Institutional Investor's Alpha Magazine - October 2008 - (Page 52)

Industry Under Siege — even if it seems to go without saying — is hedging, which, put another way, is playing long bets against short ones. Though even the most ardent defenders of shorting won’t deny the harmful effects of naked shorting (the practice of selling a stock short without ﬁrst borrowing it or having arranged to borrow it), most are clearly alarmed at the regulatory rush to judgment and warn of the longterm damage to the markets that could occur in the absence of short-selling. In a speech in July to members of the Managed Funds Association — the main voice in Washington for the hedge fund industry — Richard Baker, the group’s president and CEO, defended short-sellers as one of the forces that keep the markets honest. “Short-selling is an essential risk management tool and a critical component of ensuring market stability, not a contributor to market volatility,” argued Baker, a former Republican congressman from Louisiana. Robert McDonald, a professor of ﬁnance at the Kellogg School of Management at Northwestern University, says the SEC is behaving more like a bully than a wise regulator. “The SEC’s focus on short sales reminds one of the adage that when your only tool is a hammer, every problem resembles a nail,” McDonald explains. “If short sales are forbidden, investors with unfavorable information about a ﬁrm cannot express their information by trading.” McDonald is among those who argue that short-sellers ultimately have a buoyant effect on markets. Without shortsellers, investors may be less willing to pay as high a price are different from the extreme measures that have been taken,” Feldstein says. “If the SEC thinks there has been market manipulation and that the law has been violated, they have the tools to go after the perpetrators. But this approach is clearly different.” The current call to control short-selling is only the latest in a series of efforts by the SEC to repair the problems that its critics say it helped create. Regulation SHO, enacted by the agency in early 2005, sought to curb naked short-selling through the inclusion of a “threshold security list,” which tracked potential stock-delivery violations involving numerous companies that were said to have been targeted by short-sellers. The rule, by most estimates, was largely ineffective. Two years later the SEC abolished the 73-year-old uptick rule, which barred short sharks from moving in until a stock’s price had ﬁrst moved up. With shares of major ﬁnancial ﬁrms suddenly in free fall this summer, the SEC in July did an about-face and ordered a three-week suspension of shorting in the shares of Fannie Mae, Freddie Mac, Lehman Brothers and 16 other ﬁnancial issues. The action was to no avail, though, as those stocks and the markets in general continued to plummet. With the latest crackdown, in which the SEC reimposed and expanded its summer ban, regulators have a daunting task. They are trying to appease the chorus of corporations and other critics who place much of the blame for the market meltdown on short-sellers. And they are in the position now of having to defend a ban on short-selling even as markets have tanked while shortsellers have been sidelined. Still, the SEC and its overseas counterparts are likely to continue to try to keep short-sellers on a short leash. In the U.K., where the campaign against short-selling began, Prime Minister Gordon Brown announced in September the FSA’s intention to extend portions of the ban beyond January. “When a group of people are exploiting a difﬁcult economic situation,” he said, “it is right to stop it.” But even if short-selling as hedge funds now know it were to be outlawed permanently, there are viable and legal ways around it — although none are as easy or costeffective as selling borrowed securities. “Investors can buy puts, sell calls and short futures, effectively shorting the stock by using a derivatives market maker as a surrogate,” says Kellogg ﬁnance professor McDonald. Put and call options and futures all trade on exchanges. Investors can also use over-the-counter derivatives, which for the most part ﬂy beneath the SEC’s radar. Equity swap contracts — which allow investors to proﬁt if a company’s share price falters — are one route. Another is the use of credit default swaps, whereby investors in essence buy insurance protection on companies with questionable fundamentals. Should the company slip and its credit spread increase, investors proﬁt. (Traders using credit default swaps may currently be creating downward pressure on big stocks like General Electric Co., a late addition to the untouchables list, which saw its “Short-selling is the most efficient mechanism to express negative sentiment toward asset value.” — AARON GERDEMAN, SUNGARD ASTEC ANALYTICS for a good stock. “They will assume, correctly, that bearish opinions have been suppressed, and the price they will willingly pay for the stock will be reduced,” McDonald says. “So a short-sale restriction may even lower the price by causing investors to discount high-quality stocks.” Ari Bergmann, lead portfolio manager for Cedarhurst, New York–based hedge fund Penso Capital Markets, agrees that curtailing short activity is counterproductive. “By banning shorts, you’re not solving the problem — you’re just delaying it,” he says. Andrew Feldstein, CEO and chief investment ofﬁcer at New York–based BlueMountain Capital Management, a $5.6 billion private investment firm, smells a witchhunt. “Having a philosophical problem with short-sellers is one thing, but we need to figure out solutions that 52 • INSTITUTIONAL INVESTOR’S ALPHA • OCTOBER 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - October 2008

Institutional Investor's Alpha Magazine - October 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Process of Evolution The Good Guys: Israel's Champion Interview: Fast Lessons for Hard Times Cover Story: Industry Under Siege The New Hedge Fund Economics Good-Bye, Easy Money Caging the Shorts Strategies: Bottom Fishing Profile: Cult of Personalities Research Center: Alpha Awards: Eye of the Storm Alpha Bytes: Funneling the Chatter Unhedged: Commentary: Attention, Hedge Fund Shoppers

Institutional Investor's Alpha Magazine - October 2008

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