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The market’s favourite scapegoat

Christopher Fildes on short selling

2 July 2008

12:00 AM

2 July 2008

12:00 AM

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.

A financier with a following can refine this technique, much to his own advantage. Once he has bought a share, he allows the word to get out; his followers pile in and the price goes up. This confirms their belief that he has a magic touch. Thanks to them, he can close his position and move on to the next share. Anyone in the City with a working memory can think of wizards like these. In the end, their touch may desert them and their disenchanted followers drift away, but another wizard will be just around the corner. While they last, these long buyers are nobody’s favourite scapegoat. They rock no one’s boat and they profit from no one’s misfortune. By pushing share prices up, they can make us all richer — or at least sustain that illusion. Even the regulators are in no particular hurry to go after them with traps and poison.

The short seller’s life is more hazardous. For a start, his risk is unlimited. If you buy a share and it falls, the most you can lose is the money you paid for it, but if you go short on a share and the price then goes up, there may be nothing to stop it. No wonder short sellers set themselves limits and must be prepared to close their positions in a hurry. They may then be caught in the rush for the exit, or they may reset their limits and hope for the best.

They know, too, that even the most despised shares can find friends. Clive Cowdery made his fortune by giving the kiss of life to ‘zombie’ funds closed to new buyers by the life assurance offices. Now he has seen value in bombed-out mortgage banks. Bradford & Bingley, he says, would be a good place to start. This must have jolted B&B’s short sellers — there are four on the FSA’s list. Then he backed away, and so did the B&B share price.

The market has its own ways of imposing its disciplines on short sellers and punishing them for their excesses, or some of them. Nor can they even expect to be admired for being right. They never have been. Seventy years ago, in Where Are the Customers’ Yachts?, his Wall Street classic, Fred Schwed analysed what he called the vague, universal indignation they aroused. They were typecast as villains. In good times, he said, nobody minded the short sellers except their families, who minded going bankrupt. In bad times they were a receptacle for blame. At such times, Schwed thought, investors should ask themselves the definitive question: was my money stolen or did I just lose it? Answer: you probably lost it — but let’s put it down to financial villainy. Go after the usual suspects, and better luck this time.

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