The Benefits of Short-Selling Are Way Overrated

We've been engaged in a long debate over the merits of short-selling here at the Fool. Most involved in the debate seem to agree: The bad rap short-sellers receive is groundless; shorting can increase market liquidity; and short-sellers are sleuths exposing frauds and crummy business models, acting like market watchdogs that do us all a great service.

I'd beg to differ on that last one. I don't mind short-selling, because I think its net impact is trivial and meaningless. But for precisely that reason, I don't think we should praise short-sellers for providing a public benefit by uncovering companies' weaknesses. Their history of exposing excess isn't all it's cracked up to be.

Investors usually cite three examples when glorifying short-sellers' roles: 

  • Jim Chanos, who was short Enron before it blew up.
  • David Einhorn, who was all over Lehman Brothers before it gave in.
  • John Paulson, who bet against the housing market.

All three were spot-on in their analysis, and all are hoisted in high regard for uncovering economic cancers. "It was a short-seller, after all, that uncovered the fraud perpetrated by Enron and its supposedly independent auditor Arthur Andersen," my colleague Chuck Saletta wrote.

But was it? I think history shows otherwise.
Chanos gets most of the credit for uncovering Enron only because he made a lot of money, and the media devours that stuff. But in truth, a handful of nosy journalists, particularly Fortune's Bethany Mclean and the Wall Street Journal's John Emshwiller, Rebecca Smith, and Jonathan Weil, were first to shine light on Enron's faults.

Riding the coattails of open secrets
In fact, Chanos readily admits his Enron journey began after reading an article by Jonathan Weil about the company's accounting games. As author Malcolm Gladwell explains: "Weil's story ran in the Journal on September 20, 2000. A few days later, it was read by a Wall Street financier named James Chanos. Chanos is a short-seller -- an investor who tries to make money by betting that a company's stock will fall. 'It pricked up my ears,' Chanos said."

The first time the world heard of Chanos's Enron bet was a September 2001 New York Times article, where he called the stock "overvalued." By that time, Enron's stock had already fallen 62% amid the obviousness of its shady ways. Few heard much more of him until the company collapsed soon after.

But when Enron did fail, Chanos was suddenly showered in so much attention that you'd think -- and we've come to believe -- he was responsible for uncovering the fraud. Yet he clearly wasn't. Inquisitive journalists and whistleblowers brought Enron's offenses out into the open. Chanos just ran with their ball and capitalized on it.

Sniffing out Lehman's stench
How about David Einhorn and Lehman Brothers? Einhorn wasn't only short Lehman Brothers before it collapsed in 2008, but also quite vocal about his position -- just like his current criticisms of Moody's (NYSE: MCO  ) and MBIA (NYSE: MBI  ) . Here, too, though, it's easy for us to forget the timeline of his attacks.                                

Einhorn first bit into Lehman in November 2007, at the Value Investors Congress. His presentation was barely picked up by the media. The New York Times gave it one brief mention, and a handful of blogs and lesser-followed media outlets took notice. It wasn't until Einhorn's May 2008 presentation at the Ira Sohn Investment Research Conference that the media really began paying attention. From there, it was a circus. From May 2008 until Lehman went bankrupt that September, Einhorn's public spankings became front-page news. That's why he gets so much credit today.

But go back to the calendar. May 2008 was two months after Bear Stearns went under. By that time, many commentators and analysts, including yours truly, were already cautioning that Lehman would be the next to collapse. It was an obvious call to make.

Point being, few paid attention to Einhorn until it was plainly obvious and widely accepted that he was right. Giving him credit for opening the public's eyes is a bit gracious.

Housing's helpful enemy
John Paulson's role as a short-seller of the housing market is a strange one. Instead of shorting stocks, Paulson (and others) bought credit default swaps on mortgage products they thought would blow up. Many like to consider these guys black sheep who shed light on Wall Street's excesses.

But their role in uncovering excess in the housing market was completely backwards. Ironically, credit default swaps purchased by investors like Paulson were a major contributor to the credit bubble.

Around late 2006 and early 2007, there weren't enough mortgages being churned out to keep up with investors' thirst for collateralized debt obligations (CDOs). Wall Street banks like Citigroup (NYSE: C  ) and Goldman Sachs (NYSE: GS  ) found an answer to this: the synthetic CDO. Synthetic CDOs weren't comprised of new mortgages, but of credit default swaps tied to existing mortgages.

Here's how it works: An investor who wanted to go long housing (or just some confused dunce like AIG (NYSE: AIG  ) ) could sell a credit default swap to an investor like Paulson, who wanted to go short. If the mortgages stayed current, Paulson would have to make periodic interest-like payments to the long investor. If the mortgages defaulted, the long investor would owe Paulson the face value of the underlying security. That way, the arrangement mimicked an actual CDO, and the products were sold and traded as such. (Many investors, including Iceland, claim they had no idea they were buying synthetic products rather than the real thing.)

But the supply of synthetic CDOs had nothing to do with the supply of mortgages. Those had already dried up after everyone and their unemployed cousin OD'd on housing. Instead, increasing supply of synthetic CDOs relied on investors' willingness to go short mortgages, which is twisted beyond belief. Short-sellers like Paulson helped create mountains of CDOs that wouldn't have otherwise existed. 

And this wasn't like shorting a stock, where short-sellers free up existing supply. Credit default swaps were actually creating new supply. In 2006 and 2007, over $110 billion worth of synthetic CDOs were created -- most of which exploded, and none of which could have been created without short-sellers like Paulson. Save your praise for the guy. The main thing he uncovered was the chaos he helped create.

Save the praise
I'm not saying short-selling stocks is bad -- far from it. I'm just arguing that the benefits credited to it are often blown out of proportion.

Value investor Mohnish Pabrai gets the last word: "If you banned [credit default swaps], it wouldn't have much of an impact on the economy. Even if you ban short selling, it's just an instrument. It has no lasting impact on commerce. If all markets can do is 'go long,' you have all the mechanisms an economy needs to flourish."            

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Moody's is a Motley Fool Inside Value pick. Moody's is a Motley Fool Stock Advisor choice. Motley Fool Options has recommended an own stock position on Moody's. The Fool has a disclosure policy.


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  • Report this Comment On June 22, 2010, at 2:46 PM, Bot1 wrote:

    You say that short selling "frees up existing supply"? In theory that is correct, but functionally that is incorrect. The reason is that the people or "slow money" institutions that "think" they own common shares of stock have no clue that their shares are being lent out by the broker that actually owns and possesses their shares. The benefits of lending shares go to the brokers and not the people or institutions that think they own the shares.

    When the broker lends out the shares to abd it it shorted, there then become TWO people or entities that think they own the same shares of stock.

    Two demands have been filled with the same share of stock, which distorts actual supply and demand for a vehicle that was intended to fill the financing needs of the company whose equity is being shorted. If there is more supply than demand (created by the short sellers through their counterfeiting) then the company that depends on their equity for funding is able to raise less money through the sale of shares and the owners of the equity see less appreciation through dilution. How many times have we heard that proxy generating companies have to decide which "shareholder" votes to count because so often they receive more votes than actual shares exist, and this is due to the counterfeiting of shares through short selling.

    Maybe in the grand scheme of things for the vast majority of short selling there is no significant impact on the price or funding capabilities, but for the minority of companies and investors who HAVE been negatively affected by the counterfeiting of shares through short selling, the effect can be devastating.

  • Report this Comment On June 24, 2010, at 10:05 AM, miteycasey wrote:

    I'd praise all these guys.

    As you stated in your article they actually didn't create the idea on their own. They found the ideas in the same trade rags that each of us read daily.

    They saw an opening and had the balls to bust through.

  • Report this Comment On June 24, 2010, at 10:31 AM, TMFHousel wrote:

    Miteycasy,

    True. But the idea I'm trying to squash is that, without short sellers, these flaws wouldn't have been uncovered.

  • Report this Comment On June 25, 2010, at 3:02 PM, FleaBagger wrote:

    Short-sellers expedite the extraction of capital from failing businesses. Without short-sellers, those companies that squander capital in worthless business ventures would have that capital longer and be able to squander more of it. I wouldn't invest long in any market where short-selling weren't allowed, unless the valuation was twice as compelling as those available in a more honest market.

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