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Short selling came under fire in the wake of the collapse of financial institutions, and high-profile investors were berated as prominent public figures sought to point the finger. Will Jackson examines whether the criticisms are justified.

The reputation of short sellers has taken a battering over the past year. Following the collapse of financial institutions in Britain and America, John Sentamu, the Archbishop of York, branded those participating in shorting “bank robbers and asset strippers”.
Alex Salmond, the first minister of Scotland, even labelled short sellers “spivs”. The term – originally applied to dealers selling black market goods during the second world war – is a byword for selfish profiteering during times of collective hardship.

Individual traders have also been singled out – most notably John Paulson, an American hedge fund manager. Under new regulations imposed by the Financial Services Authority (FSA), Paulson was last month obliged to disclose significant short positions in British banks – including Barclays, Lloyds TSB and Royal Bank of Scotland. He later defended his actions, after criticism in the British press. Other investors “outed” by the disclosure process included Barclays Global Investors and Odey Asset Management, which declared a net short position of 0.35% in Investec.

In its simplest form, short selling occurs when a trader suspects a stock will fall in value. Stock is borrowed from a lender – usually a long-term investor such as a pension fund or insurance company – via an intermediary, in exchange for a lendingfee. The short seller agrees to return the stock, either on demand or at the end of an agreed period. Upon receipt of the security, the borrower immediately sells the stock into the market, in the expectation that he will be able to buy it back at a lower price. If the price falls, the short seller is able to return the stock to the lender and retain the profit. If the price rises, the stock is returned but the borrower loses money.

While the premise of short selling – effectively betting against the success of companies – runs contrary to the philosophy of traditional long-only investors, the practice is well-established. Dutch traders sold shares they did not own in the early 17th century and since Alfred Winslow Jones opened the first hedge fund in 1949 – an equity portfolio using shorting and leverage – the strategy has increasingly found mainstream acceptance.

A growing number of British retail mutual funds use the technique under modern Ucits III and non-Ucits retail scheme (Nurs) regulations. Two of the most popular funds this year – BlackRock UK Absolute Alpha and Cazenove UK Absolute Target – employ pairs trading to exploit mispricing between different stocks.

However, short selling has come under increased scrutiny over the past year. During the collapse of Northern Rock – which came to public attention when customers staged a run on the bank in September, 2007 – hedge funds were widely blamed for exacerbating falls in the firm’s share price by shorting its stock. Indeed, increased short selling is evident in statistics from Data Explorers – a stock lending data and analytics company. According to the firm, the percentage of Northern Rock’s stock on loan rose sharply at the end of last summer, from under 7% on June 28, 2007, to over 18% by September 12 (see graph, page 29).

The bank’s share price had already started falling, in the face of tighter credit conditions and widespread market uncertainty. But its decline – from over 1,200 pence at the start of 2007 – appeared to gather pace in line with increased shorting activity.

Between September 13, 2007 and September 17, the price crashed from 639 pence to 283 pence, as the Bank of England announced emergency liquidity support. Short investors were able to lock in their profits, and stock on loan quickly fell back to about 10%. A subsequent attempt by the British government to sell Northern Rock failed, and the bank was eventually nationalised in February.

However, it was not until the demise of Bear Stearns and volatility in the share price of HBOS that regulators began to take a tougher stance. HBOS was hit by rumours that it required a Bank of England bail-out, causing its share price to fall by almost 20% in a single day.

In a statement released on March 19, Sally Dewar, managing director, wholesale and institutional markets at the FSA, warned: “There has been a series of completely unfounded rumours about UK financial institutions in the London market over the last few days, sometimes accompanied by short-selling. We will not tolerate market participants taking advantage of the current market conditions to commit abuse by spreading false rumours and dealing on the back of them.”

The subsequent FSA investigation criticised “pessimistic ‘chatter’ among commentators”, but did not find “evidence that [the rumours] were spread as part of a concerted attempt by individuals to profit from manipulating the share price [of HBOS].” However, before the inquiry concluded in August, the authority had already taken its first step to curb short selling. On June 13, the FSA announced a disclosure regime for significant short positions in companies conducting rights issues. Under rules that came into effect on June 20, investors were required to declare short positions greater than 0.25% of issued shares.

In America, meanwhile, the Securities and Exchange Commission (SEC) focused on naked short selling. Naked shorting occurs when sellers do not physically borrow the stock before dealing, potentially allowing manipulative traders to force prices lower than would otherwise be possible. Speaking at a congressional hearing, Richard Fuld, the chairman of Lehman Brothers, later claimed the practice had contributed to the demise of several American institutions. “The naked shorts and rumor-mongers succeeded in bringing down Bear Stearns. And I believe that unsubstantiated rumours in the marketplace caused significant harm to Lehman Brothers,” he said.

On September 17, the SEC announced a series of measures to combat naked shorting. These included a tightening up of the commission’s requirements for the settlement of trades, and banning broker-dealers violating the new rule from further short sales in the same security. However, more significant regulatory actions soon followed, on both sides of the Atlantic. On September 18, the FSA imposed a temporary ban on the “active creation or increase of net short positions” in a selection of publicly-quoted financial companies, with immediate effect.

Scheduled to run until January 16, 2009, the ban applies to 34 firms, including Aviva, Barclays, HBOS and Lloyds TSB. The SEC followed suit one day later, with a wider-reaching but shorter ban. The commission drew up an initial list of 799 firms in which it prohibited short sellinguntil October 2 – with an option to extend the ban to a maximum of 30 calendar days. The SEC’s chairman, Christopher Cox, justified the measures as a “weapon [to] combat market manipulation that threatens investors and capital markets.” Special treatment for financial companies was warranted because of their dependence on the confidence of trading counterparties, said Cox.

The American ban was eventually lifted on October 9, but other countries – including Canada, Germany, Iceland and Russia – also imposed tighter regulations. The moves prompted dismay from short sellers around the world. In Britain, the Alternative Investment Management Association (AIMA) – a trade body representing hedge funds – said it supported the “intentions” of regulators attempting to stabilise the banking sector.

However, the association, which criticised the imposition of the disclosure rules in June, queried whether the ban would “achieve the intended results over time.” AIMA warned that additional negative consequences of the ban could include an increase in the cost of capital for banks and incorrect pricing of index products.

Robin Minter-Kemp, managing director of Cazenove Capital Management, also questions the effectiveness of the British ban. He points to continued downwards pressure and volatility in financials stocks, following an initial 9% bounce in the FTSE 100 on the first day of the new regime. “The reality of the ban has proved somewhat different from the expectations,” says Minter-Kemp. “For a weekend [short sellers] were the official bogeymen. But banks continue not to lend and shareholders continue to liquidate their holdings. Politically it went down well, but it looks like a publicity stunt in hindsight.” About one-third of Cazenove Capital Management’s assets are invested across five hedge fund strategies.

George Godber, a fund manager at Matterley who gained short selling experience during his time at Credit Suisse, is also sceptical. He says: “I can understand why the government reacted the way it did. It had to stop depositors withdrawing their cash from the banks, and a shorting ban was quick and easily enforceable. But my personal view is that the ban did very little and it did not address the underlying problem. Overexposure to the wholesale markets was the reason the banks were getting killed – not short selling.” Godber will co-manage a 130/30 investment trust for Matterley when it is launched later this year.

Godber’s view that a “two-way debate on share prices is good for the market” also receives support from James Berman, the founder of JBGlobal – an asset management firm based in New York. Despite his role as a long-only fund manager, Berman welcomed the end of the American shorting ban. “I do not believe the ban was the right thing to do and I am glad short selling is back,” says Berman. “It serves a valuable purpose in the market. It highlights problems with weaker companies – often before the regulator has seen them – and helps the market find a natural bottom, as short sellers buy back shares to repay their trades. I am more confident that we will find the bottom of the market now that the ban has come off.”

Other benefits to short selling include the provision of extra market liquidity and increased pressure on managements to “do the right thing”, he adds. Berman also calls the moral arguments used to condemn short selling “absurd”, and says the debate has become clouded by confusion over legitimate and illicit trading. “Rumour-spreading is fraud and that is illegal and immoral – that is an old rule, not a new rule,” says Berman. “The right approach is more vigorous enforcement on naked short selling and rumours – something the SEC has been awful at.

“People who speak about the two things as one are doing morality a disservice. There is nothing more immoral about shorting than long investing.”

Godber is also keen to see a tougher line from the British regulator on market manipulation. “It is disappointing that the FSA has not been able to point the finger at anyone,” he says. In Britain, short selling in conjunction with spreading negative rumours – the so-called “trash and cash” strategy – falls under the FSA’s Market Abuse Directive. Market participants are forbidden from disseminating information that “conveys a false or misleading impression about an investment or the issuer of an investment where the person doing this knows the information to be false or misleading.” While it is not a criminal offence, the FSA can seek to impose an unlimited fine. Under a settlement with the authority last month, a former hedge fund manager was fined £52,500 for market abuse conducted in 2006.

But it is not just church leaders and members of the public who are nervous about the morality and impact of short selling. Institutional investors, including Hermes – which runs the £37 billion BT Pension Scheme – are also distancing themselves from the practice. Hermes stopped lending shares in HBOS and Bradford & Bingley earlier this year, and increased its self-imposed banned list to 20 stocks on September 19.

In a statement, the firm said: “This week we took the view that what is happening in the market has switched from a healthy clear-out of excesses to an unhealthy hunting down of the weakest members of the pack.” The Strathclyde Pension Fund – one of the largest local authority schemes in Britain – temporarily suspended its securities lending programme.

While Berman dismisses the morality debate surrounding short selling as fundamentally flawed, he concedes that the “piling on” of short sellers can be problematic, and calls for the restoration of the “uptick rule”. The regulation, which was scrapped in America last year after lobbying from hedge funds, prevented short sellers from adding to downwards momentum during sharp price declines. “If you are short selling for a valid reason there is no problem with doing it on an uptick,” adds Berman. Recent reports suggest the SEC is considering a reinstatement of the rule.

According to AIMA, the British shorting ban is having a significant impact on the hedge fund industry – removing 20% of the market capitalisation available to short sellers. “Certain types of prudent hedging will be impossible – meaning that risk management and portfolio insurance for all investors including pension funds, mutual funds and insurance companies will be affected,” said Andrew Baker, the deputy chief executive of AIMA, in a statement last week.

In a letter to the Financial Times this month, Antonio Borges, the chairman of the Hedge Fund Standards Board, also warned that the ban threatens to “jeopardise the status of London as one of the world’s leading financial centres”.

However, the implications for the retail fund management industry are less severe, despite the increased use of shorting in mainstream products. A study by Standard & Poor’s (S&P), published earlier this month, found that absolute return and 130/30 funds were largely unaffected by the new regulations. The report looked at the impact on the strategies of BlackRock UK Absolute Alpha, Cazenove UK Absolute Target, Invesco Pan European 130/30 Equity, JP Morgan Europe Select 130/30 and Sarasin Equisar IIID.

S&P found that while the BlackRock portfolio held a short position in banking stocks in the third quarter, it adopted a net long position in the sector before the ban. Even funds that remain short financials, such as Invesco Pan European 130/30 Equity, are unlikely to be negatively affected. According to Invesco, the fund did not intend to extend its 4% short financials position and will instead gradually replace it with shorts from other sectors. The only additional burden applied to the managers of the Invesco fund and JP Morgan Europe Select 130/30, who are required to monitor and comply with the different shorting regulations applied in each European jurisdiction, said S&P.

Even so, retail fund managers will be keen to have the option of shorting financials once more. Whether the British ban will be extended beyond January 16, 2009, remains unclear, and the FSA declined to speculate on the outcome of its interim review, which was scheduled to take place last week.

However, the authority will have been encouraged by the market reaction to the end of the American ban. Commentators’ worst fears were apparently confirmed on October 9, as the lifting of shorting restrictions coincided with a sharp fall in the S&P 500 index. The benchmark ended the day down nearly 8% – its second-largest fall this year – and the share prices of General Motors (GM) and Morgan Stanley were hit particularly hard.

But a report from SunGard Astec Analytics showed that far from immediately establishing or increasing their positions, short sellers continued to sit on the sidelines. The SEC ban caused an overall 43% reduction in shares borrowed by short sellers (see graph, page 27). But on October 10, one day after the ban was lifted, the number of shares borrowed in previously-protected financials stocks continued to decline. Between October 8 and October 10, borrowing in those shares fell a total of 4.1%, and almost two-thirds of formerly-banned stocks saw lower levels of shorting. SunGard said the findings served as a reminder that prices are “not dictated by short sellers, but rather by company fundamentals and market fears”.

Analysis from Data Explorers also casts doubt on the theory that GM and Morgan Stanley were affected purely by a sudden increase in short selling. Before the ban, borrowing in GM shares was at elevated levels for several years, peaking at over one-third of the firm’s market capitalisation in July (see graph, above).

Borrowing ticked up by less than one percentage point on the day the ban ended, to 18.8%, and recent announcements appear to indicate more fundamental problems – GM recently cut production levels and is in merger talks with Chrysler.

But despite the apparently successful lifting of the American ban, a similar move by the FSA in January may not be so straightforward, as banks enter their reporting season, warns Cazenove’s Minter-Kemp. Godber agrees, and says he “would not be surprised” to see an extension of the regulations. “When it comes back, will we get a huge wave of short selling?” says Godber. “It would make sense for banks to first clarify their capital positions with audited numbers.” Stocks should instead be removed from the list one-by-one, he suggests, rather than a blanket lifting of the ban. The FSA says it has not yet decided how firms will be taken off the list.

Such uncertainties continue to undermine confidence in the ban, and British investors – both long and short – are hoping for clarification on the FSA’s intentions in the coming months. However, whether a ban was needed in the first place is certainly up for debate. Volatility remains high in financials and the broader market despite the ban, and short sellers have even proved their worth in detecting fundamentally flawed business models such as Northern Rock, long before the regulator.

Evidence that they have a significant impact on share prices is also unclear. While their motives may be far from alturistic, short sellers seem to be an easy scapegoat rather than the true villains of the piece.

Source: Data Explorers