Sunday, September 21, 2008

A Short Story

(not Charlton related)

Last week as outright panic characterised the world's financial markets, the public and its media were on the lookout for a handy scapegoat.

Strangely opting to overlook the wanton negligence of management teams and their regulators, attention instead focused on the 'spivs and speculators' otherwise known as short-sellers.

I've met many of these people and trust me, you'd be delighted if your daughter brought one of them home, especially the one that made $1.7billion last year I suspect. One of the media's favourite targets is so polite and softly-spoken, you'd easily mistake him for an altar boy (except that he's Jewish). Speculators for sure, but definitely no spivs.

Short-selling is a way of betting upon the fall in price of a security (typically a stock), usually undertaken by hedge funds but also by more sophisticated individual investors. The short-seller borrows the stock (in order to fulfil the sell order), and hopes to be able to buy it back at a lower price, return it to the lender, and profit from the difference.

The vast majority of short-selling is not undertaken with the intention of driving a company into the ground (some management teams are more than able to do this themselves). There are hardly any funds that solely short stocks because it is so extraordinarily risky (see below), although you wouldn't know it from the headlines.

Instead by building a diverse portfolio comprising traditional 'long' positions, as well as 'short' positions, an investor can reduce his correlation to overall market movements, and hopefully generate positive returns in different types of environments, particularly bear markets. There are no guarantees of course as many failed funds have discovered.

Some very successful hedge fund managers with long-term records have lost money overall through 'shorting', including some of those so vilified in the media this week. They welcome however the reduction in volatility that their short positions offer them during market sell-offs.

Interestingly various 'hedged' products have been launched recently, aimed squarely at the very same retail investor that the media would have us believe is the victim of such activities.

In an exuberant bull market such as those of 1999 or 2003, the short-seller would typically not even expect the stocks he is 'short' to fall, but would hope they would simply not rise as much as his 'longs'.

As it transpired however, particularly during the tail-end of the technology bubble of the 1990s, most outright short-sellers went out of business as the ridiculous valuations of Internet companies spiralled even higher (before they eventually did collapse, albeit too late).

Short-selling is very far from a one-way bet. Indeed it is so risky that most brokers will not permit its clients to undertake it unless they can demonstrate above-average financial sophistication and resources. Here are some examples why:

1. The maximum loss on a 'long' position is 100%, and the maximum return is infinite. The maximum loss on a short position is infinite, but the maximum return is only 100% (at best, the stock can only go to zero).

2. When a long position begins to move against an investor, it becomes a smaller problem. When a short position begins to move against an investor, it becomes a bigger problem.

For example, if an investor with a £1million portfolio buys £50,000 of Vodafone and it halves in price, then all other things being equal, his original 5% position is now an approx 2.5% position. The investor has less money of course, but his exposure to Vodafone is relatively lower too and he can sleep soundly.

However if an investor had sold short £50,000 of Vodafone and it doubles in price, the investor's risk has doubled too (the investor now owes £100,000 worth of stock). For this very reason, sensible investors build far smaller initial short positions than long positions. Thus not only can an investor make no more than 100% on any given short position (see 1.), he will likely have taken a smaller bet to begin with.

3. Stock prices usually go up (although it's a timely reminder in the current environment). The short-seller is not only battling the mathematical biases explained in points 1. and 2., but he is also battling the inherent ability of companies to make profits, the fuel of capitalism.

4. In the absence of leverage, a long investor cannot be 'forced' out of any of his positions. A short-seller meanwhile is using leverage by definition (he is borrowing stock), whilst the lender can typically demand back that stock without reason or notice.

Although it's thus risky and best left to experts, the short-seller provides a vital market role in enhancing market liquidity and efficiency. In a rising market, the short-seller dampens riotous enthusiasm by acting as a rare seller of stock.

In a falling market, the short-seller will be closing out his (profitable) positions by buying back the stocks he has borrowed, thus acting as a rare and welcome buyer. As a result, markets are likely less volatile and stock prices more reflective of fundamentals than sentiment, thanks to short-sellers.

The case of those financial stocks which were headline news last week do perhaps warrant some special treatment in such extraordinary times, although plenty of regulations already existed to prevent the worst excesses. For example, the spreading of (knowingly) false rumours has always been illegal, and rightly so.

The enormous leverage inherent in financial companies, makes them unusually vulnerable to a sudden collapse in their share price. But this leverage had clearly become excessive, funding increasingly crappy assets with increasingly short-term liabilities. This should never have been allowed to happen (by the regulators) , but it did happen and the short-sellers rightly suspected the true equity value might be zero for them too.

Yet as the share price falls, eventually it reaches a point where the risk/reward of remaining short worsens, whilst fundamental 'long' investors might be tempted in. On Wednesday afternoon for example, investors were offered the chance to buy shares in Goldman Sachs, the world's premier investment bank, at just five times earnings. or $98. As enticing a proposition for a long investor, as it was dicey for a short-seller (the stock closed on Friday at $130).

It is important to note that the share prices of Bear Stearns, Lehman Brothers, Northern Rock or HBOS did not collapse by virtue of 'spivs and speculators'. They collapsed through chronic mismanagment, and bets on rising house prices, all of which were lost. Each management team had opportunities to sell the business or at least reduce its risks, yet hubris told them to push on.

Short-sellers are absolutely entitled to signal to the market that the chronic asset/liability mismatch that each of the above demonstrated, was not yet reflected in its share price. Other better-run banks or those with more sustainable business models (eg. HSBC, Lloyds TSB, JP Morgan Chase) have not faced any discernable pressure from short-sellers at all. As I mentioned above, a handy scapegoat, but the wrong one.

In 2007, the US regulators removed something called the 'uptick rule' which would have prevented most of the problems observed last week. It required all short sales to be undertaken at a price higher than the price of the most recent trade, thus preventing short-sellers from adding to the downward momentum of a stock already experiencing price declines.

The reinstatement of the 'uptick rule' would seem a balanced and welcome response to some of the emotionally-fuelled nonsense written in recent days. Expect to read more about it.


At 10:14 PM, Anonymous Chris said...

You are absolutely right, of course. Moreover, I don't think that anbody who understands the issues, including the regulators who have made the temporary rules to ban short selling, would disagree with you.

However, I think that there may be two lines of thought which might justify the banning of short selling financial stocks. The first is what might be described as the "behaviour likely to mislead argument". In an market where there are information assymetries (real and perceived) and where confidence has evaporated, hedge funds shorting stock might be seen by some as a lead indicator of fundamental problems (It doesn't matter whether this is justified) leading in turn to dysfunctional behaviour, i.e self reinforcing actions and a viscious circle. Lehman was bust (or close to it), but whilst neither Goldman or Morgan Stanley are, that didn't stop their clients moving PB assets or closing out OTC positions with them, for example. If a ban on short selling helps to stabilise sentiment it makes sense to do it; whether it is a strictly logical policy response or not.

The second argument is blatantly political, reflecting a need to be seen to "be doing something" and perhaps also removing the risk of headlines saying that "as the world as we know it was coming to an end" (and it felt like that on Thursday), some "nasty" hedge funds made huge profits. This is also important since the taxpayer is now going to have to provide massive funds to bail the system out; politicians cannot afford to appear overly supportive of "incredibly wealthy indivduals" who, directly or indirectly, have been part of a financial system that has spectularly failed.

We are going to get more of this; the Greenspan ultra free market philosophy is dead. The only question is how far we now swing the other way and how.

At 12:56 AM, Anonymous newyorkaddick said...

Chris, thanks for your comment. When you say that, "In an market where there are information assymetries (real and perceived) and where confidence has evaporated, hedge funds shorting stock might be seen by some as a lead indicator of fundamental problems (It doesn't matter whether this is justified)," the regulators have clearly fallen down on the side of it not being 'justified'.

However with the independent investment bank model seemingly broken, and with Goldman and Morgan Stanley likely to have to say cut their leverage in half in due course to be viable, the market was saying last week that they may not have time to do so in an orderly manner (and thus was infact 'justified'). To reduce leverage meaningfully, they will have to earn outsized profits (impossible), sell assets or raise new capital, and neither is plausible in the current environment.

This seems to be simply an embededded (albeit usually hidden) risk of such a leveraged business model, and it now seems crazy with hindsight that these companies commanded 'growth' multiples to earnings at one time.

At 11:09 AM, Anonymous Tim said...

I agree with you that the most sensible course of action is a reinstatement of the uptick rule. It will be interesting to see who the lobbyists who were pushing for its disbandement were lobbying for... I would wager there was an investment bank in there! The one point you didn't mention is that in addition to it being extremely risky, it is also one of the more expensive strategies out there, with a chunk going to the institution (usually a pension fund) that lends the stock, and another to the Prime Broker who arranges the transaction.

At 3:10 PM, Blogger bristol addick said...

Excellent post, as always - and a good debate. Totally agree that chronic mismanagement is at the heart of the problem not a few short sellers.

As a marketer, albeit one who has worked for both a bank and insurance company, I'm a bit out of my depth here, but it's interesting to note that in the UK, the initial response from the FSA after it's "investigation" is that short sellers did nothing wrong and were not seen to be manipulating prices. Their decision for the short term ban on short selling was more in line with Chris's comments about "perceived behaviours". Chris's political point too is apposite, with Gordon Brown seemingly looking to take credit for the ban - typical knee-jerk stuff to show he is doing something.

Interesting to see that Goldman Sachs and Morgan Stanley are changing their status and becoming proper banks (licensed deposit takers) - and that this is being fast-tracked through, presumably so they can call upon the Fed's lender of last resort function for emergency loans and financial support. Not sure what's going to happen to Bradford & Bingley over here yet.

As an aside, I like the name being given to Hank Paulson's toxic cleanup solution - Manure Bank. I assume they could replace AIG as sponsors for our friends at Manu?

At 3:14 PM, Anonymous newyorkaddick said...

Bristol, the PM seems to handily forget he was the Chancellor for ten years, presiding over the light-touch regulation that led to this mess.

ps - I think B&B will go into so-called 'run off' mode.
pps - I think 'Hank Bank' has a certain ring to it too.

At 3:26 PM, Blogger Kings Hill Addick said...

As a layman on these matters it seems as though the US Government (and that of Britain too) believe in Capitalism all the time everyone is making lots of money. They believe in regulation only when it looks like their political careers are on the line.

The reason the big Investment Banks kept on leveraging up is that it worked and earned their clients, and more importantly, their employees vast sums of money. By omission most of the employees involved in these actions were carrying out their daily duties with their next bonus in their mind. It didn't occur to them that the market would fall or that their balance sheet was full of rubbish because their bonus was real (and wasn’t made up of the potentially over valued assets that they were trading or leveraging).

The Gordon Gecko “Greed is good” is king in the stock markets of the world – if this is not actually true then I can assure you it is the perception that those of us outside of it have. We talk about the unacceptable incomes of footballers, then we hear of a chap earning $1.7bn in a year. That equates to £17.7m a week, you could have one hundred and eighteen Cristiano Ronaldos for that.

It is no longer important what is right and wrong. It is no longer important how much money these ‘non-spiv’ millionaires (or billionaires) have or earn. What is now important to the Governments or the Western World (and probably their citizens) is taking control of the markets and forcing them to behave in a way that makes us more confident and feel safer. Like I said earlier Capitalism is great all the while we are all doing very well thank you very much, but when the tables are turned the Politicians are more than happy to Nationalise and Regulate to keep the economy artificially high, in order to keep the voters happy.

With little knowledge of how the markets actually work (a module that ran for just one semester of my MBA) I accept that stopping a form of legitimate trading is a little excessive. However, we are all human and tend to over react. There are limited numbers of real (rather than perceived) risks to human life in Central Park after dark, but we wouldn’t allow our children to play there now would we?

At 3:42 PM, Anonymous newyorkaddick said...

KHA, I think you have come up with a genius idea (maybe inadvertently) - bankers should have been paid their bonus in the form of junior tranches of Collateralised Debt Obligations backed by subprime mortgages, rather than cash. Would have stopped the whole thing in its tracks.

The guy who made $1.7bn did so by buying default protection on the aforementioned structures - you could spend approx 1% pa for protection and as it transpired, earn 100% (because ultimately there will be no recovery on them). It was the greatest risk/reward trade of the century - as Buffett says, "Be fearful when others are greedy."

I would argue the existence of such an enormous profit incentive helped bring the whole sorry securitisation process to an end, and not before time.

As you suggest, politicians (including Gordon 'knee jerk' Brown) were complicit throughout because the public never questioned why their houses miraculously kept rapidly going up in price, and fell for Brown's mantra about a robust economy. Luckily he'll be out of work soon.

Anyhow better dash, I need to pick up my son from Central Park :-)

At 6:06 PM, Anonymous Anonymous said...

The market will continue to privatise profit confident that debt will now be nationalised.


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