Before German Chancellor Angela Merkel utters another word about short selling, she should reflect on what Hank Paulson did after the implosion of Lehman Brothers Holdings Inc. in September 2008.
As the U.S. Treasury Secretary gawped into the financial black hole that week, Paulson says in his memoirs that he implored Securities and Exchange Commission Chairman Chris Cox to ban abusive short selling.
“If you wait any longer, there won’t be a market left to regulate,” Paulson recalls saying.
Though Cox fretted about “unintended consequences,” the SEC proceeded to prohibit the shorting of 799 financial stocks. The consequences were as ugly as they were unintended, judging from two new books, “Selling America Short” by former SEC attorney Richard C. Sauer and “Don’t Blame the Shorts” by hedge-fund specialist Robert Sloan.
“Volatility spiked,” Sauer writes. “Liquidity dried up,” and trading strategies that use shorting to hedge risk “were suddenly no longer viable.”
Is anyone in Berlin listening? Or is Germany’s unilateral ban on some bets against government bonds and financial institutions -- imposed this week -- aimed at what Sloan calls “serving public opinion without serving the public”?
Short sellers have been easy scapegoats ever since the Dutch East India Company whined about them to the Amsterdam Stock Exchange in the 1600s. Yet shorting injects liquidity into markets and is widely used for hedging the risk of all kinds of investments, including convertible bonds.
A classic short seller is someone who spots a bubble or a fraud and bets against it. The short borrows assets and sells them, seeking to buy them back at a lower price later, return them to the lender and pocket the difference. Sounds easy until you realize that other investors can remain blind to bubbles and frauds longer than you can keep a bet on.
Regulators, says Sauer, stand in the shallows of the market, puzzled by most of what happens in the murky depths. So he learned to value shorts during his 13 years at the SEC, where he ran some of the agency’s more memorable probes into corporate gems such as Belgian software maker Lernout & Hauspie Speech Products NV.
“From time to time,” he says, “someone comes along who, in a remarkable gesture, hauls forth from below a grand curiosity and drops it on the shore,” at a regulator’s feet.
These fishermen included Marc Cohodes, a beefy short seller who wore T-shirts and Bermuda shorts to work at hedge fund Rocker Partners. He resurfaces time and again as Sauer takes the reader on a self-mocking tour of probes that had him hop-scotching around Europe, from the Isle of Man to Cyprus.
Readers with a taste for skulduggery won’t be disappointed. Sauer’s war stories slither through letterbox companies, a suspicious Bulgarian government contract and documents dumped onto a roadside garbage heap. The tales are labyrinthine and could have used some streamlining, but what should Sauer have cut? Surely not the elderly French lady in Monaco who “inquires pleasantly if I am carrying a gun.”
Eventually, Sauer became an analyst and legal adviser at Copper River Management, a “short-biased” California fund formerly known as Rocker. That’s where he was when the SEC imposed the shorting ban in September 2008.
Copper River might have survived this “mother of all short squeezes,” Sauer says. Only two of its shorts made the agency’s list, he writes, and many of the stocks in its short portfolio crashed within a few weeks. If Copper River had been able to hold onto its positions, it would have reversed all its losses, he says.
Unfortunately for Copper River, its prime broker of 20 years, Goldman Sachs Group Inc., was itself in crisis mode. Goldman started demanding more collateral, as other banks were doing at the time, and prohibited Copper River from making any transactions for any purpose than to reduce its short exposure, Sauer says. Every stock purchase made to trim that exposure threatened to push the shares higher.
Copper River faced “the prospect of digging our own grave with Goldman standing behind us yelling, ‘Faster, faster!’”
Ed Canaday, a spokesman for Goldman Sachs in New York, declined to comment on the book.
Copper River’s quandary, however disturbing, should be familiar to anyone who has studied financial history. When stock investors rush for the exits, shorts can become the market’s lender of last resort, says Sloan, managing partner of S3 Partners LLC, a firm that helps hedge funds manage their prime broker relationships.
“They had to buy back stock at some point, and that very buyback mechanism was a vital emergency reserve to tap if markets could not provide liquidity themselves,” Sloan says.
Sloan tracks the populist aversion for shorts down through the years. Herbert Hoover, for one, was convinced that a league of short sellers met each Sunday to plot the market’s destruction, Sloan writes. Yet congressional investigations into alleged “bear raids” have repeatedly concluded that prices plunged “because of an absence of bids, not because of a colluding cabal that drove prices down,” he says.
Germany’s Merkel should take a deep breath and call Sloan for a lesson. Unless she’s just deflecting attention from the European Union’s own failings.
“Selling America Short” is from Wiley (324 pages, $27.95, 18.99 pounds). “Don’t Blame the Shorts” is from McGraw-Hill (247 pages, $27.95, 21.99 pounds). To buy these books in North America, click here for “Selling America Short” and here for “Don’t Blame the Shorts.”
(James Pressley writes for Muse, the arts and leisure section of Bloomberg News. The opinions expressed are his own.)