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Kass: Leave the Short-Sellers Alone

Weeks later, a short-selling ban on financial stocks was instituted in the U.S., and I wrote the following on The Edge in mid-September:
"We believe that to err is human. To blame it on someone else is politics."

-- Hubert Humphrey
Several weeks ago, I wrote an op-ed column in the Financial Times that spelled out my view that short sellers shouldn't be restricted in their activity and shouldn't be blamed for the abuses in lending, credit formation and in the growth of the unregulated derivative markets that got us into the mess that we are in today.

Indeed, history has shown -- Enron, Tyco (TYC - Get Report), Sunbeam and so on -- that market participants should be attentive in listening to the analytical warnings of the short-selling community.

A few seem to be coming to their senses -- in certain cases from surprising corners. For example, here is an email exchange I had with Ben Stein (for whom I now have newfound respect) last night:
Ben Stein: I am bound to say after all this time that you understood this so much better than I did, especially the mentality on Wall Street that would lead to this that it is profoundly humbling.

Doug Kass: Thank you, Ben. My Grandma Koufax would call you a "mensch." My constant proddings were not meant to be ad hominem attacks against you but rather to deliver my analysis and underscore my sense of foreboding that was based on my analysis of the abuses and egregious risk taken in the credit, housing and derivatives markets.
Some observers, like Bloomberg's Michael Lewis get it.

Others recognize that the blame lies squarely on the shoulders of regulators, borrowers (and lenders), banks (did the shorts tell Citigroup's (C - Get Report) Chuck Prince to "keep on dancing?"), brokerages (did the short sellers OK obscene compensation packages in the "heads I win, tails I win" culture on Wall Street in which those monies earned were withdrawn out of the firms while levering their capital to 32-1?) and The Three Stooges of 21st Century Finance (who reside in the Administration, Treasury and Federal Reserve and proved, once again, to be reactive not proactive). All of these players gleefully and drunkenly drank from the bowl of credit excess over the past decade, believing in another new paradigm (and uninterrupted growth) for the housing and credit markets, but failed to have a vision of the dangers associated with their careless risk-taking and lack of due diligence.

"If they can get you asking the wrong questions, they don't have to worry about answers."

-- Thomas Pynchon, Gravity's Rainbow
From my perch, it seems far-fetched to blame short sellers for the general lack of regulatory scrutiny and enforcement, the absence of risk controls and a continuum of reckless management decisions at the world's leading financial institutions (banks, brokers, hedge funds, private equity, etc.), all of which have combined to create a Black Swan event that has resulted in a credit market gone amok and a shadow banking system often under the radar of regulators.

Increasingly this week, however, all too many seem to be suggesting that the short sellers are the root of all evil and are to blame for a plunge in share prices (especially of a financial-kind). Indeed, SEC Chairman Cox instituted new short-selling rules last night, which included a requirement to disclose daily short positions, and some institutional investors, like CalStrs' CIO Christopher Ailman, are not permitting their investment holdings to be loaned out to short sellers, citing clear evidence that short selling is the root cause of the decline in the shares of leading investment banks.

Here are some of my reasons why the current popular game of blaming short sellers is misplaced:
  • I simply can't accept the basic assertion that there is currently a great deal of naked short selling going on. Yesterday, I undertook an experiment and tried to borrow 250,000 shares of Morgan Stanley (MS - Get Report) from my prime broker (one of the very institutions that is complaining about short sellers!); it took less than three seconds. Every other financial on the SEC's list is readily available to borrow, so why the heck would anyone illegally short without a borrow?
  • Short interest in the publicly traded investment banks has dropped in the last month. (For example, Morgan Stanley's short interest has dropped by 3 million shares in the last month, to 45 million shares, and stands at a low 2.8 short interest ratio, and at only 4% of Morgan Stanley's float.) According to Short Alert, from early July to late August (the most recent data available), the short interest in the 34 companies classified as Investment Banking Brokerage by S&P dropped from 9.42% of all shares outstanding to only 7.55%, for a 20% decline. So not only are critics of short selling wrong that shorting has increased, but it appears that covering by the short community served to provide stability to the markets.
  • Fails-to-deliver from naked short selling account for a small percentage of market capitalization, according to the Depository Trust and Clearing Corporation. Currently, fails are about 31,000 positions daily (including both new and aged fails) out of an average of 54 million new transactions processed every day by the National Securities Clearing Corporation. In dollars, fails-to-deliver-and-receive amount to only about 1.4% of the daily volume.
  • Short selling (or buying of protection) is now rampant in the credit default swaps area, an unregulated market that the very investment banks who are complaining about short sellers pushing their shares down have argued to keep unregulated!
  • As to the rumor-mongering, one should not look at the short sellers, we (or more precisely the SEC) should look at the very investment banks that are complaining the most loudly about short sellers. Chinese Walls in brokerages have long fallen, as it is widely recognized that investment firms' proprietary desks are shorting each others' stocks (and pulling capital from each other), likely with information from their own investment banking arms. What if it turns out that Goldman Sachs (GS - Get Report) was shorting Morgan Stanley and Morgan Stanley was shorting Goldman Sachs -- and that they both were shorting Fannie Mae (FNM), Freddie Mac (FRE) and American International Group (AIG - Get Report).
  • Finally, where are the hedge funds making all this money shorting stocks (illegally)? The dedicated pool of short sellers (which stands at about $5.5 billion, or about 9% the size of Fidelity's Magellan Fund) is simply too small to have a meaningful impact on the markets. Based on ISI data, most hedge funds tied to a long/shot strategy are relatively inactive, and many are liquidating out of fear of ever-greater losses and redemptions, which leaves us with the dominant quant funds that use algorithms, not fundamental security analysis or rumors, as their operating methodology. No doubt, some of these are shorting the weakness in financials based on their modeling.
In summary, the blame game is counterintuitive to the facts (above) and seems motivated by investors' and financial managements' rationalizing their poor investment and business decisions, many of which have caused unnecessary pain for a lot of Wall Streeters who have become victims of their senior managers' misdeeds.

Doug Kass writes daily for RealMoney Silver , a premium bundle service from For a free trial to RealMoney Silver and exclusive access to Mr. Kass's daily trading diary, please click here.
At the time of publication, Kass and/or his funds were long GS, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.
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