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At first sight, selling something that you don't own looks a very strange way to invest money. Most investors buy a share if they think it's going to go up, and avoid it if they think it's too dear. The short sellers, as such investors are called, actively look for stocks they think are going to fall, and set out to speed up the process. Instead of a portfolio of assets, the short seller borrows stock, sells it in the market, and ends up with a portfolio of liabilities.
Yesterday the short sellers targeted HBOS, owner of what was once Britain's biggest building society, the Halifax. They approached long-term holders of the shares and paid a fee to borrow them. If the holder has no intention of selling, this is a handy way of increasing the income from the portfolio, and eventually the short seller has to give back the shares he's borrowed. It seems risk-free and costfree.
As the market discovered yesterday, it isn't. The short sellers of HBOS chose their target well. After last week's failure of Bear Stearns, just days after the bank's chief executive had told the world all was well, no bank is above suspicion. As they sold the shares, the traders said they were getting out because HBOS was in difficulty. The market-makers immediately cut their prices, attracting the attention of others. The market-makers passed on the rumours that they'd heard, and something like a full-scale panic developed.
The panic spread to the Financial Services Authority, which put out a bizarre statement, warning against "abuse by spreading false rumours and dealing on the back of them". It's hard to pick the sense out of this phrase. Is the FSA, the City's regulator, only concerned about false rumours, as opposed to those which later turn out to be true? How do the rumour-mongers know which is which? Dealing on the back of rumour is what market-making is all about. Those practising it must make continuous two-way prices, and don't know whether the next trade is going to be a purchase or a sale. Does the FSA think short selling is inherently wrong?
There's more than a whiff of moral sanctimony here. It's impossible to imagine the FSA launching a witchhunt for a trader who caused the price to jump by spreading a false rumour about a takeover bid. It might harrumph, and in extreme cases might order the company to make a statement, but speculation which involves buying shares is all part and parcel of the constant rumour-mill that is the stock market.
Even if the FSA would like to stop the short sellers, it's impossible. The authorities could try and make it illegal to lend stock, but even if they could make it stick, it would make no difference in practice. Nowadays there are plenty of other ways for short sellers to take a position. They can buy a traded option giving them the right to sell a share at a fixed price. They can arrange a "contract for difference" which obliges them to pay the difference between an agreed price and the market price at some future date. This latter arrangement will not be disclosed, and neither buyer nor seller needs to hold the shares. It's a simple bet like that between two individuals, and the idea of outlawing it is ridiculous.
It's easy to see why the FSA and the Bank of England were furious. Banking is all about trust; every commercial bank on the planet would be bust if all its customers wanted their money back at once. The Halifax takes in deposits which can theoretically be withdrawn tomorrow, and lends the money out on 20-year mortgages. If the trust is broken, as it was with Northern Rock, the bank can collapse.
It's unlikely that yesterday's short sellers of HBOS shares expected to be so successful. From the outside, shortselling looks like a splendid way to make money by causing misery and mayhem. From the short-seller's viewpoint, it's much harder. The most that a buyer of shares can lose is the value of his shareholding; there is no limit to the liability for a short seller. The short seller must keep paying for the shares he's borrowed. Crispin Odey, who runs a fund management group, was convinced two years ago that bank shares were too expensive, and arranged to borrow stock which he sold.
For the best part of a year, bank shares failed to fall, and he had to keep paying rent on the shares he'd borrowed. It was only the collapse of Northern Rock that finally proved him right.
Whatever the FSA may think about short selling, its witch hunt is certain to end in frustration. Tracking down the original source of a rumour is like trying to trap a will-o-the-wisp. An idle remark in a conversation is transmitted, amplified and elaborated, and as the saying goes, a lie can be halfway round the world before the truth has got its boots on.
Gossip is the oil in the engine of stock markets; the first question participants ask each other as they meet is: What's going on? Nobody wants to give the impression that they're out of the loop, and if you don't know anything, it's human nature to make something up. Besides, under today's rules, if you really know something, it's dangerous in the extreme to pass it on to someone who might trade on the information.
The FSA's inspectors face a hopeless task in trying to find out why those who sold HBOS short yesterday morning did so. Most of them were simply following the crowd, as traders do whenever a share is moving in either direction. If by some extraordinary feat of detective work, the inspectors do track down someone who can plausibly claim to have started it all, he'll have his reasons at the ready; he can do what everyone else does when cornered, and blame the media.
Reader views (2)
As I'm sure Neil Collins is aware spreading false rumours is a criminal offence under the Financial Services Act and liable to a seven year prison sentence and/or an unlimited fine. It is the deliberate invention of a negative rumour and that individual trading on the back of it that is concerning the FSA.
- Nick, Ipswich, 20/03/2008 17:50
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How silly to have an organisation that does not understand the workings of markets monitoring such markets. In the land of the blind.
- Graham P Malpas, Worthing, West Sussex, 20/03/2008 13:03
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