Shorts Sweeten the Pot

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The term Black Wednesday might not mean much in the United States, but across the Atlantic it’s met with scorn. Any number of historical reference books or websites provide a rundown of what happened on September 16, 1992, when the British pound crashed through its lower limit, costing the United Kingdom more than $3.8 billion. Even though the nation’s economy eventually bounced back, the economic gaffe destroyed reputations, created voter unrest, and incited political change—and made at least one man incredibly rich.

Noticing that the United Kingdom had entered the European Exchange Rate Mechanism (ERM)—a system designed to create monetary stability throughout Europe—at a high rate, Hungarian-American investor George Soros built up an enormous short position against the pound. In other words, he placed an enormous bet that the British currency wouldn’t live up to its agreed upon billing within the ERM, and he won—big.

Soros made more than $1 billion on Black Wednesday and etched his name into financial legend in the process. Though it seemed like an huge gamble against the entire monetary system of one of the most powerful nations on Earth, Soros understood the signs before him enough to make a calculated—albeit gigantic—risk on British currency. Even though it was calculated, it’s not a risk many would take, given the institution’s standing and significance. In the mind of a short seller, however, no institution or market is too daunting for financial gain.

“The mindset of short sellers is to profit for themselves and their clients,” says financial columnist, reporter, and author Greg Zuckerman. “They’re often skeptical people, and they often have a little darker worldview than others.”

Zuckerman has written extensively about short sellers. His book “The Greatest Trade Ever” provides a behind-the-scenes story of how savvy investors like John Paulson, Mark Burry, and Jeffery Greene noticed the bubble in the U.S. housing market and shorted it for tremendous profit. The investors were considered foolish for the position as real estate prices soared, but got the last laugh in the form of billions of dollars in profit.

But it’s that same long insight that has drawn major short sellers the ire of their contemporaries. The ridicule faced by Paulson and others for shorting the housing market was vitriolic, as it appeared they were profiteering off the collapse of an economy.

Similar claims have been leveled against Soros, most notably by economist Paul Krugman, who in his 1999 book “The Accidental Theorist” wrote “nobody who has read a business magazine in the last few years can be unaware that these days there really are investors who not only move money in anticipation of a currency crisis, but actually do their best to trigger that crisis for fun and profit.”

The criticism isn’t completely unfounded—after all, coming away a billionaire when millions of people have lost jobs and homes isn’t a great look. Despite their seemingly coarse image, however, Zuckerman believes short sellers play a vital role in market efficiency.

“Instinctively to the average person, you think these guys are betting against an economy or betting against a company,” he says. “But we need those guys betting against us, as it were, because you need a full market for it to become and efficient market, and for prices to be accurate.”

Zuckerman explains that a market void of short sellers is ripe for bubbles to evolve, which can lead to economic crises like the U.S. housing market in 2008.

“If you look at every bubble in history that’s evolved, it’s often in markets where you don’t have short sellers,” He says. “With the U.S. housing bubble, it took until about 2006 until people who were worried about housing could make a bearish bet.”

Due to intrinsic skepticism and desire to look for good bets in bad places, short sellers have also been known to uncover fraudulent practices in some markets. That was true during the housing bubble, even though the fraud was never really prosecuted or dealt with on a real scale.

It was also true with Enron, which produced one of the largest corporate fraud scandals in American history. In a 2002 story about the short sellers who made off rich by snuffing out Enron as a fraud, Tom Petruno of the Los Angeles Times wrote “[t]hough often reviled for the end product of their work…short-sellers may be the last bastion of hard nosed research left on Wall Street.”

“Sometimes Wall Street can get carried away with a story and become excessively bullish, especially on the sell side,” Zuckerman says, “so you need those people like Michael Burry in a little office of a hedge fund closing the door and thinking about what could go wrong in the world. That’s what they do.”

There have been market bubbles throughout history, but given the sheer amount in over the last couple decades, the value of shorts can’t be understated.

“I think we’re in an environment where people shift quickly on a dime and throw money at things,” Zuckerman says. “We’re in a market where its more likely for a bubble to develop, and we need shorts to prick those bubbles now more than ever.”