DON’T BLAME THE SHORTS This page intentionally left blank DON’T BLAME THE SHORTS WHY SHORT SELLERS ARE ALWAYS BLAMED FOR MARKET CRASHES AND HOW HISTORY IS REPEATING ITSELF ROBERT SLOAN New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2010 by Robert Sloan. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. ISBN: 978-0-07-163687-2 MHID: 0-07-163687-0 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-163686-5, MHID: 0-07-163686-2. All trademarks are trademarks of their respective owners. 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CONTENTS Preface ix Acknowledgments xix Chapter | 1 The Great Debate: 1790–1800 1 Chapter | 2 Wall Street and Main Street: The Populist Argument Is Born: 1830–1907 17 Chapter | 3 Congress Attacks the Money Trusts: 1907–1920 27 Chapter | 4 The Markets Before and After 1929 39 Chapter | 5 A Lurid Tale of Blackmail, Spies, and Lies: 1932 49 Chapter | 6 Mr. Whitney Heads to Washington: 1932 63 Chapter | 7 The First Prime Broker Was Actually the NYSE 85 Chapter | 8 The Senate Tries Again with the Pecora Commission: 1932–1941 97 Chapter | 9 United States v. Henry S. Morgan: 1947–1953 115 • vii • viii • Contents Chapter | 10 Yesterday as the Day Before: 1987–Present 123 Epilogue 141 Appendix: New York Times Articles 161 • “Vote Wide Inquiry on Short Selling” March 4, 1932 163 • “Bears Planned Raid, Senators Were Told” April 9, 1932 166 • “Bear Raid Inquiry Opens” April 11, 1932 169 • “List of Shorts on the Stock Exchange on April 8 as Given Out by the Senate” April 21, 1932 177 Glossary 179 Notes 191 References 205 Index 233 PREFACE Well, that was what you were supposed to do. —Response to the author, as a teenager, from a Wall Street legend who was commenting on Joe Kennedy’s short-selling profits made during the 1929 crash ou can make money in a lot of ways and be celebrated. Corpo- Y rate raiders are regularly lionized on the covers of Fortune and BusinessWeek; tech gurus are lauded for their entrepreneurship; media and movie executives are revered for their creative genius; even oil companies are often given favorable treatment. In America, you can stick two trinkets together for the first time and sell it, and someone will call it revolutionary. However, you short a company’s overvalued stock and you are automatically perceived negatively, or worse, seen as unethical, undermining American capitalism. When markets turn sour, the public complains about excess and recklessness, greed and iniquity. People feel abused and helpless, and they hope Uncle Sam will sort through the mess and figure out whom to vilify. Amid the tumult of assigning blame, short sellers are time and again deemed culpable. It is just too convenient to blame the investors who bet on falling stocks for stocks actually falling. Even at a young age I was predisposed to blame the short seller. • ix • x • Preface My first experience with short selling occurred at 15 years old. One of the most senior men from an iconic Wall Street house who would later take the helm was my dad’s dinner guest at home. Dad asked me to come in and say hello. It was right after the 1979 oil crisis, and I was looking for an intelligent comment to make about the market. Somehow Joe Kennedy, the first head of the SEC, came to mind, and I recounted how he shorted the market in ’29, making over $15 million during the crash. It was not meant as a compliment. The senior executive looked at me, paused, and without the slightest bit of emotion replied: “Well, that was what you were supposed to do.” At 15, I certainly had no training or experience in the ways of Wall Street, but almost instinctively I knew that what Kennedy had done was bad. How did that thought just appear in my head and come out as conventional wisdom? Why was a negative attitude toward short selling embedded in my young worldview? What is it about shorting that drives our political and financial institutions to distraction? How does short selling manage to bring Washington elites and corporate chieftains together in rare moments of solidarity to disparage its prac- tice? Why does the financial press thrive on outing prominent short sellers in times of market turmoil while vilifying an investment tech- nique that is as old as Wall Street itself? These were the questions that encouraged me to write this book. As it turns out, the answers lie deep in the founding of this country and in the recurring tension between populism and capitalism, rural and urban America, Main Street and Wall Street. The economic crisis that began in 2007 was caused by banks that had overvalued assets on their books—assets that they could not sell at a Preface • xi price they deemed to be reasonable. The difference between their tan- gible equity and what they could fetch for their illiquid assets com- prised the crux of the credit crisis. But when it came to the cause of their troubles, many Wall Street chief executives didn’t point to their own illiquid balance sheets. Instead they relied on a familiar scapegoat: short sellers. It was the shorts, these executives claimed, who spread the rumors, innuendos, and lies that devalued—and in some cases, crippled—the stock prices of a number of the proudest names in finance, thus predi- cating the market’s downturn. Many of these same executives insisted that their own companies were awash in liquidity, their assets fairly valued, and their business models intact. But, as we know now, all was not blue sky. The system of payments that funded nearly all transactions, from the common to the most complex—from mom-and-pop establishments to multi - national credit card companies—was about to freeze, dollar by dollar, business by business, sector by sector. Lehman Brothers, one of the most troubled firms on the Street, was teetering on the precipice of bankruptcy by September, and the American system of leveraged cap- italism was about to fall under its own weight. Of course, Lehman wasn’t the first venerable Wall Street house to meet an abrupt demise. In March 2008, Bear Stearns was saved by a federally funded takeover by J.