“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 would 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 said on 13 October. “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.”
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.
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 trading, he 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%, according to Chicago-based Hedge Fund Research Inc.’s HFRX index, against a 6.9% fall for the industry.
Most academics 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.”
The short-sellers have marshalled statistics in an effort to prove they played little or no role in the 2008 market downturn.