Short-Selling Hedge Funds Started the Fire

When a building burns, the first to respond are the firemen, who generally don't care how the fire got started. Their job is to address the most urgent need of minimizing and containing the damage occurring at that moment.

Next on the scene are the investigators. Their job is to determine the fire's origin, be it accidental or intentional, in order to hold the proper parties to account and prevent future fires.

Now, imagine you're just such an investigator, looking into the causes of a huge and truly devastating blaze at an apartment building. Along the way, you find conclusive evidence of willful neglect on the part of the building's management (and many residents), which had the effect of turning the complex into a veritable fire trap. You find the signs of a future catastrophe were abundant, but either ignored or covered-up.

As troubling as that would be, imagine your investigation further uncovers evidence that the actual match which served to ignite the fire was intentionally lit, almost certainly by somebody who expected to profit from the resulting blaze.

So who's responsible for the destruction? Those who made the building a disaster waiting to happen, or those who actually made the disaster happen?

It's a question of ultimate versus proximate causes.

Like this hypothetical fire, the current economic crisis also has both ultimate and proximate causes.

Everybody seems to agree that the ultimate cause is greed, which in turn led to some deeply irresponsible and unsustainable investing practices across the board, particularly within the US banking sector. In retrospect, the signs of an impending violent reversal were abundant, but largely ignored.

What's received much less attention is the matter of the proximate cause of the global economic meltdown. Who lit the match that set fire to our much-examined economic house of cards?

I believe that on September 29, 2008, the Wall Street Journal probably said it best: Lehman's Demise Triggered Cash Crunch Around Globe.

In other words, getting to the bottom of Lehman's (LEHMQ.PK) demise is probably a good place to start looking for clues.

Like the broader economy, Lehman's failure also has proximate and ultimate causes.

This video, which I recently created, ignores Lehman's balance sheet and its long-term prospects, focusing instead on presenting evidence suggesting that the mid-September, 2008 sell-off which devastated Lehman's stock price -- directly resulting in the company's bankruptcy a few days later -- was a consequence of an enterprise designed to enrich a small handful of short-selling hedge funds.

As I demonstrate, in place of gasoline, the perpetrators used a deluge of price-depressing naked short positions as their accelerant, with much the same results.

Some may feel it's to early to begin assigning blame for the fire, since it's yet to be extinguished.

I disagree.

Congress is already debating an overhaul of our economy's "fire code," in order to keep this from happening again. Thus, laying blame where it belongs is more important now that ever. In the end, this video is my effort to raise awareness of who lit this fire to begin with.

Disclosure: No positions

Comments

[Gardener:]

Very naive to blame short sellers. Shorts kick the tires and provide the markets with critical information as to the health of companies. Enron is am excellent example. Those who don't understand how vital short selling is to free markets should really spend more time in the library than posting silly articles with childlike understanding of markets.

May 14 12:36 PM

[Jasper M:]

"Greed" would not have led to the disaster if the cerit supply had not been artificially inflated for decades. Once that course had been embarked on, it was only just a matter of time. If it had not been Lehman, some other firm would have over-extended.

May 14 02:58 PM

[Judd Bagley:]

I may or may not agree...it depends on what a "cerit" is. Help?


On May 14 02:58 PM Jasper M wrote:

> "Greed" would not have led to the disaster if the cerit supply had
> not been artificially inflated for decades. Once that course had
> been embarked on, it was only just a matter of time. If it had not
> been Lehman, some other firm would have over-extended.

May 14 03:22 PM

[user396040:]

We should remember that in September, 2008, it wasn't just a Lehman problem We had the Fannie and Freddie default wipeout of preferred stock, the WAMU debacle, Wachovia being "rescued" over a weekend, Merrill Lynch being "rescued", etc. etc. A little later we had the Madoff disclosure. It really was a Perfect Storm. However, I think it is very important to investigate(with an open mind) the role of the short sellers. As to naked short selling, I am still amazed that it goes on in a world where counterparty risk is an increasingly relevant issue. Even short sellers who "borrow" existing shares in brokerage houses create counterparty risk for which the holders of the borrowed shares are not being compensated. The whole process has to be rethought with a recognition that there is a risk that the short seller will default as well as a risk that the brokerage house will default.

May 14 04:06 PM

[Alex Filonov:]

Everybody blames "greed". Guys, let's be honest: we are all greedy, otherwise we wouldn't be in this game. Short sellers are no more guilty here than anybody else. Economy is built on greed (people are looking to make profit, aren't they?), it won't work otherwise.

May 14 05:14 PM

[ubuy2w:]

If you bothered to read the article it was NAKED short selling which the author believes contributed to Lehmans demise. The game was being played daily, buy the CDS's in weak financials start selling the stock without borrowing the stock spread a few rumours... How to blow up the capitalist system for fun and profit. No credible mkt observer thinks that LEGAL shorting is not an all round good thing for creating good deep and functioning mkts. NAKED shorting and unregulated CDS' and other derivatives however are an recipie for disaster in the hands of little hedgies with a penchant for pyromania to use the authors analogy.

On May 14 12:36 PM Gardener wrote:

> Very naive to blame short sellers. Shorts kick the tires and provide
> the markets with critical information as to the health of companies.
> Enron is am excellent example. Those who don't understand how vital
> short selling is to free markets should really spend more time in
> the library than posting silly articles with childlike understanding
> of markets.

May 14 07:14 PM

[T-Rex:]

Shorting a stock does not cause a firm to collapse- they sold their position in the stock when the IPO. The only ones affected by stock price performance are shareholders...and execs who have options.

You can try to short a stock all the way to zero...and it won't affect a company's income statement or balance sheet.

What caused the downfall was a change in the value of assets that these firms owned. When the assets lost value, they had to sell...which further depressed the prices...when assets fell far enough bond holders got worried about payments and CDS started moving...which required payment bu firms guaranteeing the losses. What started this domino effect...in 2007, there was a small quant effect which was fairly isolated to firms that employ that strategy. In 2008 the real estate marker affected everyone...mortgage backed securities and derivatives on them...as well as outright real estate ownership. Lehman was leveraged to the hilt on their Manhattan office building which they financed with short term noteds rather than a long term mortgage.

So yes, real estate bubble caused this...everything else is the effect of that.

May 14 07:20 PM

[Alan Young:]

Gardener: Obviously, you didn't watch the video. It's not about short-selling, it's about NAKED shorting--flooding the market with bogus stock with no intention of buying shares to settle the trade.

Judd: a nice piece of work; I respect your research. But it's too long for a video-clip education. Please publish it as text w/graphics for easier digestion and citation.


On May 14 12:36 PM Gardener wrote:

> Very naive to blame short sellers. Shorts kick the tires and provide
> the markets with critical information as to the health of companies.
> Enron is am excellent example. Those who don't understand how vital
> short selling is to free markets should really spend more time in
> the library than posting silly articles with childlike understanding
> of markets.

May 14 07:23 PM

[Gardener:]

He should have been more explicit in his article. Another voice contributing to the chorus of anti shorting is irresponsible.


On May 14 07:23 PM Alan Young wrote:

> Gardener: Obviously, you didn't watch the video. It's not about short-selling,
> it's about NAKED shorting--flooding the market with bogus stock with
> no intention of buying shares to settle the trade.
>
> Judd: a nice piece of work; I respect your research. But it's too
> long for a video-clip education. Please publish it as text w/graphics
> for easier digestion and citation.

May 14 11:47 PM

[Big K:]

Naked short selling is helping to make many people very wealthy. In March, there was such a fire sale going on that the smart money was picking up bargains in quality stocks at prices not seen in generations. Imagine getting some REITS for pennies on the dollar. I hope for much more selling. I look forward to buying companies like O, KO and PG for a dollar a share. These will pay a 200% dividend. Bring it on.....

May 15 12:03 AM

[Chris Butler_:]

I stopped reading after "Everybody seems to agree that the ultimate cause is greed..." Not everybody agrees that greed was the ultimate cause. I don't.

Personally, I hope that the executives of each and every one of my stocks is greedy. I hope they make hay while the sun shines because tomorrow may be overcast. This isn't a game. Real companies making real goods to satisfy real consumer wants and needs compete every day for every last dollar of profit. If they stumble in any number of ways, they go bust (and get a taxpayer bailout - but that's a different beef). Again, what kind of game do people like you think this is where, like in a game of Monopoly, you decide to take it easy on your little brother because you've already got some choice properties? In the real world, missteps cost people jobs and money.

The day any one of the companies I own decides they've had enough profit for one day is the day I sell them short, move to Texas and hope for secession.

May 15 09:55 AM

[Canbyte:]

Shoot all shorters, let God sort them out - to paraphrase a well known quote - expresses my sentiments exactly. Add your voice:
www.petitiononline.com...

May 15 02:26 PM

[Buckoux:]

Judd Bagley: Excellent video! Even a moron like me could follow the drift of your documentary. I WAS in real estate investments, but left the hard money side when I noticed that money was being loaned for homes in a way that naked short stocks were being traded. That is; a promise, backed by nothing, sold by a third party for lots of money. This isn't greed, it's a crime and there is a difference. The legal term "conversion" seems to fit this situation the best.

May 15 02:29 PM

[Judd Bagley:]

I promise to take your advice to heart next time and create both versions. Thank you very much.

On May 14 07:23 PM Alan Young wrote:
> Judd: a nice piece of work; I respect your research. But it's too
> long for a video-clip education. Please publish it as text w/graphics
> for easier digestion and citation.

May 15 08:55 PM

[FeelTheHeat:]

I wonder if anyone with half a brain believes this baloney.

#1 Lehman was materially misstating the value of its assets on its balance sheet.

#2 Lehman was using FAS 159 to inflate its earnings and then promoting these earnings as correct. FAS 159 allows firms to book earnings when the market value of their debt declines. Since credit emergencies will cause the market value of debt to decline, it allows firms to book phony earnings even when their credit situation is worsening.

#3 Warren Buffett stated that Lehman had the opportunity to raise capital from him on his terms. He also said that he felt the marks on Lehman's assets were "unrealistic". Had Lehman accepted this, they would have had more capital, plus an imparateur from the oracle of Omaha. Lehman refused.

#4 There are e-mails revealing that Lehman CEO Richard Fuld and others at Lehman considered using issuer retaliation to silence its critics. Mainly taking capital it had raised to buy back shares, manipulate the stock price.

Here is the speech given by David Einhorn at the Ira Sohn Investing Conference May 21st 2008.

www.foolingsomepeople....

Here is a an article covering his speech at the Value Investing Congress, two months earlier.

blog.valueinvestingcon.../

Anyone who seriously suggests that Lehman's demise was caused by short-sellers and not by its own misdeeds is either a crook, or needs to have their head examined.

Jun 28 06:10 AM