Short-sellers always get blamed in a financial crisis. At best, they’re a nuisance. At worse, they’re evil speculators, profiting from others’ misery, often by spreading false rumours. Shorts are the market’s misfits – oddballs, contrarians, who refuse to subscribe to the conventional wisdom. They are therefore resented by the rich and powerful, the stupid and the gullible whose pretensions they prick, whose mistakes they expose and whose attempts to order events to suit themselves they mock. When you hear the authorities blaming short-sellers, you know they are seriously rattled.
We seemed to have reached that point in Britain last week. Without warning or consultation, the Financial Services Authority (FSA) introduced new rules on short-selling during a rights issue with almost immediate effect. Anyone who has a short position equal to 0.25% of a firm’s shares must now disclose it to the stock exchange. Long holders only have to disclose their position when they own 3% of the shares.
It’s easy to see what prompted the FSA to act. Earlier in the week, HBoS shares had fallen below their rights issue price. That meant underwriters Morgan Stanley and Dresdner Kleinwort were likely to end up on the hook for the full £4bn. That followed the Bradford & Bingley rights issue, which was renegotiated once it was clear a profit warning would drive the share price below the rights issue price.
The FSA has clearly concluded that short-sellers were to blame, and panicked. The risk was that if the HBoS rights issue failed, it would make it harder for other UK banks to raise fresh capital, threatening the stability of the banking system. The FSA’s actions would seem vindicated by the sharp rise in HBoS shares, which was taken to be a sign that short-sellers were covering their positions.
But while the FSA may be pleased with the short-term results, investors should be concerned about the longer-term consequences. First, it is not clear that short-sellers were to blame for the volatile performance of HBoS and Bradford & Bingley shares. Although there has been plenty of short-selling in both during their rights issues, many of the sellers were hedging their position by buying the rights to new shares, which tend to trade at a slight discount to their theoretical value. This is a straightforward arbitrage trade that should in fact stabilise the price, rather than the other way round.
The actual number of so-called “naked shorts” – short-sellers whose positions are not hedged – is likely to be quite small. That’s because short-selling is very high-risk, particularly in financial stocks just now. Shorts face potentially unlimited losses as prices can keep rising; the cost of borrowing stock to cover short positions can be prohibitive and can change without warning; and short-sellers are at the mercy of sudden policy changes that can affect prices – as those shorting HBoS discovered. Bankers tell me that a bigger source of instability has been long-only investors dumping stock.
Many institutions allowed their portfolios to become too overweight bank shares during the boom and are now trying to rebalance their portfolios. Many are also having to sell shares to raise the cash to pay for their rights. Who knows? Some may even be selling because they think bank shares are still expensive – in which case, investors would be wrong to read too much into this week’s rally.
Second, short-sellers help to make the market more efficient. Of course, spreading false rumours is wrong, but this is rarely proved. More often, short-sellers provide a counterbalance to the hugely vested interests who want to talk up share prices. Fortunately, the FSA recognises this, describing short-selling as “legitimate”. It sensibly decided not to ban short-selling, but only to increase disclosure. However, it has not ruled out further rules designed to make shorting harder, such as restricting stock lending during a rights issue.
The risk is that the initial measures plus these threats may already be discouraging this legitimate short-selling. Hedge fund managers often don’t like to disclose short positions, partly because they don’t want to be accused of destabilising the market and partly because management teams might refuse to talk to them. The current rules kick in at very low levels of short positions, which is tricky for larger hedge funds. Some may well have had to close positions.
The FSA clearly had a duty to act if it felt the market was being abused. And transparency and disclosure are good for markets – provided all sides are treated the same. But the rules are not fair, since the disclosure rules are far more onerous for shorts than longs. That could lead to a false market in bank shares, pushing prices up higher than they would otherwise be. That’s great for bank bosses and the HBoS underwriters, but not so good for ordinary investors. The manipulation of share prices is wrong, regardless of who is behind it – regulators or evil speculators.
• Simon Nixon is executive editor of Breakingviews.com.