Summary:
John Gapper argues that, although there is a case for restricting short-selling and resulting bear raids on vulnerable financial institutions just at the moment, markets gain in the long term from this activity. Short-sellers make profits by holding a mirror to the unpleasant reality concealed in some company accounts. It is nonsense to say that Wall Street banks would be all right if it were not for irresponsible hedge funds. If the now obvious flaws in their business had been exposed earlier, there would be less turmoil now. When not enough people are asking tough questions, asset bubbles result. Leads to the misallocation of capital because companies are allowed to obtain it too cheaply and to waste it, and investors get hurt when the bubble collapses. Beauty of short-selling is that it gives people with financial expertise a motive to root around in company accounts and look for problems. (Published: 18/07/08)
Notes:
- During financial crises, short-sellers usually get the blame
- selling company shares they do not own
- investment banks blaming hedge funds
- believe they are ganging up to spread rumours that a healthy financial institution is in trouble and profiting by short-selling
- “This is even worse than insider trading. This is deliberate and malicious destruction of value and people’s lives,” (Jamie Dimon, the chief executive of JPMorgan Chase,)
- UK Financial Services Authority
- last month instituted new rules to make short-sellers in companies that are holding rights issues disclose their stakes
- But: even financial regulators admit that most short-selling is a legitimate and beneficial activity
- “naked shorting”: occurs when an investor agrees to sell shares without having borrowed them first.
- SEC believes that this creates volatility because it encourages lots of hedge funds to sell shares and then rush to buy them again.
- SEC especially worried about naked shorting of financial institutions
- they are vulnerable to sudden collapse in a way that other companies are not: banks rely on depositors believing in their soundness
- Northern Rock’s funding crisis showed what happens when they get doubts.
- Bear Stearns had to be rescued by JPMorgan because it relied on short-term funding and, as soon as investors and institutions that dealt with it lost faith, it could not continue.
- Bear Stearns executives say it was a victim of rumours that it was insolvent which became self-fulfilling.
- Traders do spread rumours to make short-term profits in markets – both to ramp shares and to make them fall.
- Nonsense to say that Wall Street banks would be all right if it were not for irresponsible hedge funds. In fact, they are having to raise billions to rebuild their capital.
- If the now obvious flaws in their business had been exposed earlier, there would be less turmoil now.
- Lots of people have an incentive to get investors to buy shares – from executives to financial analysts whose banks want business.
- Not many want to ask tough questions.
- leads to asset bubbles
- investors pile into shares and end up making losses when underlying problems emerge
- not only hurts investors but it also leads to the misallocation of capital because companies are allowed to obtain it too cheaply and to waste it
- beauty of short-selling is that it gives people with financial expertise a motive to root around in company accounts and look for problems
- although bankers complain about false rumour-mongering, professional short-sellers often do diligent and detailed research.
- there is a case for throwing some sand in the wheels of bear raids on vulnerable financial institutions just at the moment
- but markets gain in the long term from having people who make profits by holding a mirror to the unpleasant reality concealed in some company accounts
