Blaming Short Sellers: A Pointless Game


The former CEO of Lehman Brothers, Richard Fuld, testified on Sept. 1, 2010, to the Financial Crisis Inquiry Commission that Lehman was the victim of "increasingly negative and inaccurate market rumors." He said they began at the time of Bear Stearns's failure in March 2008 and continued until Lehman's own collapse in September, when the holding company declared bankruptcy and Barclays picked up Lehman's U.S. broker-dealer operations cheap.

Fuld's contention echoed much he has said over the last two years, generally to the effect that hedge funds that bet on the collapse of Lehman's stock price spread falsehoods to make that bet pay off.

In his Sept. 1 testimony, Fuld played a variation of this point. During the period leading up to its bankruptcy filing, he said, Lehman "proposed to government regulators certain measures that could have helped Lehman and bolstered confidence in the financial markets, [including] imposing a ban on naked short selling."

Pausing Over "Naked"

In a typical short sale, a hedge fund or other trader borrows shares of stock, generally through the "prime brokerage" operation of a broker-dealer, and sells them. Since the trader is obliged to return the shares he borrowed, he must hope that the stock price falls, so he can buy new, cheaper shares to replace the borrowed ones. If the price rises, he has to cover his position at a loss. In a "naked" short sale, the investor never borrows the shares, so his "sale" is just a promise regarding the eventual delivery of unspecified stock. Naked short selling is illegal in the U.S., and there is no evidence that such behavior contributed to Lehman's fall.

Yet complaints about naked short selling, as Fuld must have known, do find sympathetic ears in Congress. One example: Senator Edward Kaufman (D-Del.).

Jill Fisch, co-director of the Institute for Law and Economics and the University of Pennsylvania Law School, expresses a widespread reaction to such claims: "I've listened to the banks blaming the short sellers for two years now, and I haven't been impressed."

What about the failure to borrow stocks before selling? "The naked-shorts phenomenon allows for greater speculative activity," Fisch said, "but in this case, the point still is that the shorts were right. Lehman was burdened with overvalued and toxic assets."

Scapegoating a Profit Center

According to a report filed with the bankruptcy court in the Lehman matter, Fuld met with Warren Buffett on March 28, 2008, in an attempt to persuade the "Sage of Omaha" to invest $2 billion or more in Lehman. Buffett took a pass on the investment.

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The Bankruptcy Examiner's report explained why: "Two items immediately concerned Buffett during his conversation with Fuld. First, Buffett wanted Lehman executives to buy under the same terms as Buffett. Fuld explained to the Examiner that he was reluctant to require a significant buy‐in from Lehman executives, because they already received much of their compensation in stock. However, Buffett took it as a negative when Fuld suggested Lehman executives were not willing to participate in a significant way. Second, Buffett did not like that Fuld complained about short sellers. Buffett thought that blaming short sellers was indicative of a failure to admit one's own problems."

Hedge funds have long been a profit center for investment banks. Indeed, the relationship runs deeper than just the role the banks play in facilitating the short selling of their hedge fund clients. As derivatives consultant Janet Tavakoli put it in an interview: "All the major Wall Street broker-dealers, certainly including Lehman, had strong ties to hedge funds through their prime brokerage operations. The ties that caused them the most grief weren't those with short sellers, but with the hedge funds that were active in buying the questionable asset-linked securities that Wall Street was selling."

Ironic Twist

Some observers have remarked on the way that Lehman, like other broker-dealers, turned against it's own loyal customers when it got in trouble. Banking industry consultant Bert Ely says, "I love the irony."

Actually, even as Lehman was going belly-up, the Financial Industry Regulatory Authority (FINRA) was investigating its failure to properly document the ownership of the shares being sold short. Lehman was itself under investigation for facilitating naked short selling. After the bankruptcy filing, this unit of Lehman (by this time, owned by Barclays) was fined $250,000 for such negligence.

Blaming the short sellers may be cathartic for some. Unraveling the implausibility of the catharsis may be amusing for the rest of us. But there are serious folk who see the game as a troubling distraction. Tavakoli, who is among them, says: "We're still living with all of the problems that caused the collapse of Lehman and the whole of the resulting market turmoil. We have resolved nothing."