The U.S. Justice Department has recently announced an investigation of short sellers and their paid researchers, most likely for sharing information, perhaps verging on insider trading.
Short selling is the opposite of what most investors do, which is to buy a stock, hope the price rises, and sell. Shorts sell shares (that they have borrowed), then buy them back. The short position profits if share prices have gone down in the meantime, if the short can sell high and then buy back low.
Short positions are much riskier than long positions. A long position loses money if the stock price goes down, but the stock price can only go down to zero, so losses are capped. Short positions lose money if the stock price goes up, which it can do infinitely (in theory), so potential losses are infinite as well.
Given the risk—and the history, since markets rise most of the time—there are fewer short sellers than buyers, by far; short positions are typically a small percentage of trading in a stock. Short sellers are the contrarians that investors love to hate: the harbingers of doom, the pins that prick at our bubbles and our optimism. Besides, there is something vaguely distasteful, and certainly not collegial, about actively betting against a stock, beyond simply choosing not to invest.
In the beginning, it was just a pipeline to a pipedream: Houston Natural Gas, an offshoot of Houston Oil, was formed to take advantage of a then unregulated Texas natural gas market. Eventually, Enron expanded into electric power, as well as gas and oil. But its truest innovation was in becoming an energy company—common today, but new at that time.
An energy company not only supplies some form of energy or fuel, but it capitalizes on market dynamics to hedge and speculate on energy production and energy prices, and does so in an effort to provide competitive pricing for its customers as well as lucrative profits for its shareholders.
Power companies had long been regulated on the theory that they are natural monopolies. As such, they have long been considered sleepy though reliable corporate citizens, dependably paying dividends and, of course, keeping the lights on. The Energy Policy Act of 1994 allowed states to deregulate utilities, and their suppliers.
And then there was broadband. It was an infant industry when Enron created its own fiber optic network in 1997, with an eye toward not only owning but trading bandwidth, i.e., turning it into a commodity long before the cloud was even a gleam in Silicon Valley’s eye.
By then, Enron was riding a few waves to great success and profit: deregulation in both the energy and financial markets made energy and commodities trading--across markets and directly to customers--possible, financial engineering made pricing much more accurate and thus more profitable, and technology made it all accessible, creating the earnings that inflated all reasonable expectations into successes of epic proportions.
But there were losses too, of course, and they were hidden in a thicket of special purpose entities created just for that purpose. They were also hidden by success: by 1999, Enron was the biggest wholesaler of natural gas and electricity in the country. And the stock price soared.
The accounting firm looked the other way, but some analysts read the fine print. They later said that they just did their due diligence, saw company executives selling their own shares, and thought that energy companies shouldn’t act like hedge funds, regardless of deregulation. And they began to short, some as early as a year before the stock price finally began to fall.
By the time the fraud was revealed, too many trusting employees were not only out of a job but had lost their retirement savings, invested in Enron’s stock. The accounting firm, Arthur Anderson, as venerable as any had ever been, also went down. A few top executives were indicted for fraud, and their wives for insider trading, and there were a few best sellers and even a movie.
It’s been 20 years since Enron went down. Short sellers are still seen as spoilers: when social media hypes meme stocks, it is to undermine the imagined manipulation of a conspiracy of shorts. In hindsight, and in Hollywood, short sellers have sometimes been framed as heroic for famously seeing and saving markets from their own exaggerated exuberance. In truth they are probably no more or less manipulative, nor heroic, than their long colleagues, but their value as the counterpoint, if not the conscience, of the markets is undeniable.
Rachel S. Siegel, CFA, is the author of Personal Finance v 3.1, available at www.flatworld.com. She has been published monthly in the Northstar since July 2001.