Hedge funds clipped by short-selling ban

Date: Friday, September 19, 2008
Author: The Telegraph

As short-selling is banned to protect Britain's banks, Gordon Rayner names the men who have made millions from the financial crisis

As 70,000 employees of HBOS wonder which of them will still have jobs this time next month, they will no doubt be looking for someone to blame for the extinction of their once great employer.

As the dust settled yesterday on the ruins of Britain's fifth-biggest banking group, there was little doubt as to the immediate cause of their misery - the hedge fund billionaires who have made a killing by playing poker with their livelihoods.

Unlikely as it may have seemed even a week ago, HBOS was unable to withstand a sustained attack on its share price by mavericks who have such huge sums at their disposal that they can destroy major companies almost on a whim.

Take Philip Falcone, whose fund is said to have made £280 million by gambling that HBOS's share price would plunge. Falcone, who has just paid £24 million in cash for a 27-room mansion in New York, has been nicknamed "The Midas of Misery" for his ability to make millions by betting on failing companies.

Falcone makes a convenient pantomime villain at a time when the nation desperately needs a hate figure. He earned a staggering £950 million last year through his hedge fund, Harbinger Capital Partners, while insisting: "It's just money. It doesn't define who I am."

Perhaps not, but as one of the "vulture capitalists" who is said to have helped bring HBOS to its knees, his actions may have defined the lives of thousands of British workers.

Mr Falcone is one of a select band of private fund managers who have made their money through the morally dubious practice of short- selling which, despite involving trading something you don't own, is perfectly legal.

A short-seller will borrow shares from an institutional investor for a fee, agreeing to return them at a set time. The shorter sells the shares to a third party, gambling that the price will drop before they have to buy a similar number of shares to return to the lender on the set date. The difference in the price of the shares is the shorter's profit.

Dodgy as this may sound, short- selling has been going on for hundreds of years, but the obliteration of HBOS - which has been squarely blamed on short- selling - forced the Financial Services Authority to take drastic action last night by banning short- selling of financial stocks.

Hedge fund managers (a hedge fund is a private investment fund offering the possibility of huge returns) control an estimated £2 trillion and their clout is so great that if they gang up against a company they perceive to be weak, there is little anyone can do to stop them bringing the company down.

In the same way that a donkey will become the favourite for a horse race if enough people bet on it, a company's share price will be driven down if shorters sell enough of its stock, regardless of how healthy the company may be.

Of course, short-sellers stand to lose a fortune if share prices go up, so some have been suspected of using dirty tricks to illegally manipulate stock prices by spreading false rumours about the health of a company.

In March, HBOS shares took a sudden dive when an anonymous email was circulated to City traders which said: "We're hearing that tomorrow's Financial Times will write a piece about HBOS. It won't be pretty, likely to focus on £128billion of non-customer liabilities that must be rolled in the next three months. This will raise the spectre of a run on the bank."

The information was made up, but it was enough to wipe £3 billion off the value of HBOS shares before the company could issue a denial. Someone had made a killing.

Although there is no suggestion that anyone illegally manipulated HBOS's share price this time, the FSA was left with no choice but to impose the temporary ban on the practice because of fears that other banks could be toppled.

Hector Sants, the chief executive of the FSA, said short-selling was regarded as "a legitimate investment technique in normal market conditions", but that the "extreme circumstances" of the past week had merited the unprecedented decision. Vince Cable, the Liberal Democrat Treasury spokesman, had earlier described the behaviour of the short-sellers as "shocking" and demanded immediate action by the FSA to rein them in.

But should we really be placing all the blame for the financial meltdown on short-sellers? David Einhorn, the 37-year-old billionaire boss of the hedge fund Greenlight Capital in New York, claimed he was doing a public service by shorting Lehman Brothers stock, because he was exposing the company as overvalued and badly run.

Mr Einhorn, a top-class poker player, is seen by many as little more than a ruthless operator, but there is no shortage of City figures who agree with him.

Ian Morley, chairman of the fund manager Corazon Capital, said: " short-sellers simply expose companies which are overvalued. They don't target companies which are well run and properly priced.

"Rather than blaming short- sellers for what's going on, we should be looking at the chief executives of companies whose bad decisions make their firms vulnerable. Remember, those chief executives are guaranteed a big payoff if things go wrong, but hedge fund managers stand to lose everything if they make a bad call.

"What you have to realise is that the people who are short-selling are also buying other stocks in companies like Tesco in the expectation that they will go up," he said. "These people are investors as well as short-sellers, and if you ban short-selling you will drive away investors and reduce liquidity, which will in turn damage the stability of the financial system."

There is also growing evidence that short-sellers are not the only ones who have been guilty of morally questionable behaviour during this week's banking crisis.

The heads of America's biggest banks were summoned to a meeting last weekend at which they were told that Lehman Brothers was going to be allowed to fail, while Merrill Lynch would be bought by Bank of America. Each agreed to put aside rivalries and make money available for other banks. Then they all went back to work and did the exact opposite, refusing to make inter-bank loans and helping to drag more banks, including Goldman Sachs and Morgan Stanley, into trouble.

Many City analysts believe that, regardless of the clampdown on short-selling, it is the banks which need to be subjected to tighter regulation to prevent them becoming vulnerable to the "vultures" in the first place.

One surprisingly candid Mayfair-based hedge fund manager told me: "What has happened in the past two weeks is that the financial system itself has been exposed for the shambles that it really is.

"Banks are allowed to borrow huge amounts of money which mean they are vulnerable when there is an economic downturn. What you have to ask yourself is: if a bank is so important to the nation's financial system that it can't be allowed to fail, why aren't there better regulations in place to prevent them getting into such a mess in the first place? You can't blame the players - it's the game itself which needs fixing. Ultimately, though, perhaps we all share some of the blame for the demise of HBOS, which was hugely exposed to the collapse in house prices.

Mr Morley said: "We've all been guilty to some degree for what's going on. We have taken on huge mortgages to buy properties which have become overpriced and we have racked up debts on credit cards. No one forced us to take on those debts, but we did and now we are seeing the consequences."

Maybe so. But if the hedge fund managers are toasting their latest success in Mayfair's champagne bars tonight, perhaps they'll forgive us if we don't raise a glass to them.