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Friday 5 September 2008

The market’s favourite scapegoat

Christopher Fildes on short selling

Oh, dear, what a setback. The usual suspects have slipped through the net. They will have to be locked up in the Financial Services Authority’s waterside fortress for 42 days, while the investigators try again to find some evidence.

These suspects are the short sellers: everyone’s favourite scapegoat. They are accused of rocking the banks’ leaky boats, of destabilising the stock market, of profiting from other people’s misfortunes, of driving share prices downwards to suit their own book. If it wasn’t for them, we should all be rich, or richer, at any rate, than we are now — or so we are led to believe.

The textbook way to become a short seller is to borrow some shares and then sell them. You hope to be able to buy them back at a lower price, and then return them. Modern financial technology has come up with new ways of doing this, but they all amount to a bet that the price of the shares will go down. If the selling itself drives the price down, this becomes a self-fulfilling prophecy.

Earlier this year some heavy sellers knocked the shares of HBOS, the combination of Halifax and Bank of Scotland, just when it was planning to raise much-needed new capital. The board of HBOS protested, and the FSA smelt a number of rats. It looked forward to catching and poisoning them, but has now abandoned the search with nothing to show for it. Instead, the FSA has come up with some new rules — supposedly the world’s strictest — to make short sellers disclose their positions when new money is being raised. Even this is not quite the deterrent the regulators had hoped for. We can now see who in the City is betting that, for the banks, the worst is not yet over. Bearing out Sibley’s Law, the banks splashed their capital against the wall and must replace it. The sellers have been right about them so far, and may still be right.

They might, indeed, ask why the FSA gets no complaints about long buyers. We have not seen these creatures lately, but when the market’s mood is sunny they emerge and bask, like crocodiles on sandbanks. They buy a share, possibly with borrowed money, and hope that the price will go up. If their buying drives the price up, that becomes another self-fulfilling prophecy. How nice.

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