Short-Selling as the Healthy Exercise of Skepticism

Michael Teague |

The practice of short-selling is commonly misunderstood as a ruthless and predatory endeavor, practiced by greedy individuals who would do anything, even bet against a company or an entire market, just to make a dollar.

Irrespective one’s feelings about the inherent efficiency of markets, however, the reality behind short-selling is far different from this stereotype. But it is not hard to understand why short sellers get a bad reputation; John Paulson, after all, made as much as $4 billion on the subprime crisis that resulted in the economic disenfranchisement of millions of Americans.

But short selling is much more important, and even vital, to the functioning of a market economy than it is commonly credited for. Indeed, shorting has on numerous occasions had a significant role in drawing attention to serious structural problems in individual companies, industries, and entire markets. Short sellers are often among the first to see where the structural problems are, and how they might unravel in a disastrous manner. Furthermore, they often have to initiate short positions at times when the overall trend is going in exactly the opposite direction.

In any event, short sellers are often better positioned to pick up on weaknesses and other problematic incongruences that are tend to get overlooked or brushed off. The following are some examples taken from some of the most spectacular shorts in recent memory:

 

Jim Chanos and Enron

One of the most concise examples of how short-selling can and does have a positive role to play involves a well-known incident that occurred shortly into the new millennium, when Jim Chanos began scrutinizing the finances of the late energy/resource company known as Enron Corporation.

Chanos’s reputation as a short seller was already old news by the time he and his investment firm Kynikos (the Greek word for “cynic”) took an active interest in Enron in 1999, right at the apogee of the energy company’s salad days on Wall Street. Indeed, Fortune magazine had anointed Enron with the title of “America’s Most Innovative Company” for six consecutive years.

Those salad days were still in full swing by November of 2000 when, after nearly two years of scrutinizing the company, and its propensity for being completely untruthful about its finances, Kynikos initiated a short position on Enron’s stock, which at the time had just broken $90 dollars per share and was driving towards a target of $130 to $140.

This short position was routinely increased over the next year, by the end of which period Enron had fallen rapidly from grace. As allegations of scandal and malfeasance morphed into concrete evidence, the stock was trading for a dollar by the end of 2001. Chanos and Kynikos had not only walked away with a handsome profit, but had also provided an invaluable service to the investment community in demonstrating how hype can lead to the hasty overlooking of hard facts.

 

John Paulson and the Sub-Prime Mortgage Crisis

In the historiography that has accumulated around the 2007-2008 financial crisis, one of the more commonly heard refrains is that few people, if any, saw it coming.

John Paulson was one of those few. In the run-up to the collapse of the housing bubble, giant investment banks were by all appearances on a mad scramble to purchase any kind of financial asset, so long as it was backed up by a questionable subprime mortgage.

The subprime market was still in the upswing of its Daedalus-like trajectory when Paulson and his hedge fund Paulson & Co. bet against them aggressively. One of the delightful ironies of this story is that the legendary fund manager used the same type of “complex financial instrument” to short the life out of the subprime market. He managed to compel some banks to write credit-default-swaps on the rotten mortgage-backed assets, and then purchased as many as he could.

Paulson & Co. walked away from the smoldering wreckage of the housing market with a cool $3 billion, minimum. While this tale offers little in the way of solace or comfort for those who lost everything as a result of the unreserved negligence and criminality that led to the subprime crash, Paulson’s bets against the market were important in that they came at a time when everyone else was still sating themselves on the trend, no less for their subversive use of so-called complex financial instruments in order to extract profit from financial institutions that had employed those very same means to inflate their profits.

 

 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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