Wall Street’s short sellers wrongly maligned — detected red flags ahead of US financial crisis

Short sellers were first to react to impending crisis among the financial intermediaries examined, including equity analysts, ratings agencies and auditors.

Numerous banks in the United States failed during the recent financial crisis — and more would have, absent governmental intervention, writes short-selling expert Hemang Desai, a professor at Southern Methodist University.

Subsequently, a substantial contraction of credit occurred and the effect on the economy was devastating for businesses and households. In new research, Desai and co-authors provide evidence that short sellers were sensitive to the leading indicators of the crisis from banks’ financial statements. They were first to react to the impending crisis among the financial intermediaries examined, including equity analysts, ratings agencies and auditors, according to Desai, an accounting professor in the SMU Cox School of Business and nationally recognized researcher on mergers and acquisitions, corporate restructuring, short selling and financial reporting.

Even from the highest levels of leadership in the financial sector, the suggestion was that academia, regulators and the Federal Reserve “missed” the warning signs of the banking and financial crisis. Did financial statements of the banks provide an early warning of their upcoming distress? Commentators have argued that transparency was lacking in banks’ financial statements. And, why did few observers foresee impending problems at banks? The United States has the most developed financial system in the world with arguably the most sophisticated information intermediaries.

“The notion that everybody missed it is just not true,” states Desai. “This is not the first time we have had a wave of overvaluation — or that banks have failed. We have seen overvaluation in other sectors, like the technology bubble in the late 1990s.” In this case, there was a bubble in the housing market and the financial sector was overheated. Prior work finds that short sellers are sensitive to indicators of overvaluation; it follows that they would have been sensitive to indicators of overvaluation in the housing or the financial sector.

Short sellers saw warning signs of bank distress
The research indicates that short sellers were sensitive to the warnings signs of bank distress in the banks’ financials.

“We looked at the financial statement indicators of bank distress,” says Desai. “We find that these indicators are correlated with the short interest in banks, which suggests that the information set of short sellers was correlated with information in banks’ financials.” Short interest is a market-sentiment indicator that tells whether investors think a stock’s price is likely to fall.

“Short sellers consider a company’s business model,” explains Desai, “and if the model is conflicted and the firm’s valuation is not justified, then such stocks invite scrutiny and are shorted.” When the firm’s fundamentals, prospects and performance are not in alignment, that’s likely to catch the attention of short sellers.

A number of factors played into the perfect storm that became the financial and economic crises. From 1997 to mid-2006, housing and other real estate prices rose sharply before the crisis, which drove growth in the overall economy. Real estate represents the biggest asset class not only in the United States but also on banks’ balance sheets, dominating both loans and securities. In early 2004 to mid-2007, just before the crisis, the cost of debt capital fell and market liquidity rose sharply. Leverage was very high throughout the economy. Some banks relied on cheap but hot short-term funding to maintain their spreads.

Other signs began to manifest. Modest but growing levels of early payment defaults and repurchase requests began to be reported for subprime home equity mortgages in late-2005 and for subprime mortgages in early- to mid-2006. In November 2006, the Case-Schiller National House Price Index reported that house prices fell from June to September 2006. The subprime crisis began in February 2007.

That crisis was primarily a housing or real-estate driven crisis, Desai observes. “Home prices were going up but income levels were not. While the number of subprime loans originated and securitized by banks was increasing dramatically, the quality of the loans was deteriorating,” he says. “This information was likely observed by the short sellers.”

The majority of the subprime loans were designed to either default or be refinanced, explained Desai. “Thus, given the dramatic growth in these loans in the years prior to the crisis, there was either going to be a wave of refinancing or defaults. Additionally, the refinancing was predicated on a continued increase in housing prices. Once the housing prices peaked, we had a massive default.” It appears that short sellers were sensitive to the developments in the housing market and were targeting banks due to their exposure to the housing market, Desai offers.

“These guys were smart enough — I do not know how everyone ‘missed it,’” notes Desai. That the short interest was higher for banks that failed subsequently provides further evidence to support the authors’ conclusion that short sellers were sensitive to the warnings indicators.

The evidence shows short sellers were the first to react
In the study, four types of intermediaries’ responses to the unraveling situation were analyzed: short-sellers, equity analysts, Standard & Poor’s credit ratings and auditors. The authors examined the actions of the intermediaries well in advance of the onset of the crisis. Banks’ financial statements did reflect, at least partially, the risks that were building up prior to 2008. They find that the indicators from the fourth quarter of 2007 are associated with bank failures over the period 2008-2010. In terms of the actions of the intermediaries, their research indicates that there is a dramatic increase in the level of “abnormal” short interest from March 2005 to March 2007 and a further increase in March 2008.

Thus, short sellers apparently recognized that the banks’ valuation and performance could not be sustained — well before the crisis unfolded. Short sellers were the first to react, followed by equity analysts. Credit ratings were sluggish in responding to information about bank distress.

The trigger point for short sellers to act was the drop in housing prices — the bubble burst. When home prices declined, homeowners could not refinance, and a huge wave of defaults occurred. The banks also had implicit guarantees embedded in the securitization transactions, holding riskier tranches.

Shorts sellers unfairly maligned, instead they can provide market oversight
“Our evidence suggests that the financial statements did reflect some footprints of the crisis,” says Desai. “The short sellers were sensitive to it. Thus, financial statements were not as uninformative as some have claimed.”

Short sellers have been unfairly maligned. “There is value in tracking their actions, which are informative,” Desai relays. “As the banks have become bigger and more complex, the regulators are looking to capital markets to provide discipline and to supplement their own oversight. Our evidence suggests that the short sellers potentially provided this discipline.”

From society’s point of view, over-valuation is not desirable. Desai explains, “If growth expectations are overblown, it results in overinvestment and misallocation of resources and this destroys value in the long run. The actions of short sellers have the potential to keep firms’ valuations in check. This is an important role that short sellers play in the economy.”

Capital markets function best when the optimists and the pessimists have an opportunity to reflect their views through trading, according to Desai. “Pessimists do play an important role because it is their business to ferret out adverse information; they are instrumental in identifying firms that should not be valued so highly and therefore should not be investing more.” Desai suggests that there can be misallocation in the financial sector in particular. For example, with banks, it is difficult to know what their portfolios contain. Short sellers provide oversight that can be helpful to regulators, directing them toward the banks they should pay attention to.

The results suggest that the proposed restrictions on short selling by politicians, regulators and CEOs need to be tempered in light of the evidence reported in this study. Short sellers were sensitive to red flags of upcoming bank distress, and their actions provided a timely warning about the fragility of the banking system.

The paper, “Were the Information Intermediaries Sensitive to the Financial Statement Based Leading Indicators of Bank Distress Prior to the Financial Crisis?” by Desai; Shiva Rajgopal, Goizueta Business School, Emory University; and Jeff Jiewei Yu, SMU Cox, is under review.

Desai, the Robert B. Cullum Professor of Accounting in Cox School of Business since 2007, is often quoted in publications such as The Wall Street Journal, Barron’s and The New York Times, among others. — by Jennifer Warren

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