A riposte to the Archbishop

Leading hedge-fund manager Paul Marshall says Rowan Williams was wrong to scapegoat share traders When Rowan Williams and John Sentamu took up their crosiers against shortsellers, they chose strange company: Ken Lay, the disgraced chief executive of Enron, Dennis Kozlowski, the jailed boss of Tyco (who took out full-page ads against short-sellers, before his company sank under the burden of accounting fraud) and the former prime minister of Malaysia Dr Mahathir Mohamad are probably the most renowned critics of shortsellers. In recent weeks they have been joined by assorted Labour frontbenchers, including Yvette Cooper and Hazel Blears.

They are a motley crew. The common thread, linking business executives and politicians, is blame shifting — or to use a more biblical term, ‘scapegoating’.

The best short-sellers, on the other hand — the likes of Jim Chanos of Kynikos, or David Einhorn — see themselves as defenders of truth, lone rangers who take on the might of corporations such as Enron, Tyco, Freddie Mac, Fannie Mae and Lehman Brothers and shine a light on flawed business strategies and bad practice. So who is right?

Regulators around the world appear to have endorsed the criticisms of short-sellers in recent weeks by imposing a variety of restrictions, ranging from greater disclosure (Spain) to an uptick rule (Taiwan) to bans on naked shorts (Belgium, Germany, Netherlands, Portugal) to outright bans (the UK, US, Ireland, Australia, Switzerland). Our own FSA has led the charge with the longest outright ban — three months — of any market in the world.

But there is a pattern in the severity of the measures and it is not in relation to malpractice. The scale of restrictions in each country is more or less in direct proportion to the weakness of the banking system. So the paradox is that it is the developed markets and not the developing ones which are imposing restrictions on short-selling. Indeed, one market is going in quite the opposite direction. Two weeks ago, China announced that short-selling would be permitted for the first time.

The moves against short-selling in Western markets were a sort of circuit-breaker, an attempt to provide stability to the market by removing one source of selling pressure. It is understandable, given what is as stake, that regulators will use all the tools in their armoury to stabilise the banking system. Banks are dependent on ‘confidence’ and there is a reflexive interplay between the three barometers of confidence: share price, the ‘credit default swaps’ (CDS) market, and deposit flows. Aggressive selling of bank shares can be self-fulfilling, especially when combined with the widening of CDS spreads (indicating higher perceived levels of risk in relation to particular banks) and can in theory produce a ‘death spiral’ if it feeds into depositor withdrawals. For these reasons a temporary restriction on short-selling can be justified as being in the public interest.

But it is a trump card which can only be used once. Given that short-selling interests represent just under 5 per cent of UK equity market capitalisation, the fundamentals will reassert themselves rapidly. If people want to sell, with or without shorts, that is what they will do. No one (fortunately) can blame shortsellers for the collapse of Bradford & Bingley, Washington Mutual and Wachovia in the US, Fortis, Dexia and Hypo Real Estate in Europe, or Glitnir Bank in Iceland.

Beyond the context of the banking crisis, it is difficult to see any basis for restrictions on shortselling. It is now deeply embedded in all aspects of financial markets. BP uses short-selling to hedge its commodity exposure; the Church of England uses short-selling to hedge its currency exposure; hedge funds use short-selling to hedge their equity and credit exposures and so limit the volatility of their returns to investors. The entire derivatives market depends on the ability of market-makers to hedge themselves through short and long positions.

There certainly can and should be a debate around the disclosure of short positions (which should apply equally to the CDS market) and there should be continued vigilance against market abuse. But let’s be clear: regulations already exist to prevent market abuse. ‘Trash ’n’ cash’ — short-selling combined with false rumour-mongering — is bad, but no worse than ‘pump ’n’ dump’, which is share ramping, also based on false expectations. Both are against the law.

This brings us to the area where I must defer to the Archbishop — morality.

It is tempting to join in the blame game. Was it the Ninja borrowers, symptomatic of our ‘something for nothing’ society; or the lenders who abandoned sound banking practice for short-term asset growth; or the investment banks, who repackaged dud loans like rats in a stew and sold them on to unsuspecting savers; or the rating agencies who were suckered into placing triple-A ratings on junk paper; or the accountants who failed to blow the whistle; or the Federal Reserve, which kept interest rates too low for too long; or the regulators who failed to control the expansion of bank leverage; or governments, which tried to take credit for the boom but refuse to take responsibility for the bust? Who is really to blame? The answer, as Henry Paulson himself opined after the implosion of the last stock market bubble in 2002, is ‘everyone’.

Periodic collective failures are an inevitable part of the market system, because markets are a reflection of human nature. No matter what new regulations are imposed on banks and hedge funds, we will not banish the cycle of greed and fear. Human ingenuity will see to that. Where the Archbishop must surely be right is that capitalism will be lost if it becomes detached from its moral moorings.

And he is right to attack ‘market fundamentalism’, the quasi-religious belief in markets which still holds sway in parts of the Republican and Conservative parties. But he is late to the debate. George Soros — hedgefund manager and renowned short-seller — has been warning of the dangers of market fundamentalism for over a decade.

What is important today is that public debate retains a balanced view of the role of markets. After much experimentation with other systems — notably those espoused by Karl Marx, whom the Archbishop curiously chose to refer to ahead of the Bible — the evidence so far suggests that markets provide the least bad means of allocating resources. But, as anyone who works in them knows, markets fail. They fail when one company is able to acquire an excessively dominant position (Lloyds-HBOS?). They fail when externalities such as carbon emissions are not priced efficiently. They fail when there is an asymmetry between the seller and the buyer — as is the case with all too many financial products. They fail when participants behave irrationally, in the grip of greed or fear.

It is the job of government to prevent and mitigate market failures. But we need to be equally, if not more, wary of government failure. Because, as Marx failed to anticipate, and as the Archbishop knows only too well, both markets and government are subject to the fallibility of mortal men.

Paul Marshall chairs Marshall Wace, a Londonbased hedge-fund group, and is a founder member of the Hedge Fund Standards Board.