For sure the 2008 financial crisis lingers on in the minds’ of long-only investors, but perhaps it’s surprising to hear the episode scarred the shorts too. And not just because they got banned, scapegoated or squeezed.
Data Explorers is marking the third anniversary of the credit crunch by delving into short-selling perspectives in the run-up to the crisis’ apogee in September 2008, and its aftermath.
And they’ve got a nifty timeline/chart too:
Here’s what the data company’s Will Duff Gordon has to say:
Today focuses on the period pre the full blown crisis up until the end of 08. Short selling moved in this period from being the preserve of the brave, to being THE skill, and finally to being highly challenging.
The difficulty, apparently, was that anyone prescient enough to actually be short financials right before September 2008 — think Paulson, Greenlight and co., or hedge funds with their famous long commodities/short financials trade – would not necessarily have benefited from those positions.
As Gordon describes it:
Equity markets had much further to fall but the rug was pulled from beneath the feet of hedge funds in the form, initially, of investor redemptions. Investors could now see the writing was on the wall for share prices and began to redeem their investments.
Long/short US equity funds aimed at large cap and liquid names were the easiest to withdraw from. They were used as the cash machines for investors locked up in illiquid investments elsewhere – regardless of how good their performance was. Given the scale of leverage deployed and the size of client withdrawals, managing redemptions had damaging consequences that began to make short selling a more dangerous activity.
The most glaring example of this was the events of September 08, the month when Lehman (LEH) was allowed to go into bankruptcy. Ahead of this event an all time high of 37% of securities lending revenue came from the re‐investment of the cash collateral ‐ of which more to come. At this seminal moment, most asset managers were either short or underweight Financials. Sadly, the very act of returning money to investors led many funds to close positions that caused a rebound in Financials that made September 08 a miserable month for those expecting the opposite – a far from unreasonable view!
To meet redemptions, the logical thing for an asset manager to do is sell some of their best performing longs and buy back their best performing shorts. When the weight of money is as large as it was that month (as was the case in Aug 07 in a similar squeeze) a counter intuitive pattern appears. Good companies (best longs) spiral down in price as they are sold while the worst performing companies (best shorts) go up in price due to the stampede to cover. This surprising market behavior in September 08 lasts long in the memory of all types of fund manager and they started to seriously question the risk versus return of short selling or being aggressively underweight.
After that, the volume of short-selling seems to have fallen in almost a straight line (i.e. going up in that chart), as regulators cracked down.
Although that trend seems to have culminated with the lifting of the UK short ban, partly explaining the ‘dash for trash‘ experienced from the first quarter of 2009 onwards as shorts once again became squeezed.
Another major exception is the period in the spring of 2010 — when Europe’s sovereign crisis reared its ugly head. Except that that episode ended in a short ban too.
History really does repeat itself.
For more on that point, Data Explorers will be publishing Part II this Thursday.
Related links:
Short selling perspectives on the third anniversary of the credit crunch? – DataExplorers video
In defence of hedge funds - FT Alphaville, 2008
Shadow bank failure – FT Alphaville, 2008