Sunday, November 22, 2009

Financial Detectives: A Primer on Short selling

Introduction by Jim Chanos

As short sellers, we are often called financial detectives, asking the hard questions and seeking the truth.

We test management’s ideas and try to understand what the company’s leaders want to achieve and where their business model might go wrong. Through this analysis, we assess the downside risks.

There are many examples of how short sellers have uncovered problems early — Baldwin-United, Coleco, Enron, Lehman, and MBIA, to name a few. Short sellers called into question the validity of these companies’ financial statements long before the regulatory bodies uncovered earnings manipulation or other improper activities. During the heyday of these companies, many asset managers ignored the financial detectives’ work because it was contrarian. They later wished they had listened more carefully.

Beyond uncovering the “Enrons,” short selling also deepens liquidity, a key component of efficient markets. In highly liquid markets, you can turn your asset into cash quickly and vice versa, without adversely influencing the price of the asset you’re buying or selling.

Market quality is also improved through short selling: spreads are narrower, stocks react more quickly to price-moving news, and buy and sell transactions are both handled more orderly. All these actions counter the market’s predilection towards excessive optimism, which tends to drive markets to unreasonable heights, as we saw during the “” era. Short sellers help to ensure that securities’ prices reflect fundamental values — not optimists’ irrational exuberance.

Financial market leaders, such as Federal Reserve Chairman Ben Bernanke, have acknowledged repeatedly the valuable role of short selling in shining a light on the irrational market behavior that creates “bubbles.” For, as Yale University Professor Owen Lamont put it, “when security prices are wrong, resources are wasted and investors are hurt.” Efficient markets require that prices fully reflect all views.

Short selling has risks and costs because we are often swimming against the tide and may face unlimited losses if our analyses prove wrong. “In reality, short selling is far from being financial black magic,” the Economist observes. “It is a difficult strategy to pull off, because in the long run stock markets tend to rise.”

Let’s be clear, too, that shorting stock when you know you can’t borrow the securities (naked shorting) is illegal, and we wholly agree that the Securities and Exchange Commission should take appropriate action against those who commit illegal acts.

More about short selling and its importance to investors, capital markets, and our economy is provided in this primer. Our approach at the Coalition of Private Investment Companies is to engage constructively in public policy dialogue. By helping policymakers, regulators, the media, and the investing public better understand short selling, we can ensure that our financial markets continue to offer investors opportunities to hedge risks, earn profits and realize their financial goals.