It was in the mid-1980s that the short seller James Chanos first realised he was being investigated. People were ‘going through my garbage’, he says. They didn’t find anything incriminating: Chanos lives a ‘nice quiet yuppie existence’, said one of the private investigators, whose report ended up in the hands of the Wall Street Journal. That didn’t stop Chanos losing his job at an investment house owned by a German bank. The WSJ story fingered him as a central figure in what it called ‘an ad hoc network of short sellers’ in the US, who ‘pick a stock, then sow doubt in an effort to depress it’. Chanos told me he was ‘shown the door by my German masters’.
‘Short selling’ is selling shares or other financial instruments that you don’t own, or own only temporarily – shares, for example, that have been borrowed from another investor. Chanos was – and still is – short selling shares that seem demonstrably overvalued. Perhaps a corporation’s way of doing business has run out of steam, or its managers have surreptitiously been overstating its revenues. Once other investors come to realise this, the price of the shares will fall and the short seller will be able to buy them at the lower price before returning them, pocketing the difference. (The short seller doesn’t have to give back the same shares that were borrowed: except in a few special cases, a corporation’s shares are identical and interchangeable.)
It seems to have been the managers of corporations that Chanos was short selling who paid for the investigation into him. But they aren’t the only ones who don’t like short sellers. In September 2008, Alex Salmond, then Scotland’s first minister, lashed out at the ‘bunch of short-selling spivs’ he blamed for the falling price of shares in Halifax Bank of Scotland. (Alas, the spivs were right: were it not for the takeover by Lloyds and then the taxpayer bail-out, HBOS would probably have collapsed.) As in 2008, when financial crises hit, short selling is often banned, in the hope – usually forlorn – of stemming price falls. Beyond its actual economic effects, there’s also a general feeling that there is something inherently fishy about selling things you don’t actually own, or that it’s morally dubious to profit from misfortune. Both Christianity and Islam have traditionally disapproved of short selling. In 2008 Rowan Williams spoke out against it, and his fellow archbishop John Sentamu compared short sellers to ‘bank robbers’. (In the event it transpired that the Church of England’s pension fund had been earning fees for lending out its holdings of shares to short sellers.) (...)
Even in the relative safety of the US, short sellers seem security-conscious (it’s sometimes hard to find the street addresses of their offices), but their more pressing concerns are economic. A perennial issue is whether they will be lent shares to short sell, and if so at what cost. Although a firm called Equilend has developed a new electronic marketplace for stock borrowing, much lending still goes on by direct negotiation between institutions – ‘over the counter’, as market participants put it. The deals are often made between people who know each other well, but no one lends out shares on a simple promise they will be returned:the borrower has to leave cash (or government bonds, or sometimes other assets) with the lender as surety. Cash is the most common form of collateral, and the norm in the US is to hand over 102 per cent of the market value of the shares. Until the short seller returns them, the lender can earn interest on that cash. In the past, all the interest was kept by the lender, but in recent decades borrowers have usually been able to negotiate what’s called a ‘rebate’: a share of the interest payments.
The fee that the lender earns (the ‘borrow fee’) is the interest on the collateral, minus the rebate. If the borrowed shares are in a big, heavily traded US or UK corporation, and not too many people are trying to short sell its shares, borrowing is easy and cheap: currently, the borrow fee is unlikely to exceed around 0.25-0.3 per cent per year. A fee larger than that often indicates that, as market participants put it, a borrow is becoming ‘warm’, usually because demand from short sellers is growing. Warm can rapidly become very hot indeed, as borrow fees soar to 50 per cent per year or more. In those cases, borrowers are having to make large, explicit payments to lenders, and the shares are said to be ‘hard to borrow’ or ‘on special’. Short sellers also have to be wary of ‘recall’. The lender of the shares has the right to demand them back at any point (with very limited notice). If their price has risen in the interim, even temporarily, a recall can inflict a nasty loss on the short seller. Lenders’ right of recall gives them a further advantage as a borrow becomes warmer: the short seller may get a phone call gently suggesting a higher borrow fee.
To be a successful short seller you need therefore to understand what Chanos calls ‘the plumbing’ of lending. One of the partners in his firm, Kynikos Associates, has ‘been on [Wall] Street for almost fifty years, and he has taught me all that I know about borrow, rebates, sourcing [finding shares, to borrow] … He has a good sixth sense, even if something looks to be quite available and very liquid, that there’s trouble down the pike. He’s kept us out of a lot of situations where that’s happened.’ Short sellers also need to be wary of ‘squeezes’, in which a targeted corporation’s managers, or other investors, deliberately push share prices upwards in the hope of forcing short sellers to liquidate their positions at a loss. One good way for a corporation to engineer a squeeze is to announce a programme of buying back its own shares.
A short seller must be able to identify shares that aren’t simply overvalued but that can credibly be shown to be overvalued: you won’t succeed merely by having a hunch that the high prices of the shares of Google’s parent company, Alphabet ($1095 at the time of writing), or of Amazon ($1590) can’t possibly be justified. Chanos teaches his analysts to think of the information about a corporation as an onion: ‘The outer layer is Wall Street stories and rumours. The next layer in is Wall Street research. The next … is company presentations … [then] company press releases. Then the final core of the onion [is] the mandated financial statements. Most investors work from the outside of the onion in; they never get to the core. I always stress to my people: start from the core, then work your way out.’
The numbers in firms’ financial statements, though, aren’t considered hard facts by short sellers. They know only too well that there are many ways a corporation can tweak its accounting in order to present a flattering view of its finances. Short sellers must have a ‘nose’ for situations in which these tweaks add up to something worse than everyday embellishment. Chanos’s most famous ‘short’ was the energy company Enron, which eventually went bankrupt in spectacular fashion in December 2001. The crucial moment was in September 2000, when a contact in Dallas phoned Chanos to ask if he had read an article in the Wall Street Journal by a journalist called Jonathan Weil, who specialised in accounting. Much of the profit being recorded by energy companies such as Enron, Weil reported, came from their estimates of the current market value of contracts to supply oil, gas or electricity that could stretch many years into the future. The companies, however, were supplying few details of how they were making these estimates. Chanos hadn’t read Weil’s article (it appeared only in the Texas edition of the WSJ since the companies in question were based mainly in Houston) so his contact faxed it to him. Chanos’s nose twitched. As he later told the Yale Alumni Magazine, he spent much of that weekend poring over the details of Enron’s financial statements, becoming increasingly convinced that an apparently highly profitable company with an enviable reputation for innovation was actually steadily losing money.
But there’s a limit to how much you can learn while sitting at your desk reading the footnotes to balance sheets. Sometimes, a short seller has to become a field worker, ‘talking to people at the loading dock’, as Chanos puts it. Photographs, videos, sometimes even recordings of telephone calls can form part of the case that short sellers seek to build. Look at the website of Carson Block’s firm, Muddy Waters Research, for example, and notice the attention it pays to the physical world: precipitous, hairpin mountain roads down which huge volumes of timber would have to be hauled; satellite images of the possibly crumbling walls of a giant opencast mine; a solitary lorry idling outside what one might have expected to be a busy factory.
‘Short selling’ is selling shares or other financial instruments that you don’t own, or own only temporarily – shares, for example, that have been borrowed from another investor. Chanos was – and still is – short selling shares that seem demonstrably overvalued. Perhaps a corporation’s way of doing business has run out of steam, or its managers have surreptitiously been overstating its revenues. Once other investors come to realise this, the price of the shares will fall and the short seller will be able to buy them at the lower price before returning them, pocketing the difference. (The short seller doesn’t have to give back the same shares that were borrowed: except in a few special cases, a corporation’s shares are identical and interchangeable.)It seems to have been the managers of corporations that Chanos was short selling who paid for the investigation into him. But they aren’t the only ones who don’t like short sellers. In September 2008, Alex Salmond, then Scotland’s first minister, lashed out at the ‘bunch of short-selling spivs’ he blamed for the falling price of shares in Halifax Bank of Scotland. (Alas, the spivs were right: were it not for the takeover by Lloyds and then the taxpayer bail-out, HBOS would probably have collapsed.) As in 2008, when financial crises hit, short selling is often banned, in the hope – usually forlorn – of stemming price falls. Beyond its actual economic effects, there’s also a general feeling that there is something inherently fishy about selling things you don’t actually own, or that it’s morally dubious to profit from misfortune. Both Christianity and Islam have traditionally disapproved of short selling. In 2008 Rowan Williams spoke out against it, and his fellow archbishop John Sentamu compared short sellers to ‘bank robbers’. (In the event it transpired that the Church of England’s pension fund had been earning fees for lending out its holdings of shares to short sellers.) (...)
Even in the relative safety of the US, short sellers seem security-conscious (it’s sometimes hard to find the street addresses of their offices), but their more pressing concerns are economic. A perennial issue is whether they will be lent shares to short sell, and if so at what cost. Although a firm called Equilend has developed a new electronic marketplace for stock borrowing, much lending still goes on by direct negotiation between institutions – ‘over the counter’, as market participants put it. The deals are often made between people who know each other well, but no one lends out shares on a simple promise they will be returned:the borrower has to leave cash (or government bonds, or sometimes other assets) with the lender as surety. Cash is the most common form of collateral, and the norm in the US is to hand over 102 per cent of the market value of the shares. Until the short seller returns them, the lender can earn interest on that cash. In the past, all the interest was kept by the lender, but in recent decades borrowers have usually been able to negotiate what’s called a ‘rebate’: a share of the interest payments.
The fee that the lender earns (the ‘borrow fee’) is the interest on the collateral, minus the rebate. If the borrowed shares are in a big, heavily traded US or UK corporation, and not too many people are trying to short sell its shares, borrowing is easy and cheap: currently, the borrow fee is unlikely to exceed around 0.25-0.3 per cent per year. A fee larger than that often indicates that, as market participants put it, a borrow is becoming ‘warm’, usually because demand from short sellers is growing. Warm can rapidly become very hot indeed, as borrow fees soar to 50 per cent per year or more. In those cases, borrowers are having to make large, explicit payments to lenders, and the shares are said to be ‘hard to borrow’ or ‘on special’. Short sellers also have to be wary of ‘recall’. The lender of the shares has the right to demand them back at any point (with very limited notice). If their price has risen in the interim, even temporarily, a recall can inflict a nasty loss on the short seller. Lenders’ right of recall gives them a further advantage as a borrow becomes warmer: the short seller may get a phone call gently suggesting a higher borrow fee.
To be a successful short seller you need therefore to understand what Chanos calls ‘the plumbing’ of lending. One of the partners in his firm, Kynikos Associates, has ‘been on [Wall] Street for almost fifty years, and he has taught me all that I know about borrow, rebates, sourcing [finding shares, to borrow] … He has a good sixth sense, even if something looks to be quite available and very liquid, that there’s trouble down the pike. He’s kept us out of a lot of situations where that’s happened.’ Short sellers also need to be wary of ‘squeezes’, in which a targeted corporation’s managers, or other investors, deliberately push share prices upwards in the hope of forcing short sellers to liquidate their positions at a loss. One good way for a corporation to engineer a squeeze is to announce a programme of buying back its own shares.
A short seller must be able to identify shares that aren’t simply overvalued but that can credibly be shown to be overvalued: you won’t succeed merely by having a hunch that the high prices of the shares of Google’s parent company, Alphabet ($1095 at the time of writing), or of Amazon ($1590) can’t possibly be justified. Chanos teaches his analysts to think of the information about a corporation as an onion: ‘The outer layer is Wall Street stories and rumours. The next layer in is Wall Street research. The next … is company presentations … [then] company press releases. Then the final core of the onion [is] the mandated financial statements. Most investors work from the outside of the onion in; they never get to the core. I always stress to my people: start from the core, then work your way out.’
The numbers in firms’ financial statements, though, aren’t considered hard facts by short sellers. They know only too well that there are many ways a corporation can tweak its accounting in order to present a flattering view of its finances. Short sellers must have a ‘nose’ for situations in which these tweaks add up to something worse than everyday embellishment. Chanos’s most famous ‘short’ was the energy company Enron, which eventually went bankrupt in spectacular fashion in December 2001. The crucial moment was in September 2000, when a contact in Dallas phoned Chanos to ask if he had read an article in the Wall Street Journal by a journalist called Jonathan Weil, who specialised in accounting. Much of the profit being recorded by energy companies such as Enron, Weil reported, came from their estimates of the current market value of contracts to supply oil, gas or electricity that could stretch many years into the future. The companies, however, were supplying few details of how they were making these estimates. Chanos hadn’t read Weil’s article (it appeared only in the Texas edition of the WSJ since the companies in question were based mainly in Houston) so his contact faxed it to him. Chanos’s nose twitched. As he later told the Yale Alumni Magazine, he spent much of that weekend poring over the details of Enron’s financial statements, becoming increasingly convinced that an apparently highly profitable company with an enviable reputation for innovation was actually steadily losing money.
But there’s a limit to how much you can learn while sitting at your desk reading the footnotes to balance sheets. Sometimes, a short seller has to become a field worker, ‘talking to people at the loading dock’, as Chanos puts it. Photographs, videos, sometimes even recordings of telephone calls can form part of the case that short sellers seek to build. Look at the website of Carson Block’s firm, Muddy Waters Research, for example, and notice the attention it pays to the physical world: precipitous, hairpin mountain roads down which huge volumes of timber would have to be hauled; satellite images of the possibly crumbling walls of a giant opencast mine; a solitary lorry idling outside what one might have expected to be a busy factory.
by Donald MacKenzie , London Review of Books | Read more:
Image: via
[ed. See also: Why you should never short-sell stocks]
Image: via
[ed. See also: Why you should never short-sell stocks]
