Lehman Brothers and the Pesky Short Sellers

Wonder what brought down the investment banking industry?  Richard Fuld, the CEO of the now bankrupt Lehman Brothers, has an explanation and its not his approach to management or his excessive risk taking.  What brought down Lehman (and Bear Stearns, for that matter) was naked short selling.  As he noted in his prepared testimony in the House of Representatives on Monday:

• Naked short selling, followed by false rumors, dealt a critical, if not fatal blow to Bear Stearns. Many knowledgeable participants in our financial markets are convinced that naked short sellers spread rumors and false information regarding the liquidity of Bear Stearns, and simultaneously pulled business or encouraged others to pull business from Bear Stearns, creating an atmosphere of fear which then led to a self fulfilling prophecy of a run on the bank. The naked shorts and rumor mongers succeeded in bringing down Bear Stearns. 
  

Fuld is certainly closer to the market than this Blog ever will be and his views deserve some weight.  But the comments have to be put into perspective.  The SEC itself noted in a highly critical report about its inspection of Bear Stearns that the investment banking firm had been increasing its concentration of mortgage securities and had gone beyond internal limits.  The position represented "a significant concentration of market risk."  Yet Fuld makes no mention of this, preferring to instead blame naked short sellers. 

He does the same with respect to the collapse of Lehman.  He mentions a few reasons, the loss of confidence and an outdated regulatory system.  Mostly, though, it was the naked short sellers.  "And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers. In our case, false rumors were so rampant for so long that major institutions issued public statements denying the rumors."  It was the ban on naked short selling instituted by the Commission that "stabilized the share prices of Lehman Brothers and the other firms. However, this restriction was temporary, and on August 13 it expired after 17 trading days."  The failure to maintain the ban had serious consequences:

• Many of the firms that have recently collapsed or have been forced into emergency mergers, takeovers, or government bailouts – Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, AIG – did so during the gaps of time in which there was no meaningful regulation of naked short selling. On September 15, when the market opened after the collapse of Lehman, naked shorts appeared to turn their attention to Morgan Stanley and Goldman Sachs. In the three days between the announcement of Lehman Brothers’ bankruptcy and the SEC instituting an emergency ban on short selling, Goldman Sachs’ and Morgan Stanley’s share prices fell 30% and 39% respectively. None of this was a coincidence.

Only after Lehman failed did the SEC take action, instituting "an emergency ban and other restrictions on short selling financial institutions."   Of course, the market has more or less been in free fall since the ban was put in place suggesting the downward pressure was coming from a source other than short (much less naked short) sellers. 

Fuld's explanation would have more credibility if it was paired with some degree of his own responsibility for the collapse of Lehman Brothers.  He appears to have encouraged enormous risk, risk for which he was compensated handsomely.  Now that the firm has collapsed, it has nothing to do with his leadership or risk taking but turns on malevolent and unnamed players in the market place.  The testimony looks less like an explanation and more like a rationalization and an attempt to avoid personal responsibility.   

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