Hiltzik: Why short selling is good for the markets

A man talks into a microphone near his cheek.

By Michael HiltzikBusiness Columnist

May 31, 2023 5 AM PT

The very human instinct to seek scapegoats for every crisis is playing out again on Wall Street.

As so often happens, this time the target is short selling, which supposedly is helping to drive banking stocks lower.

As so often also happens, the loudest cries for relief are coming from the people most responsible for the stocks’ decline — in this case, banking executives themselves.

Even with the bans in place, prices continued to fall.

— New York Federal Reserve Bank, on the uselessness of a 2008 ban on short-selling financial stocks

The cries to clamp down on short selling started even as the banking crisis of 2023, touched off by the failure of Silicon Valley Bank and other institutions in March, was running at full bore.

In an interview with Bloomberg, Jamie Dimon, chairman and chief executive of the banking giant JPMorgan Chase & Co., urged the Securities and Exchange Commission to “go after them, and vigorously,” if it could be shown that “people are in collusion or ... going short and making a tweet about a bank.”

In a May 4 letter to clients, the law firm Wachtell, Rosen, Lipton & Katz, which represents big corporations, urged the SEC to impose a 15-day prohibition on short selling in stocks of financial firms to forestall “coordinated short attacks” on those companies.

The American Bankers Assn., in a May 4 letter to SEC Chairman Gary Gensler, called for “appropriate enforcement actions against market manipulation and other abusive short selling practices.”

Pay them no heed.

Such calls for regulatory actions against short sellers are all based on the assumption that short selling is nefarious — that daring to take a negative view of a company’s stock is tantamount to market manipulation, especially if the short sellers have the impudence to publicize their viewpoint.

Before we proceed, a simple primer in short selling is in order. Fundamentally, short sellers follow the traditional investment advice to buy low and sell high but reverse the order of those steps: They sell high, in the expectation that they will ultimately be able to buy low, pocketing the difference between the sale and purchase prices of their investments. They don’t own the stocks they sell in Step 1 but borrow them from shareholders for a fee, repaying the loan with shares hopefully acquired at a lower price.

Short selling is not illegal, and as we’ll see it’s, in fact, healthy for the markets. Critics of short sellers sometimes emphasize “naked” short selling — selling shares one hasn’t borrowed — as the real cause of damage to the markets, but that’s not always illegal either.

Short investors aren’t always required to have borrowed shares before selling them; it’s alright if they can show they’ve done something like a “locate,” meaning that they’ve identified shares they can eventually borrow to complete their transaction if necessary. It’s only when shorts sell shares they don’t ever intend to borrow that the SEC will charge them with illegal naked shorting, but that’s a very rare occurrence.

To its credit, the SEC seldom takes campaigns to restrict short selling very seriously. The agency has pledged to launch an investigation into whether this year’s downdraft in bank stocks is due to market manipulation. But there’s little evidence that the agency is doing more than trying to mollify bank managements fretting that a widely followed index of regional banking shares has fallen by about 33% since the March 10 failure of Silicon Valley Bank.

Short selling is an appropriate strategy if you believe or fear that a stock’s price is headed down. But it goes against the grain: Selling something you don’t own smacks, at first blush, of a confidence scheme.

It’s also very risky: If you own a stock, you can only lose what you invested, but your potential gain if the stock goes up is theoretically unlimited. If you short a stock, your potential gain is limited to what you collected by selling the borrowed shares, even if the stock falls to zero; but your potential loss is infinite, if the stock rises instead of falls.

The interplay between optimism and pessimism is what makes markets, just as it does horse races. That’s no less true when optimism and pessimism go to extremes, as they often do.

History documents a long-term preference in financial markets for optimism, broken by occasional outbreaks of fear trending toward panic; that’s why stock investment returns handsomely exceed inflation (over the very long term).

Corporate managements have no right to expect optimists always to prevail. The optimists are not invariably right, after all. They are, however, typically more numerous than pessimists. That’s because investors with negative views of a company’s future don’t normally short its stock; they simply don’t invest in it.

Short selling is an indispensable counterbalance to the general sunniness about a company’s prospects that issue from executive suites. Short sellers have helped to expose not a few fraudulent or incompetent managements, most notably when the veteran short seller James Chanos blew the whistle on Enron in 2000-01.

Proposals to ban or limit short selling in selected companies or industries arise persistently on Wall Street, even though the evidence is strong that they don’t work to stem downdrafts.

During the financial crisis of September 2008, for instance, the SEC temporarily banned short selling in 799 financial stocks “to protect the integrity and quality of the securities market and strengthen investor confidence.”

The Federal Reserve Bank of New York concluded in a 2012 study that “the bans had little impact on stock prices,” because “even with the bans in place, prices continued to fall.”

The bans did, however, raise trading costs by about $1 billion, largely because the bans prevented market makers such as New York Stock Exchange floor brokers from engaging in the short-term shorting they relied on to balance their trading books.

Short-selling bans, the New York Fed warned, also “prevent ... short-sellers from rooting out cases of fraud and earnings manipulation.”

Almost inevitably, when corporate managements bellyache about short selling, their shares are under pressure for fundamental reasons, such as management ineptitude or dishonesty.

Lehman Bros. Chairman and CEO Dick Fuld, for example, aired out the naked short-selling excuse when trying to explain why his Wall Street firm failed in 2008, helping to trigger the financial crisis that year.

The truth was that Lehman under Fuld was spectacularly mismanaged, bristling with accounting gimmicks that concealed, at least temporarily, the horrible misjudgments and business choices that led to its demise. Shorts, especially naked shorts, had nothing to do with it.

Elon Musk has been on a seemingly permanent warpath against short sellers of Tesla shares. Back in April 2022, he erupted in fury at Bill Gates, who was reported to have accumulated a $500-million short position in the electric car maker’s shares. Musk accused Gates of betting in favor of global warming by undermining Tesla stock.

At the time, Tesla shares were trading at a split-adjusted price of about $335. As of this writing, they’re floating below $199, for a decline of more than 40%. Maybe Gates knew something that Musk either didn’t know about Tesla or wasn’t saying.

The idea that short sellers are determined to undermine deserving companies purely for profit isn’t unusual. A great example emerged a few years ago related to stock in the Washington-area biotech firm Northwest Biotherapeutics, which is in the business of developing cancer drugs.

Northwest’s supporters, including a Washington Post financial columnist, got it into their heads that Wall Street hedge funds and Adam Feuerstein, a reporter for TheStreet.com, were somehow in cahoots to drive the company’s shares lower.

This was an example of how short sellers worked to “stifle innovation and damage the economy in their relentless pursuit of short-term trading profits,” in the Post’s words.

As I wrote at the time, this smelled like nonsense. Feuerstein’s reports were well-informed and properly skeptical. Northwest Bio was trading at about $5 a share at the time of the brouhaha over short selling. Today it’s about 60 cents.

In its latest annual report, issued in February, the company acknowledged that it has never turned a profit since its inception in 1996. “We may never achieve or sustain profitability,” it said. Sounds like the shorts had it right.

That brings us back to the agitation for a short-selling ban on bank stocks. The American Bankers Assn.’s letter to Gensler is a masterpiece of the genre. It wrings its figurative hands over short sales that “do not appear to reflect the issuers’ financial status or general industry conditions.”

Indeed, the bankers say, short sales have followed “relatively favorable earnings reports.” The letter complains about “extensive social media engagement about the health of various banks ... disconnected from the underlying financial realities.”

In truth, the underlying financial reality of commercial banks is that they live on a knife edge that in any other sector would suggest impending disaster.

Put simply, they fund long-term investments with short-term borrowings. That is, they invest in assets such as long-term loans, Treasury securities and mortgages with durations as long as 30 years, backed by customer deposits that can be withdrawn at any moment by a single phone call or the click of a mouse.

That’s precisely the practice that brought down Silicon Valley Bank and others that crashed in recent weeks: Depositors pulled billions of dollars in deposits, leaving the banks stranded with assets that had cratered in real value because interest rates had risen rapidly.

The “relatively favorable earnings reports” of many banks were based on sleight-of-hand, which investors finally noticed. The banks acknowledged on their balance sheets that they had losses pending on assets they were poised to sell into a falling market. But they didn’t count unrealized losses on assets that they planned to hold to maturity, when they’d be guaranteed to get their original investments back.

When the deposits fled, investors quite naturally took a closer look at those supposedly secure assets, and realized that in real, fundamental terms the banks were insolvent. That they started selling shares was as natural a reaction as your knee twitching when the doctor tests your reflexes.

Tellingly, the ABA letter never specifies what it means by short sellers’ “manipulation and abuse” that it wants the SEC to stamp out.

The bankers say they want to “restore investor confidence.” If that’s so, they’re barking up the wrong tree. Nothing will undermine investor confidence more than the impression that the nation’s chief financial regulator is out to rig the markets to favor executives looking for a free hand to paint their companies as positively as they wish, the truth be damned.

Column: Short selling makes markets work better. So why do banks want to outlaw it?

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