Our man of the hour, David Einhorn, has said academic research and his firm’s experience indicate that whenever management complains about short-selling, it is a sign that management is attempting to distract investors from serious problems. Einhorn said that back in May. I would like to add a corollary to Einhorn’s principle: whenever management convinces regulators and attorney generals that short-selling is a problem, it is a sign that entrenched interests are using the state to protect their firms from the gales of creative destruction.
Today’s story begins with John Mack of Morgan Stanley working in concert with Lloyd Blankfein of Goldman Sachs to persuade numerous federal officials to ban the short-selling of stocks. Much to their delight, I am sure, Andrew Cuomo entered from stage right, announcing he is opening “a wide-ranging investigation into short selling in the financial market.” (These New York Attorney Generals sure know how to wag a finger!) Unsurprisingly, the attorney general’s logic is impeccable: “Short selling is not illegal,” he says, “but when combined with the spread of wrong information, that is illegal.” So without offering so much as a hint as to what false information has been circulating throughout the markets–the implication of his quote is that the downfall of Lehman was unjustified, since it was based on false information–Attorney Generalissimo Cuomo deftly concludes, “I believe the SEC should freeze short selling of financial stocks on a temporary basis.”
But the problem isn’t that false information is putting undue downward pressure on the price of stocks in the banking industry. The problem is that the information available is damning. Lehman deserved to fail, short-selling of their stock notwithstanding. In fact, short-sellers like Einhorn provide a valuable service, first by trading on this information, but secondly, and most importantly in Einhorn’s case, by making this information public. So what are we to conclude from Mack’s statements? (Other than that he has some influence in the attorney general’s office?)
Michael Lewis raises a good point here. He says one positive upshot of the Lehman collapse is that we’ll finally get to see inside a big Wall Street firm. With Lehman, he writes:
We’ve just witnessed the largest bankruptcy in U.S. history and we know neither the inciting incident (though there is speculation that sovereign wealth funds decided to stop lending to Lehman Brothers Holdings Inc.), nor the deep cause. But there’s now a pile of assets and liabilities smoldering in New York awaiting inspection.
The assets include subprime mortgage-backed bonds and no doubt many other things that aren’t worth as much as Lehman hoped they might be worth. But it’s the liabilities that are most intriguing, as they include more than $700 billion in notional derivatives contracts. Some of that is insurance sold by Lehman, against the risk of other companies defaulting.
The entire pile might be benign, but somehow I doubt it. We may well find out that Lehman Brothers, in liquidation, has a negative value of hundreds of billions of dollars. In that case the natural question will be: How much better could things be inside Morgan Stanley and Goldman Sachs, both of which were engaged in the same lines of business?
If things are only marginally better for Morgan or Goldman, then investors need to know. They also ought to be allowed to trade on that information. If some bureaucratic time-server manages to forbid short-selling, then contrary to Cuomo’s assertion, they wouldn’t be preventing irrational selling on false information. Oh no, good citizens–they would be preventing you from trading upon the truth.
See also Robin Hanson here. And Michael Lewis again.