Finance
The Scourge of Short Sellers
Citibank 15, AIG 20, Merrill Lynch 22, B of A 19, LNC 42, Freddie Mac 4, Lehman 13 ... the list of financial companies whose stock has been battered the past few months is seemingly endless. Most are down at least 50%, many over 70% from their 52 week highs. By now we all know the story behind the plummet - sub-prime CDOs, CDO2, CPDOs, CDS and the resulting very large write downs. Certainly, some degree of punishment was appropriate for these companies given the poor risk controls and for some, reduced earnings potential over the next few years due to de-leveraging. Some have also taken realized losses on their bad investments or non-performing loans. Yet many, especially the insurance companies, have only taken paper losses and will quite likely see write-ups over the next two to three years. This is because they are valuing many of their holdings at extremely low levels because of a lack of liquidity in the markets for these specialized assets. Simply, if nobody wishes to buy anymore of these assets the only bids (if any) will be below fair/intrinsic value. Anybody who has sold a home or auto in a stagnant market understands this - bids will be few and usually well below what anyone would consider 'fair' value yet unless you absolutely needed to sell you would wait for the market to improve. The same applies to many of the CDOs and CDS on the books today but unlike a house which remains yours until sold, these assets are continuously receiving income streams which shortens their expected life. So while nobody may want to buy your CDO or CDS, you may in fact be paid back all you were due (or not pay in the case of a swap).So why have their stock prices gone so low? Is it simply panic selling? We will concede a portion of the move to 'panic' selling by investors who have suffered margin calls, wish no more pain or no longer understand what they own and are willing to take their lumps immediately. But panic selling happens over a short period of time, not over weeks and months. The plummet from late last week through this past Tuesday smelled of panic selling but that explains only the last few points. What of the rest that could be deemed 'excessive?' To begin, one should probably look at the daily volume traded.
Since June 17, Citibank has traded 49% of its 5.2 billion share float. AIG about 46% of its free float. Freddie Mac 274% of its float. A typical trading day a year ago would see each of those companies trade 0.5% of its float, or 11% over a 22 day period. So without question, turnover is way up. As are the number of shares being sold short. Short sales are the sale of borrowed stock - perhaps you think company A will report bad earnings and you would like to profit on an expected move lower. You can ask your broker to 'borrow' shares from another account which you can then sell. When you close your short position by buying the stock back, those shares are returned to the original holder. Most times there is no asking involved, brokers as part of their normal operations will borrow shares of common names and typically provide traders with a 'short-list' detailing which stocks can be shorted and how many shares are available. If the name you want is not on the list, they can usually call around to find some shares to short but probably will not bother unless the amount is worth the trouble. Not surprisingly, brokers get a small fee for lending the shares (you didn't think the actual owner would, did you?) which may rise as demand for shortable shares grows.
Short selling has always been viewed negatively by many investors who rush to blame 'evil short sellers' every time their stock declines in price. This is, of course, a naive view. In the normal course of things, short sellers provide additional liquidity to a market thus enabling those seeking to buy to obtain shares at a better price. In thinner issues, a short seller could also be the difference between buying your amount at one price instead of paying increasingly higher offers for smaller pieces until your order is complete. And those investors who regularly blame short sellers for all their ills rarely, if ever, thank them for pushing prices higher when they cover en masse creating a 'short rally'.
There are also non-speculative, legitimate reasons for short selling used daily by hedge funds and portfolio managers. As an example, a fund might hold a long position in Chevron feeling it is well run and has good reserves. However, they may not have good feel for the direction of crude prices in the near to medium term. In addition, when deciding on the purchase of Chevron they reviewed Exxon Mobil but felt it was not replenishing reserves fast enough and that management was not proactive. This presents the fund manager a way to stay long Chevron while minimizing his exposure to uncertainty in the crude market - to sell short an equal value of Exxon Mobil. As long as he holds this position his return will be based on the relative performance of these two companies. There are also a large number of hedge funds which use a 'long-short' strategy as the underlying basis for the fund, seeking to be market neutral. Gains (or losses) are achieved through fund manager 'alpha' - the ability to add (subtract) return in excess of the market. But again, we are speaking of relative stock/sector performances. A long/short strategy can be successful even if those stocks sold short increase in value. -more-
