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Book Review "Selling America Short"

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Picture this.  Instead of inhabiting the grown-up world of financial markets, we're back at high school.  What teenage subclasses would investors represent?  Quants, no doubt, are the jocks.  They are the brash muscle guys, the BMOCs.  The huge sums of money their algorithms whirl around move markets and all participants. The geeks have inherited the earth.

Long-term fundamental investors are the new nerds: bookish, no longer conventional, and happy to stay at home.  One day, they could be relevant once again.

Momentum investors are the cheerleaders: always looking to chase what's hot, and avoid what's not.  The trend is their friend: they wouldn't be caught dead at study hall.Selling America Short

And what about market contrarians?  This clique lurks around the dark corners of financial disclosure, hunting for corporate fraud and hated for its efforts. Cynical and shunned, these short-sellers are the goths.

In his new book, "Selling America Short", Richard Sauer chronicles his experience as an SEC attorney and administrator and an analyst for one of the most gothic of short-sellers. Combining legalese and descriptive flair, he details some of the SEC's highest profile cases over the past several years: ACLN, Lernaut & Hauspie, AremisSoft,, NovaStar, and Fairfax Financial Holdings. 

He also delivers a hard-punching defense of David Rocker and his colleague Marc Cohodes, who later would lead the short-lived hedge fund Copper River.  Sauer advised Rocker as a defense attorney and later worked for Cohodes as an analyst.

The SEC, he writes, has a difficult time finding its regulatory advantage:

      Most of what happens in the market is a puzzlement even (or perhaps particularly) to the people who regulate it.  From its deep waters, things now and then float to the surface that can be identified as requiring a certain treatment under the law.  Other pieces of market flotsam, when seen, are harder to classify.  But what lies beneath the surface for the most part remains a mystery.

In fact, he argues that the agency suffers a distinct disadvantage, not just because it's poorly staffed, but that it's underresourced. Rogue targets, especially if located overseas, often use complex legal maneuvering to thwart the agency's challenges, and force it to burn through its limited case budgets. 

According to Sauer, the SEC is constantly reconciling its own economic reality:

      In deciding to litigate a run-of-the-mill case, a government agency will do a cost-benefit analysis, however informal, balancing the importance of the matter against its potential cost, and the likelihood of losing at trial. But in high-profile cases in which the agency will be criticized for inaction, the analysis shifts to one of weighing how much grief it will get should it bring the case lose compared to the amount to be expected should it forego bringing the case at all. And, of course, the pain from a eventual loss at trial will not occur for a few years, so it is given a sort of psychological discounting to present value.

Perhaps its biggest disadvantage is that it's a government agency, run by politicos with staffers doing the actual investigative work, often at odds with each other.  Sauer cites the example of the insider trading case against John Mack, soon to be CEO of Morgan Stanley. Despite some significant evidence, the politicos killed the case before it could be more thoroughly investigated.

High-octane mouthiness
Cohodes, who possessed "disarming candor and high-octane mouthiness", had once shown up at a shareholder meeting dressed as a referee.  Whenever he deemed that management was misleading, he blew his whistle and threw a red penalty flag.

Unlike trading firms, Cohodes and other contrarians typically manage concentrated portfolios of companies carefully scrutinized for fraudulent practices, such as falsified revenues, money laundering, and phantom asset valuations. 

Pay-offs, though substantial, might not occur for several months, or years in some cases, as Sauer notes:

      Short investments often follow a path of long-term pain followed by sudden jubilation when the short-seller at last "gets paid" for his trouble and patience. Timing, as in stand-up comedy, is everything, and hard to get right. Warren Buffet has said it's easier to pick bad companies than to predict when they will come to grief. They can blow up without warning or their faults can escape notice for longer than anyone who believes in efficient markets would think possible.

Copper River, which Cohodes formed after Rocker retired in 2006, fought a long, costly war against Patrick Byrne, CEO of  The several pages Sauer devotes to the various fronts and battles portray Byrne as borderline psychopathic. The reader almost feels embarrassed at having walking into a bitter family feud.

Lehman's collapse, the SEC ban on short-selling and rough-treatment by Goldman Sachs sank Copper River almost instantaneously.  The SEC ban, hypocritical for executing the same market manipulation it prosecuted, did nothing to ease volatility, and Goldman's actions, attacking a bleeding hedge fund—and also a prime-brokerage account—in shark-like fashion, strongly suggested front-running and total disregard for Chinese Walls.

So, what of financial reform? For someone like Sauer, he's seen it all, and is decidedly pessimistic:

      When the government imposes rules that come down to telling economic actors to "tell the world what you're really up to" some will regard this as more a challenge than a directive. Something to finesse when the stakes are high. And experience teaches that they will succeed in getting around the new rules and the government sloggers who enforce them—until they become altogether too good at it and bring on the next crisis. A cycle of creative destruction that creates less than it destroys.

Goths see dark while the rest of us see light.  As in high school, many different actors make up the financial markets.  The balance among these cliques can shift, but they are each important to each other. 

Short-sellers expose the dark side of company management, which most of us want to believe is doing the right thing. And with regulators usually steps behind, they represent an important self-correcting mechanism. 

Lawmakers, not realizing this balance, could overshift market equilibrium.  Imagine, for example, a world of just jocks and cheerleaders.  Not a pretty thought.

Disclosure: "No positions"