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Originally published Sunday, November 9, 2008 at 12:00 AM

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Short-sellers: We're not jackals, just bears

Short-sellers, investors who profit by betting that a stock will fall, have been blamed by some for causing the stock-market meltdown. They say they aren't doing anything wrong, they're just bearish about stocks and investing wisely.

Bloomberg News

An upright stuffed grizzly bear guards the entrance to the office of Fleckenstein Capital on a quiet, leafy street on Capitol Hill in Seattle.

The bear sends a clear message: The man inside, Bill Fleckenstein, founder and president of the firm, is a short seller and proud of it.

Fleckenstein, 55, has emerged as one of the most outspoken defenders of what has been depicted by everyone from the chief executive of Morgan Stanley to the Archbishop of Canterbury as a renegade class of investors.

Since world markets began plunging in July, 17 countries have banned or restricted short selling, including the U.S., Canada, the U.K., Germany, France, Switzerland, Australia, Japan and Taiwan. Commentators around the world have labeled short sellers as hyenas, jackals, vermin and vultures.

Fleckenstein says that investors who bet that stocks will decline, as short sellers do, are simply bears. And he says they are not to blame for the market meltdown.

"Short sellers didn't lower the fed funds rate or tell people to take out mortgages when they shouldn't have," he says. "Now we are the bad guys, the ones wearing black hats."

Fleckenstein's offices are a monument to his trading strategy, in which investors borrow stock from institutional investors and then sell it in hope of buying the shares back at a lower price before returning them to the lender and pocketing the difference.

The grizzly bear was wearing a "Dow 10,000" baseball cap when the index was still at 11,000. A large sign on the wall of Fleckenstein's three-room office suite advises, "Protect Your Right to Arm Bears."

The Seattle native is one of a corps of investors who have been blamed for market manipulation going back to the 17th century.

The recent attacks began after a deterioration in the share price of Bear Stearns in March.

When Bear Stearns' stock fell 47 percent on Friday, March 14, the Federal Reserve stepped in and that weekend brokered the sale of the investment bank to JPMorgan Chase.

Later, Bear Stearns Chief Executive Alan Schwartz told Congress that the firm was toppled by rumormongering and abusive trading — often euphemisms for short selling. The Securities and Exchange Commission launched an investigation that is still in progress.

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After Bear Stearns' demise, each new crisis in the banking sector raised alarms about short selling. When the share prices of Goldman Sachs Group and Morgan Stanley dropped sharply Sept. 17, Morgan Stanley CEO John Mack declared in a memo to his staff, "Short sellers are driving our stock down."

And in testimony before Congress on Oct. 6, former Lehman Brothers Holdings CEO Richard Fuld singled out "naked" short sellers as one of the culprits in the Sept. 15 bankruptcy of his firm.

Naked short selling occurs when a short seller tells a broker to sell shares that the seller has not yet borrowed. On Sept. 17, the SEC ruled for the first time that naked short selling was a fraud. Japan has banned naked short selling in its markets through March 31, 2009.

U.K. campaign

In the United Kingdom, the campaign against short sellers also goes back to March, when the Financial Services Authority (FSA) said it suspected that "false rumors" linked to short selling led to a sudden drop in the share price of HBOS, the country's biggest mortgage lender. An FSA investigation found no evidence of abuse.

In September, when Lloyds TSB Group agreed to buy HBOS for a fifth of its value a year earlier, both Archbishop of Canterbury Rowan Williams and Archbishop of York John Sentamu continued to blame the short sellers, with Sentamu calling them "bank robbers."

In response to the furor, the FSA banned short selling of the stocks of banks, insurance companies and securities firms from Sept. 18 through the rest of the year. A day later, the SEC imposed its own ban on short sales of 799 financial stocks. It later added 170 additional companies, including IBM and Sears Holdings.

The SEC ban, after one extension, expired Oct. 9, six days after passage of the $700 billion U.S. bailout plan for the banking system. During the period the ban was in effect, the Standard & Poor's 500 index lost 17.7 percent of its value.

The short sellers say they are scapegoats for the real villains in the meltdown.

"The shorts who warned about the real-estate bubble have been proven right," Fleckenstein says. "Now the government has changed the rules overnight. They're blaming the shorts and bailing out the ones who lost all the money and almost took the financial system down."

Manuel Asensio, president of New York-based Mill Rock, says he and his brethren keep the stock market honest by going after companies with rotten accounting, dubious business plans and excessive debt.

"There was a legitimate reason as to why the financial stocks went down; it was mispriced securities on their balance sheets that caused the problems," he says.

Mill Rock is a hedge fund that holds long and short positions in equities and invests in distressed bank loans.

After mid-2007, when two Bear Stearns hedge funds collapsed, investors had every reason to believe financial shares would decline, says George Feiger, CEO of investment manager Contango Capital Advisors, which oversees about $2 billion.

"Short selling is an expression of doubt, not a criminal activity," Feiger says. "The management at Lehman, Bear Stearns and Merrill kept saying everything was fine. Then, every few weeks, they'd write off billions."

Exaggerated power

The power of short sellers has been exaggerated, says Douglas Kass, founder of the hedge fund firm Seabreeze Holdings, which manages $200 million.

"The dedicated short pool totals about $5.5 billion," Kass says. "Dedicated" short-selling firms run funds that do nothing else. "That's too small to have an impact," Kass says.

Under certain circumstances, short sellers can manipulate stock prices — either through concerted action or through a "feedback loop," says Itay Goldstein, a finance professor at the Wharton School at the University of Pennsylvania. A feedback loop is simply a chain reaction.

An example might be when creditors refuse new loans to a company after reports surface that there is heavy short interest in its stock, Goldstein says. Short interest is the total amount of stock that has been borrowed by short sellers. The credit pullback leads to a further share decline and a decrease in the value of the firm.

The short sellers have marshaled statistics in an effort to prove they played little or no role in the market downturn. According to Short Alert Research, a firm that produces research for short sellers, from early July to late September short interest in 33 investment banks and brokers plunged by 33.3 percent. Yet, share prices still declined.

"It was the longs getting out," Fleckenstein says. "Probably the insiders."

First short-selling ban

The first recorded ban on short selling took place in the Netherlands in 1609, when Issac Le Maire, a Flemish merchant and former board member of the Dutch East India Company, formed a secret society of short sellers to drive the company's stock price down, says Edward Chancellor, author of "Devil Take the Hindmost: A History of Financial Speculation" (Farrar, Straus & Giroux, 1999).

Part of Le Maire's scheme was to form a French company to compete with the Dutch trading firm. The Dutch East India Company then persuaded the government to ban short selling.

Short sellers were blamed for the gyrations of the stock market after the crash of 1929 — and for good reason, says Charles Geisst, professor of economy and finance at Manhattan College in New York, and author of "Wall Street: A History."

"During the year prior to passage of the Securities Act and Banking Act in 1933, there was a massive bear raid on Wall Street," Geisst says. "Some executives were shorting their own stock." In 1938, the SEC adopted the "uptick" rule, which let short sellers borrow a company's shares only when the shares were on the rise.

The SEC eliminated the rule in 2007, and also relaxed its rule on naked short selling — decisions that brought a storm of criticism on the head of SEC Chairman Christopher Cox a year later when the markets melted down. The two actions "overthrew 71 years of stability," Geisst says. "That's what broke the camel's back."

Fleckenstein says the SEC's short-selling ban and the federal government's $700 billion bailout package just postponed the day of reckoning.

"Capitalism is all about boom and bust," he says. "To ban short selling is to say that the government is going to determine what stock prices should be."

Fleckenstein, a graduate of Newport High School in Bellevue, got a degree in mathematics from the University of Washington in 1976 and then worked for three years as a software engineer. In 1979, he joined investment bank Kidder Peabody as a broker.

Three years later, he left to form a private-investment advisory firm, managing money for pension funds and wealthy individuals. In 1996, he started Fleckenstein Capital, which from the beginning was a short-only fund specializing in technology stocks.

The fund was launched in a time of unbridled enthusiasm for all things technological. The Internet boom was unfolding.

His fund did well until 1999, when the tech-heavy Nasdaq rose 86 percent. Even though his short positions were in hardware companies rather than dot-coms, Fleckenstein's fund took a beating.

"Internet stocks were trading at a wacky number," Fleckenstein says. "That meant legitimate companies, with real business and revenue, were trading at a higher level than they were worth."

At the end of 1999, Fleckenstein's investors, including Microsoft co-founder Paul Allen, had to provide him with more funds.

Fleckenstein declines to disclose either the size or returns of his fund. One Fleckenstein investor, Tor Braham, head of technology mergers and acquisitions at Deutsche Bank, says he couldn't be happier with his returns, though he won't disclose what they are.

He says he invested with Fleckenstein in April 2000, when technology and Internet stocks were coming off their all-time peak. The Nasdaq has fallen more than 50 percent since then, generating big profits for investors who bet against it.

"Fleckenstein has been saying for a long time that the economy is going to get into trouble because of leverage," Braham says. "He's very thoughtful as to the bets he takes on companies and doesn't do things he doesn't understand."

Copyright © 2008 The Seattle Times Company

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