17 PM
    funny how FS starts with " long and alarmist"...sound... like his writing style.

    Reply | Link to Comment
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