Imagine someone borrowing/renting your pristine car, valued at JA$10M, for a week. In the glove compartment is your clear transferable title. He backs out the driveway, waves and goes down the road, stops briefly, sticks a FOR SALE sign on the windshield and proceeds on his journey.
An hour into his journey he strikes a deal to sell the vehicle to an interested party in a supermarket parking lot for JA$9.5M. He collects the proceeds of the sale and walks home. Soon after, he begins scanning the classifieds to find a similar make, model, year, colour and mileage as the one sold.
After a week, he’s in luck; he finds such a vehicle and runs out to purchase it. The negotiated purchase price is JA$7M. He drives up to your driveway, smiles, hands you the keys and you watch him disappearing off down the street doing a Charlie Chaplin dance.
His profit on the transaction for a week’s work: JA$2.5M.
This anology is similar to a good week in the life of a short seller. This is a trader who typically “borrows” or “rents” the securities to be sold and later repurchases identical securities for return to the lender.
If the securities’ price falls as expected, the short-seller profits from having sold the borrowed securities for more than he or she later pays for them - thus allowing an investor to gain from the decline in their price. But, if the price rises, the short seller loses by having to pay more for them than the price at which he or she sold them. These securities could be Stocks (shares in a company), Bonds (Sovereign) or Commodoties.
Since the end of the second half of the year, the economy of the United States - and especially Wall Street - began its grasp of the slippery pole downwards. The Bear market saw dramatic declines in values of portfolios. As weak economic data and news about faltering financial companies came at an accelerated pace, this exacerbated the panic selling of shares.
This set off a global pandemic affecting not only financial houses’ liquidity and viability but also triggered a downward slide in the value of Sovereign Debt instruments. Especially affected were emerging market debt, such as Jamaica.
During all of this frenzied selling, in steps the short selling trader. At no time in recent history has such a dramatic downturn happened on a global scale and the beauty of it was that the short selling trader could operate with near certainty of a continued fall in global security prices.
They have been blamed for the collapse of investmnet bank Bear Stearns and for the 40 percent slide in Lehman shares within a month. Sometimes referred to as the “hort and distort,” this technique takes place when traders manipulate stock prices in a bear market by taking short positions and then using a smear campaign to drive down the target stocks.
To have an idea of the profits to be made in such panic conditions, Bear Sterns’ 52-week high share price was US$133.20, freefalling to US$30 in March 2008 and to an all time low of US$2 before being gobbled up by JPMorgan for US$10 per share. A similar scenario happened in October 2008 in the Global Bond market.
A trader ‘shorting’ 1000 shares of this company at a price of US$80 expecting the company’s performance to be poor on the heels of the growing mortgage crisis and buying back at a price of US$10 would in a few short weeks gain US$70,000.00. Consider that the volumes traded are in the hundreds of thousands and these brokers would be clicking their heels in wild abandon.
It gets more interesting in a Naked Short Sale. Investors are not required to even borrow the shares first before selling them, but they must have a reasonable expectation that they will able to locate shares they can borrow in order to be able to deliver on them to the buyer on settlement. Investment banks have stock loan desks that specialize in going out into the market and locating shares for investors who want to go short.
In fact, lending shares to hedge funds is a very big, very lucrative activity for the banks. When the Securities & Exchange Commission saw the sharp drop in prices of Fanny Mae and Freddie Mac shares, they limited the ability of traders to bet on a drop in shares believing that there was stock manipulation.
They then took the decision to suspend the short selling of 799 Financial stocks. Britain’s Financial Services Authority on Thursday September 18th 2008 announced the unprecedented move of banning short-selling and forbidding any increase in new positions; additionally, the Authority required disclosure by traders on all positions of more than 0.25% of a stock.
The ban is due to remain in force until January 16, 2009. The reason was that the current extreme circumstances have given rise to disorderly markets. But by then the short traders had made their mark. Global share prices hit records for speed of decline, as well as lows. We have watched that phenomenon raze the financial landscape in dramatic fashion.
The most recent victims were Merrill Lynch which fell into the arms of Bank of America, and Fannie Mae, Freddie Mac and AIG - all three of which were nationalized to avoid failure. Finally, the fear of a run on the bank pushed Goldman Sachs and Morgan Stanley to become bank holding companies.
Even in adverse financial times there is always opportunities to make profits.
This certainly has been the year to be a naked short trader.
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