Why we cannot live without bears

Don’t Blame the Shorts: Why Short Sellers Are Always Blamed For Market Crashes And How History Is Repeating Itself
By Robert Sloan
McGraw Hill ($27.95)

After a financial crisis everyone needs a scapegoat. Who better, apart from bonus-hungry bankers, than short sellers? Politicians need to pass the buck for the damage to people’s pockets. Bishops have to sermonise about something. Company chairmen always think the share price undervalues the company, so short sellers are their natural targets.

The extreme case of this syndrome was Dick Fuld of Lehman Brothers, who famously said: “When I find a short seller, I want to tear his heart out and eat it before his eyes while he’s still alive.” In short, the social utility of short sellers lies in their being handy pariahs for all those who have an urgent need to play the blame game.

They are thus an unlikely subject for an encomium, especially at book length. If Robert Sloan manages to go the distance in Don’t Blame The Shorts : Why Short Sellers Are Always Blamed For Market Crashes And How History Is Repeating Itself it is because his book is as much about historical tensions between Washington and Wall Street as the practice of short selling. He puts it all in the context of the opposing views of the federalist Alexander Hamilton, who was pro-speculation, and Jeffersonian republicans, who were pro-agriculture and convinced that making money from money was a nonsense.

The book explores the populist backlash against finance as reflected in the Pujo hearings after the financial panic of 1907 and the Pecora hearings that followed the 1929 Crash. And the case for short selling is well enough made. One long-standing argument is that of Bernard Baruch, who said: “A market without bears would be like a nation without a free press. There would be no one to criticise and restrain the false optimism that always leads to disaster.”

Certainly short sellers performed a useful role in identifying the weaknesses of Enron, though it would have been helpful if they had twigged a little earlier. And nobody could say they were wrong in their diagnosis of the inadequacy of Lehman Brothers’ capital and funding position.

After the Crash, Richard Whitney, chairman of the New York Stock Exchange, who was later jailed for theft, told a Senate committee in 1932 that prohibiting short selling would not only reduce market liquidity but freeze five or six billion dollars-worth of collateral loans secured on quoted securities, thus exacerbating the financial crisis. Part of his case was that federal regulation of shorting would be unconstitutional and a violation of states’ rights.

The liquidity argument has become more powerful today, when so much short selling is about sophisticated arbitrage and the off-setting of risk. Nor is shorting simply about selling shares. It can be carried out through credit default swaps, put options, equity swaps and sundry other instruments, all of which makes the practice harder to regulate.

As Sloan points out, when Washington finally succeeded in curbing short selling in 2008, there were unintended consequences. Regulators inadvertently shut down higher-yielding capital markets, including convertible bonds, a $200bn market that is often the lender of last resort for companies, high yield bonds, and distressed debt and equity issuances. Hedge funds that specialised in convertibles closed.

The ban on shorting financial stocks also meant that there was a sharp rise in the cost of trading and a big decline in volume in those stocks that could no longer be shorted. The irony was that Washington only introduced the ban at the behest of Wall Street firms that had hitherto made a fortune via their prime brokerage operations from short selling. Wall Street, in Sloan’s terms, suddenly became self-servingly Jeffersonian.

His book is a useful corrective to the view of short selling as “unpatriotic” or uniquely anti-social. But it could have explored the counter arguments a little more. Now that efficient market theory is tarnished, there is a question about whether short selling exacerbates the effects of momentum trading, which shifts prices further from fundamental values. A more extended discussion of potential systemic consequences of shorting in the banking sector would also have been welcome. The banks’ efforts to raise capital in the UK, for example, were not helped by short selling, which did nothing to increase investors’ appetite for their shares.

That said, it is a brave act to take on anti-finance populists at this time, as one of the book’s Jeffersonian quotes beautifully underlines: “Every bank in America is an enormous tax upon the people for the profit of individuals.” Spot on, across the centuries.

The writer is an FT columnist