Oct. 29 (Bloomberg) -- A six-foot stuffed grizzly bear guards the entrance to the offices of Fleckenstein Capital Inc., located on a quiet, leafy street in the Capitol Hill neighborhood of Seattle. The bear sends a clear message: The man inside, Bill Fleckenstein, founder and president of the firm, is a short seller and proud of it.

Fleckenstein, 55, has emerged as one of the most-outspoken defenders of what has been depicted by everyone from the chief executive officer of Morgan Stanley to the Archbishop of Canterbury as a renegade class of investors. Since world markets began their most serious plunge in decades in July, 17 countries have banned or restricted short selling, including the U.S., Canada, the U.K., Germany, France, Switzerland, Australia, Japan and Taiwan. Commentators around the world have labeled short sellers as hyenas, jackals, vermin and vultures.

Fleckenstein says that investors who bet that stocks will decline, as short sellers do, are simply bears. And he says they are not to blame for the market meltdown. ``Short sellers didn't lower the fed funds rate or tell people to take out mortgages when they shouldn't have,'' he says. ``Now we are the bad guys, the ones wearing black hats.''

Fleckenstein's offices are a monument to his trading strategy, in which investors borrow stock from institutional investors and then sell it in hope of buying the shares back at a lower price before returning them to the lender. The grizzly bear was wearing a ``Dow 10,000'' baseball cap when the index was still at 11,000. A large sign on the wall of Fleckenstein's three-room office suite advises, ``Protect Your Right to Arm Bears.''

SEC Investigation

The long-haired Seattle native is one of a corps of pessimistic investors who have been blamed for market manipulation since the 17th century.

The recent attacks began after a rapid deterioration in the share price of Bear Stearns Cos. in March. When Bear Stearns's stock fell 47 percent on Friday, March 14, the U.S. Federal Reserve stepped in and that weekend brokered the sale of the investment bank to JPMorgan Chase & Co. Later, Bear Stearns Chief Executive Officer Alan Schwartz told Congress that the firm was toppled by rumormongering and abusive trading -- often euphemisms for short selling. The Securities and Exchange Commission launched an investigation that was still in progress in mid-October.

After Bear Stearns's demise, each new crisis in the banking sector raised alarms about short selling. When the share prices of Goldman Sachs Group Inc. and Morgan Stanley dropped sharply on Sept. 17, Morgan Stanley CEO John Mack declared in a memo to his staff, ``Short sellers are driving our stock down.'' And in testimony before Congress on Oct. 6, former Lehman Brothers Holdings Inc. CEO Richard Fuld singled out ``naked'' short sellers as one of the culprits in the Sept. 15 bankruptcy of his firm.

HBOS Rumors

Naked short selling occurs when a short seller tells his broker to sell shares that the seller has not yet borrowed. On Sept. 17, the SEC ruled for the first time that naked short selling was a fraud. On Oct. 28, Japan banned naked short selling in its markets through Mar. 31, 2009.

In the U.K., the campaign against short sellers also goes back to March, when the Financial Services Authority said it suspected that ``false rumors'' linked to short selling led to a sudden drop in the share price of HBOS Plc, the country's biggest mortgage lender. An FSA investigation found no evidence of abuse.

In September, when Lloyds TSB Group Plc agreed to buy HBOS for a fifth of its value a year earlier, both Archbishop of Canterbury Rowan Williams and Archbishop of York John Sentamu continued to blame the short sellers, with Sentamu calling them ``bank robbers.''

Anglican Investments

The 2007 annual report of the Church of England shows that its 5.5 billion pounds ($8.75 billion) of assets included a 34.5 million pound position in HBOS and 40.4 million pounds in Barclays Plc, whose stock also plunged in September and October. The Church of England Pensions Board at the end of 2007 managed another 850 million pounds, including 8.5 million pounds worth of HBOS shares.

In response to the furor, the FSA banned short selling of the stocks of banks, insurance companies and securities firms from Sept. 18 through the rest of the year. A day later, the SEC imposed its own ban on short sales of 799 financial stocks. It later added 170 additional companies, including International Business Machines Corp. and Sears Holdings Corp. The SEC ban, after one extension, expired on Oct. 9, six days after passage of the $700 billion U.S. bailout plan for the banking system. During the period the ban was in effect, the Standard & Poor's 500 Index lost 17.7 percent of its value.

Scapegoats

The short sellers say they are scapegoats for the real villains in the meltdown. ``The shorts who warned about the real estate bubble have been proven right,'' Fleckenstein says. ``Now the government has changed the rules overnight. They're blaming the shorts and bailing out the ones who lost all the money and almost took the financial system down.''

Manuel Asensio, 53, president of New York-based Mill Rock LLC, says he and his brethren keep the stock market honest by going after companies with rotten accounting, dubious business plans and excessive debt.

``There was a legitimate reason as to why the financial stocks went down; it was mispriced securities on their balance sheets that caused the problems,'' he says. Mill Rock is a hedge fund that holds long and short positions in equities and invests in distressed bank loans.

After mid-2007, when two Bear Stearns hedge funds collapsed, investors had every reason to believe financial shares would decline, says George Feiger, CEO of investment manager Contango Capital Advisors Inc., which oversees about $2 billion in Berkeley, California.

`Expression of Doubt'

``Short selling is an expression of doubt, not a criminal activity,'' Feiger says. ``The management at Lehman, Bear Stearns and Merrill kept saying everything was fine. Then, every few weeks, they'd write off billions.''

In fact, by early 2008 financial shares were so volatile that James Chanos, founder of Kynikos Associates Ltd., which runs a $5 billion short-only fund, says he stopped shorting them. ``We have the least amount of financial shares short in our portfolio than we've had in four years,'' Chanos told Bloomberg TV on Oct. 13. ``We're looking elsewhere.''

The power of short sellers has been greatly exaggerated, says Douglas Kass, founder of Palm Beach, Florida-based hedge fund firm Seabreeze LP Holdings, which manages $200 million. ``The dedicated short pool totals about $5.5 billion,'' Kass says. ``Dedicated'' short-selling firms run funds that do nothing else. ``That's too small to have an impact,'' Kass says.

The ban on short selling has exacerbated the financial crisis by driving dozens of hedge funds to the edge of bankruptcy, says Richard Baker, president of the Managed Funds Association, a hedge-fund-industry lobbying group.

Quants in Jeopardy

Quantitative hedge funds were put in the most jeopardy by the ban, he says. They use sophisticated computer algorithms to choose a group of stocks to buy. They then hedge the bet by shorting a second set of stocks. Their response to the short-selling ban has been to cut back on all trading, Baker says.

Convertible bond funds have been hurt the most by the ban. Investors who buy convertible bonds -- bonds that can be converted to stock at a certain price -- usually short the same company's stock as a hedge against a fall in the price. Financial companies sold more than $30 billion of convertible bonds in the first nine months of 2008. In September, convertible bond arbitrage was the worst-hit hedge fund strategy, plunging 16.6 percent, according to Chicago-based Hedge Fund Research Inc.'s HFRX index, against a 6.9 percent fall for the industry.

Power Exaggerated

Most academic observers agree with Kass that the power of short sellers is overblown. ``In the current crisis, shorts are like flies on a carcass on the side of a road,'' says James Angel, a finance professor at Georgetown University in Washington who studies short selling. ``We should focus on who or what killed the animal.''

Under certain circumstances, short sellers can manipulate stock prices -- either through concerted action or through a ``feedback loop,'' says Itay Goldstein, a finance professor at the Wharton School at the University of Pennsylvania. A feedback loop is simply a chain reaction.

An example might be when creditors refuse new loans to a company after reports surface that there is heavy short interest in its stock, Goldstein says. Short interest is the total amount of stock that has been borrowed by short sellers. The credit pullback leads to a further share decline and a decrease in the value of the firm.

``It's hard to tell whether the recent market decline is due to manipulative attempts,'' Goldstein says. ``The conditions were such that this is quite possible.''

No Data Supporting Mack

The short sellers have marshaled statistics in an effort to prove they played little or no role in the 2008 market downturn. Kass, for instance, points out that Morgan Stanley offers no data supporting CEO Mack's contention that short sellers were responsible when his company's stock price retreated 44.5 percent to an almost 10-year low of $22.55 in the three weeks ended on Sept. 18, the day short selling was banned.

Morgan Stanley shares closed at $15.20 on Oct. 28, down 71 percent for the year. Data from custodians and brokerages compiled by London-based Data Explorers Ltd. show that as of Sept. 16, about 2.9 percent of Morgan Stanley's outstanding shares had been loaned to short sellers, down from more than 7 percent in July.

According to Short Alert Research, a Charlotte, North Carolina-based firm that produces research for short sellers, from early July to late September short interest in 33 investment banks and brokers plunged by 33.3 percent. Yet, share prices still declined.

``It was the longs getting out,'' says Fleckenstein. ``Probably the insiders.''

First Ban in 1609

The first recorded ban on short selling took place in the Netherlands in 1609, when Issac Le Maire, a Flemish merchant and former board member of the Dutch East India Company, formed a secret society of short sellers to drive the company's stock price down, says Edward Chancellor, author of ``Devil Take the Hindmost: A History of Financial Speculation'' (Farrar, Straus & Giroux, 1999).

Part of Le Maire's scheme was to form a French company to compete with the Dutch trading firm. The Dutch East India Company then persuaded the government to ban short selling.

In 1792, the New York state legislature forbade short selling after the U.S.'s first-ever stock market crash. Just five weeks later, two dozen brokers signed the Buttonwood Agreement, which created what later became the New York Stock Exchange, where short selling was allowed.

Short sellers were widely blamed for the wild gyrations of the stock market after the crash of 1929 -- and for good reason, says Charles Geisst, professor of economy and finance at Manhattan College in Riverdale, New York, and author of ``Wall Street: A History.''

Uptick Rule Eliminated

``During the year prior to passage of the Securities Act and Banking Act in 1933, there was a massive bear raid on Wall Street,'' Geisst says. ``Some executives were shorting their own stock.''

The Securities Act created the SEC.

In 1938, the SEC adopted the ``uptick'' rule, which allowed short sellers to borrow a company's shares only when the shares were on the rise. The SEC eliminated the rule in 2007, and also relaxed its rule on naked short selling -- decisions that brought a storm of criticism on the head of SEC Chairman Christopher Cox a year later when the markets melted down.

The two actions ``overthrew 71 years of stability,'' Geisst says. ``That's what broke the camel's back.''

Fleckenstein, sitting among stacks of newspapers and analyst research reports in his Seattle office in late September, says the SEC's short-selling ban and the federal government's $700 billion bailout package just postponed the day of reckoning.

`Boom and Bust'

``Capitalism is all about boom and bust,'' he says as he scans e-mails and monitors stock prices. ``To ban short selling is to say that the government is going to determine what stock prices should be.''

Fleckenstein got a degree in mathematics from the University of Washington in 1976 and then worked for three years as a software engineer. In 1979, he joined investment bank Kidder Peabody & Co. as a broker. Three years later, he left to form a private investment advisory firm, managing money for pension funds and wealthy individuals. In 1996, he started Fleckenstein Capital, which from the beginning was a short-only fund specializing in technology stocks.

The fund was launched in a time of unbridled enthusiasm for all things technological. The Internet boom was unfolding. Even as early as 1996, Fleckenstein thought the run-up in stock prices of the companies was unwarranted.

Fleckenstein's Nadir

His fund did well until 1999, when the tech-oriented Nasdaq rose 86 percent. Even though his short positions were in hardware companies rather than dotcoms, Fleckenstein's fund took a beating.

``Internet stocks were trading at a wacky number,'' Fleckenstein says. ``That meant legitimate companies, with real business and revenue, were trading at a higher level than they were worth.''

At the end of 1999, Fleckenstein's investors, including Microsoft Corp. co-founder Paul Allen, had to provide him with more funds.

Fleckenstein declines to disclose either the size or returns of his fund. One Fleckenstein investor, Tor Braham, head of technology mergers and acquisitions at Deutsche Bank AG, says he couldn't be happier with his returns, though he won't disclose what they are. He says he invested with Fleckenstein in April 2000, when technology and Internet stocks were coming off their all-time peak. The Nasdaq has fallen more than 50 percent since then, as of Oct. 28, generating big profits for investors who bet against it.

Leverage

``Fleckenstein has been saying for a long time that the economy is going to get into trouble because of leverage,'' Braham says. ``He's very thoughtful as to the bets he takes on companies and doesn't do things he doesn't understand.''

Fleckenstein places most of the blame for the crisis in housing and mortgage-backed securities at the feet of former Federal Reserve Chairman Alan Greenspan. Fleckenstein has written a book on the topic called ``Greenspan's Bubbles'' (McGraw-Hill, 2008).

Over three years starting in January 2001, Greenspan and the Fed slashed the fed funds rate to 1 percent from 6 percent. Fleckenstein says it was this extremely aggressive monetary policy that led to the housing bubble and mortgage-market abuse.

``Financial companies learned there was no risk,'' he says. ``They didn't even pay attention as mortgage defaults exploded.''

Inept Leaders

Fleckenstein says his research shows mortgage defaults took their first sharp jump in February 2007; yet, he says, few leaders in either the government or financial industry sounded an alarm until it was too late. ``How inept are our leaders when they missed something so obvious,'' he says.

Like his fellow short sellers, Fleckenstein sees no profit in optimism. He told Bloomberg News on Sept. 24, when the Dow was at 10,825, that he expected it to bottom out at 8,500. The Dow sank as low as 8,176 on Oct. 27, before rebounding yesterday to 9,065. Fleckenstein insists, however, that it gives him no joy that his grizzly bear's ``Dow 10,000'' hat is now out of date.

To contact the reporters on this story: Kambiz Foroohar in New York at kforoohar@bloomberg.net

Last Updated: October 29, 2008 00:10 EDT