First : What is short selling ?
Short selling is a way profit from falling prices. You can sells shares you don’t actually own on the assumption that the price will fall, with the aim of buying them back later for less. But how can you sell something you don’t own ?
Simple: You can borrow them for a fee from long term investors such as pension funds, banks and insurers who lend the stocks that they have in portfolio. This helps to boost their own returns. The borrower then sells the borrowed stock, hoping to buy them back on the cheap to return it to the owner. Shorting in most cases is a hedge operation. As the name implies, it is an operation where you go long buying stocks, but where you also “hedge” this with some shorts on other stocks. This way you can protect your portfolio against losses if the markets drop.
But is shorting not ‘Evil’ done by rutheless vilified persons?
Because of rumours about critical issues such as the health of French banks and the stability of France’s triple A credit rating, the bank stocks dropped massively and the regulators blamed everything on the usual culprit: the short sellers. As a result some European countries (France,Italy, Spain and Belgium) decided to ban short selling on their beloved financial institutions.
But did these same regulators not conduct a European stress tests on the same institutions a couple of weeks ago ? The tests were performed on banks in 21 countries to assess their ability to withstand a prolonged recession. Most of the banks under the ban rule passed the tests. The same banks are now protected with this shorting ban! Very odd, would you not say ? What does this say about the quality of this stress tests? My opinion is that these test were a waste of time! Things are getting out of control and the authorities are in panic.
In contrary to the populists who see short sellers as rumor mongers and conspirators, they are actually among the most fundamentally driven of all the investors. They are closer to the accounting policy than the authorities. They’re specialised in detecting companies that are cooking the books. While companiess often accuse short sellers of lying and conspiracy, it turns out that the accusers are often the guilty party (cfr Owen Lamont, Chicago University). Read David Einhorn’s book ‘Fooling Some of the People All of the Time ‘ about Allied Capital and Lehman Brothers, and you will understand what I mean.
You just don’t shoot the messenger. The short sellers are not the problem, the bank’s bad debts are the problem. A study by academics at Cass Business School and the University of Naples, on the bans in 30 countries in 2008 and 2009, suggests the prohibition could be counterproductive. “It disrupted liquidity and it worsened price discovery”, said Marco Pagano, co-author. So bans are not a good idea as the academic studies show that they don’t have no long term effect. UK financials stocks actually increased their average daily decline in the months after the ban in 2008.
For example during the financial cricis of 2008 in Belgium, local governments (cities, regions, federal state) borrowed money to invest in the capital increases of theirs major banks. So they levereged to invest in already leveraged companies. The argument was that they would actually earn money by the high dividend yield distributed by the banks. But these banks don’t distribute dividends anymore now. How stupid can one be? Now they say that it is the fault of speculators and short sellers. The stocks are still valued at prices 3 times the market value in the books of these municipal structures. But according to them this is only a virtual loss, because the price is down due to the short sellers. Warren Buffett once said: “In the short run, the market is a voting machine. In the long run, it’s a weighing machine”. If the price of the banks has been 2 to 3 times lower than the estimated value since 2008, doesn’t this indicate there’s something wrong about the value? It’s time for serious reform instead of ostrich policy and accusing the wrong parties.