March 28, 2002
Securities Lending: Markets Behave Strangely When Shorting Is Thwarted
STANFORD, CA - They tend to hit the headlines for the wrong reasons. The practice of short-selling made news after the attacks on the World Trade Center and the Pentagon. Terrorist groups were suspected of profiting from their foreknowledge by taking short positions in financial markets. Hedge funds came under the spotlight when their activities contributed to the 1997 Asian financial crisis, and when Long Term Capital Management almost precipitated a global crash in 1998. However, these seemingly pariah branches of the financial industry increasingly are being taken more seriously by both participants and researchers.
Indeed, when the Stanford Graduate School of Business launched a recent, one-week program of seminars for its second-year MBAs, finance professor Darrell Duffie decided to use the opportunity to discuss these specialized areas. The seminar, limited to just 10 students, focused on hedge funds, convertible bonds, and securities lending, which is a prerequisite for short-selling. "These are topics that tend to be left out of most introductory finance courses and textbooks, but they are in fact fairly important," said Duffie, who is the James I. Miller Professor of Finance.
One sign of the times is the impending launch of EquiLend, an automated software platform for securities lending, which is a prerequisite of shorting. Until now, most banks have brokered the transactions manually. Ten top banks-including Goldman Sachs, JP Morgan Chase, Merrill Lynch, and Morgan Stanley-are expected to launch EquiLend in 2002, to streamline and standardize the connections between borrowing and lending institutions.
To analyze the practice of shortselling, Duffie uses Palm Inc. as a case in point. Palm's handheld computers may be icons of efficiency and systematic organization, but to academics studying finance, the company's initial public offering has come to represent something else altogether. For a few months in 2000, its stock price seemed downright irrational. "It was a truly weird situation that caused a lot of head-scratching," says Duffie.
Scholars now point to the Palm case to illustrate how things can go wrong when short-selling isn't working as it should. Short-sellers move in when they expect a stock's price to fall. They borrow the stock, sell it, and later buy it at a lower price to return it to the lender.
This strategy of selling high and then buying low depends on a properly functioning securities-lending market-stockholders who are prepared to loan out their equity for others to trade with, in return for cash collateral. Following its IPO, Palm was ripe for shorting, but would-be short-sellers were thwarted by a sluggish securities-lending market.
The IPO resulted from a decision by parent company 3Com to carve out 3 percent of its stake in Palm. 3Com said that it would spin off its remaining Palm shares by year-end, with shareholders promised 1.5 shares of Palm for every 3Com share they owned. Logically, one share of 3Com should have been worth at least 1.5 times the Palm share price.
Instead, after the first day of trading, Palm closed at $95.06 a share, while its parent company's stock price fell to $81.81. The market thus implied that 3Com's non-Palm assets and businesses had a negative value-a plainly absurd proposition. Hence, the opportunity for short-selling. In this case, anyone who bought 100 shares of 3Com and shorted 150 shares of Palm would have basically been getting the non-Palm part of 3Com for minus $63 a share. Enough of these transactions would have quickly corrected the mispricing. Yet the imbalance lasted more than two months.
Why? First, traders found it difficult to get their hands on stocks to borrow. This is generally true of IPOs, when there are often restrictions on lending. Second, even stockholders willing to lend their equity demanded prohibitively high fees. The standard practice is for lenders to rebate interest on the cash collateral to the borrower, but when borrowable equity is scarce, the rebates shrink. Such arrangements, called "specials," are in effect a premium lending fee.
Palm's mispricing was not unique. Owen Lamont and Richard Thaler of the University of Chicago found five other cases between April 1996 and August 2000 in which parent companies were valued unambiguously lower than the firms they had just carved out and were going to spin off. In each case, the market eventually corrected itself -but only gradually. "The mispricing persisted because of the sluggish functioning of the shorting market," the researchers wrote. Another study suggested that such dynamics may have helped inflate the internet bubble. Eli Ofek and Matthew Richardson of New York University's Stern School of Business have found that shorting was more difficult for Internet stocks than for other stocks. Pessimists-read "realists"-who wanted to short-sell patently overvalued stocks, couldn't. With more and more optimists arriving in the market, the researchers write, "it becomes like a stampede without any initial way of stopping it."
Thus, although shorting is a layer of securities practice that lies below normal trading, its effects do filter up and affect prices of stocks and bonds, Duffie notes. It is a layer that increasingly is being taken more seriously by financial institutions that have securities to lend or that are in a position to act as brokers between borrowers and lenders. For some banks and brokerages, securities lending has become a major source of income. (The fine print on brokerage agreements may allow them to lend out retail investors' holdings without needing to seek permission each time they do it.)
Also growing in number are exclusive lending agreements between brokers and institutions with large, long-term investments. One such deal was struck in November 2000 between a pension fund, the California Public Employees' Retirement System (CalPERS), and Credit Suisse First Boston. The lockup enables CSFB to be a major broker in securities lending.
===== Kevin Dean Buffalo, NY ICQ: 8616001 AIM: KDean75206 Buffalo Activist Network http://www.buffaloactivist.net http://www.yaysoft.com
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