Demonic Short Sellers

Jim Surowiecki says, quite rightly, that short selling can cause viciously self-fulfilling downward spirals, especially in financial stocks. But reading the WSJ's long and alarmist tale of what happened to Morgan Stanley in September, I'm more convinced than ever that short-sellers, be they in the stock market or the CDS market, are not the cause of current problems.

I'm with Jim Chanos on the subject of the WSJ story: he writes that

The WSJ piece, despite its sensationalist headlines, actually confirms what we have been telling Washington for some time now. That is, that most of the "short activity" in the banks/brokerages, was to hedge embedded long exposure to these institutions, often by other banks/brokerages! These were NOT "bear raids", but prudent fiduciary-related decisions made by these entities to protect their capital/investors. An important story to the Financial Crisis narrative so far.

The bulk of the WSJ story concerns the activity of September 17, which precipitated the SEC's short-selling ban. But then, at the very end, comes the kicker:

The cost of insuring its debt has come back down from its peak, but its stock remains in the doldrums. On Friday, it was trading at $10.05 a share in 4 p.m. composite trading on the New York Stock Exchange -- less than half of the $21.75 close on Sept. 17.

Even now, after yesterday's massive rally and a further uptick this morning, Morgan Stanley stock is trading at less than $15 a share. Clearly the stock price is not being driven down by manipulative speculators taking advantage of an illiquid CDS market to sour sentiment. Robert Teitelman says that the WSJ story tells the tale of "the hellish tangle of unforeseen consequences of certain derivative instruments" -- yes, he's jumping on the CDS demonization bandwagon as well.

In fact it tells a much simpler tale: Morgan Stanley's counterparties were forced to buy CDS protection to hedge their exposure to the bank, and Morgan Stanley's hedge-fund clients withdrew a lot of money, not in a bear-raid attempt to kill it off, but because prudence demanded that they do so, and also because they were understandably upset about John Mack's role in getting the short-selling ban put in place. That ban devastated many hedge-fund relative-value and convertible-arbitrage strategies and caused a lot of anger in the hedge-fund community.

Short sellers are known by many names: right now, the WSJ seems to like to think of them as "speculators", which carries a tinge of opprobrium. But they're also known as "noise traders" and "liquidity providers": the people who ensure that there's so much volume in the stock that bid-offer spreads are very narrow and large trades don't move the market very much. Check out the biggest single short-selling trade named in the article:

Third Point, after seeing the surge in swaps prices, made a substantial bearish bet, selling short about 100,000 Morgan Stanley shares, trading records indicate. Third Point quickly closed out that position for a profit of less than $10 million, says one person familiar with the trading.

In other words, as Morgan Stanley shares were reaching their intraday lows, Third Point was buying, rather than piling on and selling more. And in general, as any stock-market trader will tell you, large short interest tends to drive stock prices up, not down.

So yes, it's possible that those demonic short-sellers were responsible for the fall not only in Morgan Stanley's share price, but also in Citi's at the end of last week. But it's also possible that it was just old-fashioned sellers, who weren't selling short but were rather selling down their existing long positions. And it's also possible that it wasn't selling at all, but simply a lack of buyers willing to place bets on a fragile institution with a possible leadership vacuum. We simply don't know -- which is why it's silly to assume that short-sellers were to blame.