The Financial Crisis

Politicians and the media have much in common with respect to the financial crisis: one characteristic is a never ending search for scapegoats. High on the list of such undesirables are short sellers - as much because they profit from the adversity experienced by others as for any other reason.

Short sellers borrow, usually paying a small fee, shares and other financial instruments. Their plan, after the price has dropped, is to buy back and return the stocks. Their profit is the difference between the higher sale price and the lower repurchase cost.

That sounds simple but, in reality, it is a very risky way to make money. In general, the prices of shares, which are the most commonly shorted instruments, rise so a short seller is betting against the market trend. Further, the profit is limited by the fact that a share's price cannot fall below zero while the potential loss is infinite.

The underlying reason for the risk is aptly described in this aphorism:

“He who sells what isn’t his’n, must buy it back or go to prison.”

The origin of the saying is unknown, but it is generally attributed to American financier Daniel Drew (1797-1879).

When short sellers have wrongly analyzed the situation - or when the market refuses to see what is in front of its nose - the requirement to 'buy it back or go to prison' imposes, on the short seller, the necessity of paying far more to buy back the shares than the earlier revenue received. That can be a really large loss.

Your corespondent knew a speculator who understood, correctly, that the Australian nickel mining stock boom of 1969 - 1970 was really a bubble. His mistake was to start his short selling program too early. His target was Poseidon Nickel and, when the stock price reached 10 British Pounds (about $24), he began a program of short selling.

As the price of Poseidon stock continued to rise, he sold more shares short - even at prices as high as 30 British Pounds. After that, he sold no more but refrained from realizing his losses by buying back all that wasn't hisn. Not until the price reached 50 British Pounds, and under great pressure from his broker to post additional collateral to prove that he could afford to buy back what wasn't hisn, did he concede, buy in the stock and accept losses ranging from 20 - 40 pounds per share. His losses were not just ugly, they were really ugly! Had he waited to begin his short selling until the price came close to its peak (over 100 British Pounds or $250) before it dropped like the proverbial stone, he would have been a very, very, rich man.

A good short seller's life, when he is on top of his game, consists of many small losses, a few small gains, and the occasional blockbuster profit. It is the blockbuster profit that earns him the enmity - if not hatred - of politicians and the commentariat because, they say, he conspires to blacken the reputations of companies that little deserve such treatment. The problem with such accusations, is that spectacular profits are available because there really was something badly wrong that few others in the market understood.

So do short sellers perform a useful function?

Markets, in spite of common wisdom, are not efficient and short sellers provide information not otherwise easily available. Since the information unearthed is usually unflattering to the target company, the first wave of dislike comes from its executives. Such an attitude, however, is only rational when there is negative information that is being withheld from the market or when the executives have failed to understand the real situation.

Markets operate best when there is open information flow and clear price signals. In a bubble, by contrast, irrational exuberance rules and prices rise uncontrollably, without regard to reality, until the bubble bursts.

Short sellers, then, are far from the best available scapegoats so, perhaps, politicians and the media should turn their attention to real problems. Protecting Wall Street from its own stupidity, herd mentality, and self deception, without adding to moral hazard or penalizing the long suffering taxpayer, would be a small start.