Tuesday, June 24, 2008

Defending the shorts

Even when they are right short-sellers get no respect. Lehman Brothers just reported a $2.8 billion loss, announced a plan to raise $6 billion in new capital, and replaced its CFO amid a long-standing and very public "dialog" with famous (or is it infamous) short-seller David Einhorn of Greenlight Capital.

Trouble is that people and many in the media still don't know quite what to make of him and his breed. Even other hedge fund managers won't endorse his practices.

It's never been popular to say that the emperor has no clothes. Fortunately some, like Einhorn, say it anyway.

That even Einhorn, who is renowned for forensic dissection of balance sheets and earnings reports to uncover hidden truths or at least very tough questions for management, faces criticism of his strategy illustrates how much work he and the hedge fund industry needs to do to educate the media and everyday investors about the facts of short selling.

A starting point is stressing that shorts have more skin in the game than long investors. First, they must keep collateral and pay fees to borrow stock. Then they must return shares bought on the open market to the lender. Profit arises when they are able to repay the lender with shares worth less than the ones borrowed. Thus, shorts are as on the hook and economically vested as long investors. This fact gives them equal moral authority to advocate their position and engage in public debate about the merits of a company.

Second, as noted by UConn law professor Steven Davidoff in the New York Times' DealBook blog, it is not illegal to "talk your book."

The opinions of equity analysts are considered part of the way the game is played on Wall Street. But doesn't a downgrade send the same message to the market as a short position? Just today, analysts at Goldman Sachs urged investors to "underweight" U.S. financials. It should be realized that short-sellers signal the market in similar ways, except they put their money where their mouth is.

As we witness the depth of the credit crisis and await action from the Fed and the SEC on the future of financial services regulation, what we need is more debate in the market, particulalry when it comes to accounting, reporting and governance issues, not less.

The industry is catching on. Today, the Financial Times reported that Bill Hwang, founder of Tiger Asia Asset Management noted that companies with major corporate governance issues are "a big red flag for short-selling for us."

New York magazine recently profiled Einhorn and his stance on Lehman.

Fortune reviewed Einhorn's new book, Fooling Some of the People All of the Time, which recounts his battle with Allied Capital.

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