Monday, March 17, 2014

Stock Market: Why Short Selling Should Be Illegal

(Drivebycuriosity) - For years I had the belief that short sellers do a lot of harm to the economy, but I didn`t find much proof for that yet. This changed with a recent article in the New York Times. They write about William A. Ackman, a hedge fund billionaire ("After Big Bet, Hedge Fund Pulls the Levers of Power" (nytimes). The CEO of the hedge fund Pershing Square Capital Management is betting big against Herbalife, a producer and seller of nutritional supplements traded on Wall Street.

Ackman tries to make a huge profit by short selling Herbalife stocks: Short sellers borrow stocks from a broker and sell the shares immediately (going short or shorting) in the hope that stock prices will fall and then they could buy back these stocks for much less. In December 2012 the hedge fund manager revealed that he had shorted massively stocks of Herbalife (value $1 billion) and then started bad-mouthing the firm. Since then he is accusing the company to administer "a pyramid scheme" and claims "that the company relies primarily on pushing products to its recruited sales staff for its profits, rather than sales to retail customers and outlets" (dealbook). Ackman’s staff acknowledges that this crusade is really rooted in one goal: finding a way to undermine public confidence in Herbalife.



To bring the stock down Ackman did not just use his huge reputation as a billionaire hedge fund manager - there is cult around short sellers like Ackman (dealbook): "His team has helped organize protests, news conferences and letter-writing campaigns in California, Nevada, Connecticut, New York and Illinois, against his victim - although several of the people who signed the letters to state and federal officials say they do not remember sending them" (nytimes). Ackman also pulled the political puppet strings, acccording to the New York Times. He announced that Representative Linda T. Sánchez, Democrat of California, had sent a letter to the Federal Trade Commission calling for an investigation of the company even that the FTC hadn`t stamped the receipt of the letter yet. But not enough: Mr. Ackman’s firm hired the lobbyist Larry Rasky, who was an aide to Senator Edward J. Markey, Democrat of Massachusetts, when Mr. Markey was a member of the House. Another lobbyist, Malcolm Grace, is a former aide to Ms. Sánchez. Ackman’s efforts bore fruit on Jan. 23, when Senator Markey’s office, which Ackman had lobbied himself and which had been provided with detailed information about Herbalife by Ackman’s team, sent letters to the U.S. Securities and Exchange Commission (S.E.C., an US government agency for enforcing securities laws) and Federal Trade Commission (F.T.C, a US government organization for consumer protection)., calling for investigations of the company, writes the New York Times.

So far,  Ackman has persuaded four members of Congress, a New York State senator, a City Council member in Boston, the majority leader of the Nevada Senate and other elected officials in California to join the cause. Prominent consumer advocates in Washington, as well as leaders of well-respected Hispanic and African-American community groups who have been lobbied by Ackman’s team, have also written regulators demanding action.



Recently Ackman got what he wanted: The SEC started an investigation and the stock dropped. As you can see in the chart above, the stock had peaked in spring 2012 and dropped before and after Ackman´s shorting announcement end of 2012 (google). It recovered most of the losses in 2013, but started falling again after senator Markey’s letter and the begin of the S.E.C. investigation.

Ackman isn´t alone. Many hedge fund managers like Jim Chanos, David Einhorn of Greenlight Capital and others practice massive short selling. The Wall Street firm Muddy Waters even is specialized on shorting. Last autumn Carson Block, their founder, attacked NQ Mobile Inc. (NQ), a Beijing-based mobile services provider (bloomberg). The stock lost temporary half its value after Block said on Oct. 24 that it fabricated revenue and lied about its cash. Since then NQ recovered most of its values because Muddy Waters couldn´t prove their allegations (google).



Casino Royale?


All short sellers benefit from falling stock prices. Thus they have a natural interest that the business of the shorted company fails. Ackman openly goes for a bankrupt of Herbalife and he uses his power to bring the stock down. In the James Bond movie "Casino Royale" the villain, named "Le Chiffre", shorted stocks of an airline and then ordered an assassin to bomb a valuable new plane in order to destroy the whole company. This is just fiction, but gives an idea how short sellers could work. Even when short sellers do nothing illegal they can inflict a lot harm by spreading  rumors and allegations which can ruin the reputation of a company and thus irritate customers, creditors, investors and employes and so inflict damage on the company.

The harm done gets worse when herding behavior comes into play. Ackman and others try to persuade other hedge fund managers to join their attack. When they are successful their collective shorting could put the stock under severe pressure and irritate other stockholders and maybe induce a chain reaction.



In the recession of 2008 and early 2009 short selling was a viable business model. Herds of hedge funds and other speculators were betting on a meltdown of the market. Massive shorting enhanced the fall of the stock market, created panic and downward spirals for almost any stock on the market. After the fall of Lehman Brothers, the weakest of the financial firms, herds of short sellers attacked everybody who seemed vulnerable. Thus the stock market got into a downward spiral which paralyzed the whole economy. Companies ceased investing & hiring, the recession was on the brink to turn into a disaster like the great depression of the 1930s. Only with a temporary ban of shorting and massive cash injections of Bernanke´s Federal Reserve Bank the dangerous short selling avalange could be stopped.





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