Short Selling: Profiting From Others' Misery?

Financial concerns at Fannie Mae and Freddie Mac have dominated the news and introduced more specialized business jargon into the mainstream society. One of those terms is "short selling."

DEBORAH AMOS, host:

This is MORNING EDITION from NPR News. I'm Deborah Amos.

STEVE INSKEEP, host:

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We're about to hear a defense of people whose work often drives the stock market down. They're investors who sell short. That essentially means they place a bet that a stock will drop in value. It's a practice the federal regulators want to restrict. Yet, short-sellers have their defenders. To understand why, it helps to know exactly what they do. NPR's Alix Spiegel begins with this example.

ALIX SPIEGEL: In October of the year 2000, a New York short-seller named James Chanos sat down with the financial statements of one of the largest and most respected companies in America, a Texas behemoth called Enron. Now, Chanos obviously had a lot of experience with financial filings, but try as he might, he couldn't make sense of the records, couldn't understand how this company could possibly be making money.

Enron, he concluded, was nothing more than a house of cards, but says Columbia Law Professor John Coffee, when he tried to explain his findings to other people, they simply didn't believe him.

Mr. JOHN COFFEE (Law Professor, Columbia University): Originally, he got no support because Enron was then considered to be the most-admired company in America and to have the best corporate governance, according to Fortune Magazine.

SPIEGEL: But, Coffee says, Chanos persisted until finally a journalist named Bethany McLean in the spring of 2001 published an article titled, "Is Enron Overpriced?"

Mr. COFFEE: And the fissures began to widen under Enron, and suddenly Enron began to plummet, and the person who started all this was a short-seller, performing really a function not unlike Woodward and Bernstein in Watergate in pointing out that there was something very suspicious going on in the White House.

SPIEGEL: This is what short-sellers do, Coffee explains. They scour the market for businesses with expensive stock and hidden problems, make a bet that the stock will fall and then try to drive down the stock price by exposing the problems and convincing others that the companies are seriously flawed.

One way to look at this behavior, says Coffee, is as a social good because short-sellers provide an alternative vision of what's going on.

Mr. COFFEE: Managements tend to be overly optimistic. They tend to put out good information and deny bad information, and we need short-selling to have a fair, objective and unbiased market.

SPIEGEL: But for most of history, says Coffee, short-sellers haven't been seen as social do-gooders. They've been viewed with hostility and skepticism.

Mr. COFFEE: Napoleon actually passed a law, it was part of the Napoleonic Code, against short-selling because he thought that it was somehow inherently fraudulent and deceptive.

SPIEGEL: Ever since, governments have periodically tried to squelch or limit short-selling one way or another. Why? What's wrong with being Woodward and Bernstein or exposing incompetence? Business professor James Angel of Georgetown University says people don't like short-sellers for a very basic reason.

Mr. JAMES ANGEL (Business Professor, Georgetown University): They're profiting from the misery of others.

SPIEGEL: Also, short-sellers are often accused of manufacturing false information in order to drive down a price. In fact, when a company's stock falls precipitously, management frequently tries to pin the blame on short-sellers peddling false rumors. But, says Angel, this is always hard to prove because rumors are spread in whispers and are difficult to trace.

Mr. ANGEL: Clearly there is some, but exactly how much is really hard to tell.

SPIEGEL: In fact, if you ask Professor Angel, someone who studies short-selling for a living, to name one instance where it was absolutely clear that short-sellers brought down an otherwise healthy company, he pauses for a long time.

Mr. ANGEL: I can't name one off the top of my head.

SPIEGEL: Still, the bad rep persists. It's part of the reason that the SEC moved against an extreme version of shorting, called naked short selling, a couple days ago. There's a fear that part of what's been driving down the stock price of companies like Fannie Mae and Freddie Mac are short-seller whisper campaigns. Time will tell. In the meantime, since the SEC took action on Tuesday, the stocks of Fannie and Freddie have risen. Alix Spiegel, NPR News, Washington.

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