Big investors who make money by selling stock short have enjoyed a money-making paradise. The Wall Street Journal provided a valuable public service by investigating how they made money shorting Morgan Stanley (NYSE: MS), helping its stock plunge in mid-September.
Conceptually, what shorts did was very simple -- they shorted the stock then they bought thinly-traded Credit Default Swaps (CDSs) on the bonds of the stock they wanted to short. (The Journal quotes Erik Sirri, a Babson Finance professor now working at the SEC whose office is next to mine, on the ease of manipulating CDS premiums.) This forces up the premiums and scares investors. The short sellers, in many cases, also withdraw their considerable funds from the targets' prime brokerage accounts; when asked why, they say that the firm in question is going bankrupt.
Needless to say, these rumors get spread around trading desks. Whether or not they're true, many investors are inclined to withdraw their money first and ask questions later. (The bankruptcy of Lehman Brothers highlighted the dangers of waiting too long to get out -- in the form of frozen hedge fund accounts.) As the stock goes down, the CDS premiums rise further, which spooks more investors and creates a vicious downward cycle for the stock -- and a short seller's paradise.
The same kind of dynamic may well have been behind last week's precipitous decline in Citigroup (NYSE: C). The question for government is whether it makes sense for taxpayers to fork over tens of billions of dollars to rescue big financial institutions for the benefit of these short sellers' profits.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
Is there a Bernie Madoff in your portfolio?
New McDonald's to include recharging stations for electric cars
Cramer on BloggingStocks: Dirty manipulation 
Reader Comments (Page 1 of 1)
11-25-2008 @ 4:53PM
paul said...
This short selling must be stopped. Let these people go to Foxwoods.
11-25-2008 @ 4:57PM
BHarrison said...
the "bottom line" is that "short selling should be outlawed . . . it promotes false manipulations of the market to generate profits by short selling. I cannot think of one legitimate reason that short selling in in the long term interests of the market for the 'average people". it is merely a tool for market manipulators to artificailly squeeze profits out of the market. (Even Cramer acknowledges that he did this back in the days that it was 'legal".)
Short selling, the use of phony rumors to stimulate panic selling, etc. simply is not healthy for the integrity of the market.
11-26-2008 @ 3:42AM
BHarrison said...
If "panic" is good for short sellers, then the more "panic" that short sellers can generate, the more profits they can make, right?
But, if "panic" is detrimental to the stability of the maket and the economy, does it make sense to allow short selling? Short sellers can earn some big bucks in all of this; but only at the costs of driving the market down, stripping investors of their capital, and further weakening the economy. Then on the rebound, the short sellers can sell and earn even more profits . . . but this is a "suckers game" and detrimental to our economy . . . if the market worsens as it is being projected to do, a lot of short sellers may lose a bundle . . . and it couldn't happen to more deserving people.
1-07-2009 @ 12:02PM
Fernando said...
I wrote this in one post and will write it again here:
Short sellers do not hurt the market. In a matter of fact they help
the market to control the manipulation of bringing up a stock.
And is not short sellers who start a bear market, is insiders! get
it, is insiders! And do you know what an insider is?
People who know information about a corporation.
These insiders might have so much money, but they can't fight
conditions! When they see that the economy is shrinking, they start
selling.
And those so called bear raids is the public who had stock and
sold. They realize that they should have gotten out 10 points higher
ago, so when the rally comes, they sell fast so they can cut their
loses fast!
I suggest you read Reminiscences of A Stock Operator. You will read
how one of the best trader ever lived recount how people blamed him
for shorting so much the market, when it fact it was insiders that
where selling their own shares! He just read conditions and follow
the trend! It happened back then and its the same dilemma that is
happening right now. Like Jesse Livermore said, there is nothing new
in the market!
And one last thing. Short selling a stock is limited. You can short a
certain amount before you can't short no more. But buying stock is
endless. Buyer outnumbers short seller. But when is a bear market, its a bear market, and you can't fight conditions.
Hence all those buyers who sell their stocks trigger a
faster drop then a short seller shorts.