How to Solve the Puzzle

Donald MacKenzie on short selling

It was in the mid-1980s that the short seller James Chanos first realised he was being investigated. People were ‘going through my garbage’, he says. They didn’t find anything incriminating: Chanos lives a ‘nice quiet yuppie existence’, said one of the private investigators, whose report ended up in the hands of the Wall Street Journal. That didn’t stop Chanos losing his job at an investment house owned by a German bank. The WSJ story fingered him as a central figure in what it called ‘an ad hoc network of short sellers’ in the US, who ‘pick a stock, then sow doubt in an effort to depress it’. Chanos told me he was ‘shown the door by my German masters’.

‘Short selling’ is selling shares or other financial instruments that you don’t own, or own only temporarily – shares, for example, that have been borrowed from another investor. Chanos was – and still is – short selling shares that seem demonstrably overvalued. Perhaps a corporation’s way of doing business has run out of steam, or its managers have surreptitiously been overstating its revenues. Once other investors come to realise this, the price of the shares will fall and the short seller will be able to buy them at the lower price before returning them, pocketing the difference. (The short seller doesn’t have to give back the same shares that were borrowed: except in a few special cases, a corporation’s shares are identical and interchangeable.)

It seems to have been the managers of corporations that Chanos was short selling who paid for the investigation into him. But they aren’t the only ones who don’t like short sellers. In September 2008, Alex Salmond, then Scotland’s first minister, lashed out at the ‘bunch of short-selling spivs’ he blamed for the falling price of shares in Halifax Bank of Scotland. (Alas, the spivs were right: were it not for the takeover by Lloyds and then the taxpayer bail-out, HBOS would probably have collapsed.) As in 2008, when financial crises hit, short selling is often banned, in the hope – usually forlorn – of stemming price falls. Beyond its actual economic effects, there’s also a general feeling that there is something inherently fishy about selling things you don’t actually own, or that it’s morally dubious to profit from misfortune. Both Christianity and Islam have traditionally disapproved of short selling. In 2008 Rowan Williams spoke out against it, and his fellow archbishop John Sentamu compared short sellers to ‘bank robbers’. (In the event it transpired that the Church of England’s pension fund had been earning fees for lending out its holdings of shares to short sellers.)

Being denounced by an archbishop isn’t the worst danger faced by short sellers. In December 1998, ‘several terrified investors’ told the financial weekly Barron’s as well as the police that they had been threatened with violent retribution for their alleged short selling of shares in a US cable TV company. A year later, one of the investors, Maier Lehmann, was found dead in Colt’s Neck, New Jersey, with multiple gunshots to the head. (The murder, apparently a professional hit, remains unsolved, and it seems there might have been other reasons people wanted Lehmann dead.) A British short seller called Fraser Perring told Bloomberg Markets that in 2016 he was sitting in his car, parked outside his daughter’s school, when two men suddenly got in and interrogated him, making it clear they knew a lot about his family.

In December 2011, Kun Huang, a Chinese-Canadian researcher for Jon Carnes, who specialises in short selling Chinese companies, was arrested at Beijing airport. He was placed under house arrest, and after a one-day trial, held behind closed doors, on a charge of criminal defamation, spent two years in a cramped, foul cell that held more than two dozen other prisoners. Carson Block, another short seller who at first focused on Chinese companies, told me if he hadn’t moved back to the US, ‘I would probably be in a prison in China,’ or worse: ‘There are several not great things that very well could’ve happened to me by now.’

Even in the relative safety of the US, short sellers seem security-conscious (it’s sometimes hard to find the street addresses of their offices), but their more pressing concerns are economic. A perennial issue is whether they will be lent shares to short sell, and if so at what cost. Although a firm called Equilend has developed a new electronic marketplace for stock borrowing, much lending still goes on by direct negotiation between institutions – ‘over the counter’, as market participants put it. The deals are often made between people who know each other well, but no one lends out shares on a simple promise they will be returned:the borrower has to leave cash (or government bonds, or sometimes other assets) with the lender as surety. Cash is the most common form of collateral, and the norm in the US is to hand over 102 per cent of the market value of the shares. Until the short seller returns them, the lender can earn interest on that cash. In the past, all the interest was kept by the lender, but in recent decades borrowers have usually been able to negotiate what’s called a ‘rebate’: a share of the interest payments.

The fee that the lender earns (the ‘borrow fee’) is the interest on the collateral, minus the rebate. If the borrowed shares are in a big, heavily traded US or UK corporation, and not too many people are trying to short sell its shares, borrowing is easy and cheap: currently, the borrow fee is unlikely to exceed around 0.25-0.3 per cent per year. A fee larger than that often indicates that, as market participants put it, a borrow is becoming ‘warm’, usually because demand from short sellers is growing. Warm can rapidly become very hot indeed, as borrow fees soar to 50 per cent per year or more. In those cases, borrowers are having to make large, explicit payments to lenders, and the shares are said to be ‘hard to borrow’ or ‘on special’. Short sellers also have to be wary of ‘recall’. The lender of the shares has the right to demand them back at any point (with very limited notice). If their price has risen in the interim, even temporarily, a recall can inflict a nasty loss on the short seller. Lenders’ right of recall gives them a further advantage as a borrow becomes warmer: the short seller may get a phone call gently suggesting a higher borrow fee.

To be a successful short seller you need therefore to understand what Chanos calls ‘the plumbing’ of lending. One of the partners in his firm, Kynikos Associates, has ‘been on [Wall] Street for almost fifty years, and he has taught me all that I know about borrow, rebates, sourcing [finding shares, to borrow] … He has a good sixth sense, even if something looks to be quite available and very liquid, that there’s trouble down the pike. He’s kept us out of a lot of situations where that’s happened.’ Short sellers also need to be wary of ‘squeezes’, in which a targeted corporation’s managers, or other investors, deliberately push share prices upwards in the hope of forcing short sellers to liquidate their positions at a loss. One good way for a corporation to engineer a squeeze is to announce a programme of buying back its own shares.

A short seller must be able to identify shares that aren’t simply overvalued but that can credibly be shown to be overvalued: you won’t succeed merely by having a hunch that the high prices of the shares of Google’s parent company, Alphabet ($1095 at the time of writing), or of Amazon ($1590) can’t possibly be justified. Chanos teaches his analysts to think of the information about a corporation as an onion: ‘The outer layer is Wall Street stories and rumours. The next layer in is Wall Street research. The next … is company presentations … [then] company press releases. Then the final core of the onion [is] the mandated financial statements. Most investors work from the outside of the onion in; they never get to the core. I always stress to my people: start from the core, then work your way out.’

The numbers in firms’ financial statements, though, aren’t considered hard facts by short sellers. They know only too well that there are many ways a corporation can tweak its accounting in order to present a flattering view of its finances. Short sellers must have a ‘nose’ for situations in which these tweaks add up to something worse than everyday embellishment. Chanos’s most famous ‘short’ was the energy company Enron, which eventually went bankrupt in spectacular fashion in December 2001.[*] The crucial moment was in September 2000, when a contact in Dallas phoned Chanos to ask if he had read an article in the Wall Street Journal by a journalist called Jonathan Weil, who specialised in accounting. Much of the profit being recorded by energy companies such as Enron, Weil reported, came from their estimates of the current market value of contracts to supply oil, gas or electricity that could stretch many years into the future. The companies, however, were supplying few details of how they were making these estimates. Chanos hadn’t read Weil’s article (it appeared only in the Texas edition of the WSJ since the companies in question were based mainly in Houston) so his contact faxed it to him. Chanos’s nose twitched. As he later told the Yale Alumni Magazine, he spent much of that weekend poring over the details of Enron’s financial statements, becoming increasingly convinced that an apparently highly profitable company with an enviable reputation for innovation was actually steadily losing money.

But there’s a limit to how much you can learn while sitting at your desk reading the footnotes to balance sheets. Sometimes, a short seller has to become a field worker, ‘talking to people at the loading dock’, as Chanos puts it. Photographs, videos, sometimes even recordings of telephone calls can form part of the case that short sellers seek to build. Look at the website of Carson Block’s firm, Muddy Waters Research, for example, and notice the attention it pays to the physical world: precipitous, hairpin mountain roads down which huge volumes of timber would have to be hauled; satellite images of the possibly crumbling walls of a giant opencast mine; a solitary lorry idling outside what one might have expected to be a busy factory.

The need credibly to demonstrate that a corporation’s shares are overvalued creates similarities between short selling and investigative journalism. Indeed, Chanos’s Kynikos Associates has hired several former journalists, including Weil. At the start of the 1980s, Chanos led the Forbes reporter Dick Stern through the tangled finances of Baldwin-United, which was Chanos’s first short; the company was a piano-maker which, at that point, had – somewhat bizarrely – diversified into insurance services. Twenty years later, a tip-off from Chanos helped Fortune’s Bethany McLean uncover Enron’s growing troubles – and in so doing she became one of America’s premier investigative reporters.

Given the decline of print media, short sellers today would count themselves lucky to find a Stern or a McLean, a journalist backed by a high-profile publication and able to spend months probing the affairs of a corporation that will likely prove to be both opaque and litigious. As a result many short sellers have abandoned Chanos’s more discreet approach in favour of simply short selling a corporation’s shares and then posting on their websites a detailed account of the reasons they think its shares are overpriced. The first to do this were Manuel Asensio’s New York-based Asensio & Co and Andrew Left’s Citron Research, based in Los Angeles. (‘Citron’ is a joke, based on the US slang meaning of ‘lemon’, but Left is a deadly serious short seller.) Since 2008, Asensio and Left have been joined by around 15 other firms, including Block’s Muddy Waters, that operate in a similar way.


You might think there was a temptation for short sellers to go for quick profits by making flimsy or exaggerated accusations, but that seems in general not to be the case. For a National Bureau of Economic Research paper published in 2014, the economists Alexander Ljungqvist and Wenlan Qian painstakingly examined every report – on any corporation traded on US exchanges – published in a five-year period by every firm active in this kind of short selling. (They used the Internet Archive’s Wayback Machine to check whether the firms had subsequently deleted reports from their websites; they hadn’t.) On the day of a report’s publication, Ljungqvist and Qian found, the target corporation’s shares fell by 8.2 per cent on average. If the accusations were flimsy, one would expect a rapid reversal of the price fall, but that wasn’t what happened. Three months after the release of a report, the shares in question were down, relative to the market overall, by an average of 21.9 per cent; a year on, by 56.8 per cent. (This was true only of reports that presented new fieldwork or accounting data; reinterpretation of existing data seemed to be ignored. The short sellers’ reputations also mattered: only those whose previous accusations had been confirmed seemed to be listened to.)

These falls in share price, Ljungqvist and Qian found, were not the result of short sellers ganging up on target corporations: after the publication of a negative report from a reputable short seller, the fees for borrowing shares typically rise so much, so fast, that it deters this sort of behaviour. Rather, it seems, short sellers’ reports sparked price falls by causing mainstream institutional investors to revise their opinions of corporations and reduce or eliminate their holdings in them.

It’s a remarkable finding. A set of fewer than twenty web-enabled short-selling firms, all of them very small (as far as I can tell, the typical firm consists of a founder and a handful of assistants), were successfully puncturing the façades of major corporations, and sometimes even initiating the process of holding them to account: a quarter of the corporations covered by Ljungqvist and Qian’s paper ended up being investigated by the US Department of Justice or the Securities and Exchange Commission. Indeed, if you are British, it’s hard not to feel envious of the US when reading Ljungqvist and Qian’s study. ‘Angry directors … could go for you,’ a UK-based short seller says, and publishing in the UK reports of the kind posted by the US firms would risk catastrophic libel damages. (‘We are snow leopards,’ he says, suggesting both the rarity and the near invisibility of specialists in short selling in the UK, where it is usually just a sideline for those who make most of their money buying shares they expect to go up in price.) In the US, the freedom-of-speech safeguards in libel law protect short sellers. It’s not that US corporations don’t sue but, as Chanos told me, the suits are ‘more a cost and hassle than a real legal risk’.

For all short sellers’ success in detecting fraud and having corporations held to account, their activities are no panacea. You can’t, for example, hope to use short selling to curb the activities of companies that are big but legal polluters, have poor labour practices, or make their money from gambling or by selling cigarettes, pornography or guns. (If they’re genuinely making money, you’ll just lose yours.) Nor is short selling effective against capitalism’s big bubbles, such as the huge, indiscriminate surge in the prices of dotcom shares at the end of the 1990s. Even if you are certain it is a bubble, and you are right, you can’t know when it will burst, and until it does you will simply rack up stomach-churning losses. If you are managing other people’s money, they’ll want it back, and you’ll have to abandon your short positions.

It’s worth noting that Ljungqvist and Qian’s data come from 2006-11. Since then, US share prices have doubled, driven not just by economic recovery but also by the cheap money resulting from low interest rates and the Federal Reserve’s quantitative easing programme. Short sellers can relatively straightforwardly hedge themselves against an overall rise in stock prices, but they need other investors to take note of their findings about the corporations they are shorting, and an increasing proportion of the stock market is now made up of mechanistic buyers such as index funds, which simply buy the shares of all the corporations in a given index. Also, short sellers have on occasion suffered badly when the price of a stock they have short sold rises sharply because the company in question has become the subject of a takeover by a corporation that has failed to notice its problems. That is ‘a big thing that could go wrong’, Carson Block says: ‘There is probably more dumb money out there than at any point in … modern history.’

A short seller in a world awash with dumb money can pay a psychological as well as an economic price. ‘When I wake up in the morning,’ Chanos told me, ‘I know of eighty stocks that we’re involved with, and at least twenty of them will be [being given a] “buy” rating [by stock market analysts], estimates [of profits] raised, CEOs on Bloomberg, takeover rumours. It’s mostly all noise, but it’s there, it’s every day and … it’s the muzak of the investment business in the elevator: it’s always on … You’re constantly being told you’re wrong … Most people have a problem with that: life is too short; I want … positive reinforcement.’ Sometimes, too, short sellers are drawn into draining, years-long public feuds, not just with corporate executives but with investors who take a different view of the prospects of a corporation: that happened most recently with Herbalife, the controversial US distributor of nutritional supplements.

It’s hard sometimes not to think that most short sellers would have become richer, worked less hard, and suffered less psychological pressure, if they had chosen a career in conventional investment management. They would, however, have missed out on what Chanos calls the ‘psychic income’ of short selling. Recalling his first major ‘short’, Baldwin-United, Chanos says he ‘loved the puzzle aspect of it’, trying to figure out what exactly was wrong. Block says something similar: ‘There is the surface business, but then there is what’s really going on … Really trying to understand what they’re doing, why they’re doing it, how they’re doing it: that’s often the puzzle. My favourite thing … is [to] lie down and just really try to think about these things pretty deeply.’ Psychic income of that sort is priceless. It’s good for the health of financial markets that short sellers have a way to earn it.

[*] Donald MacKenzie wrote about Enron in the LRB of 22 May 2003.