Which financial stocks did short sellers target in the subprime crisis?

https://doi.org/10.1016/j.jbankfin.2014.12.021Get rights and content

Highlights

  • Investigates whether short selling of stocks be restricted by regulation.

  • Focuses on SEC ban on the short selling in September 2008.

  • Questions whether selling was manipulative or rational.

  • Reports that short-sellings of financial versus non-financial firms were similar.

  • Restricted regulation may mute the market disciplining effects of investors.

Abstract

Tracing the SEC ban on the short selling of financial stocks in September 2008, this paper investigates whether such selling activity before the 2008 short ban reflected financial companies’ risk exposure in the subprime crisis. Evidence suggests that short sellers sold short stocks that had the greatest asset and insolvency risk exposures, and that the short selling of financial firms’ stocks was not significantly greater than that of non-financial firms after we match them on firm size and insolvency risk. When the short ban was in effect, the market quality of financial stocks without subprime assets exposure had deteriorated to a larger degree than that of financial companies with subprime assets exposure. The findings imply that such a regulation may mute the market disciplining effects of investors and may also be seen as a counterweight to any perceived macro or systemic risk reduction benefits resulting from such a ban.

Introduction

Short sellers such as hedge funds were accused of using short sale strategies to push down the prices of financial company equities below their fundamental values during the 2007–2009 crisis. Indeed, a sequence of actions taken by the SEC seems to be consistent with this belief. On 15 July 2008, the SEC issued an emergency rule to limit certain types of short selling,1 namely, the “naked” short selling of 19 major financial firms. On 17 September 2008, the SEC announced that this rule was to be extended to all publicly traded financial firms. On 18 September 2008, the SEC announced a ban effective immediately on all types of short selling of the stocks of 797 public financial companies, which continued until 8 October 2008. At the time, the SEC’s Chairman, Christopher Cox, claimed that this short selling ban was an effort “to combat market manipulation that threatens investors and capital markets.”2 Within a week, the prohibition on short selling had spread to markets overseas, including the United Kingdom, Australia, Taiwan, and the Netherlands.3

The 2008 short ban triggered significant controversy. A number of hedge fund managers and other investors actively opposed the ban, arguing that regulators were actually punishing short sellers for the mistakes made by financial companies that had exposed themselves to risky asset investments, such as subprime mortgage-backed securities and other credit derivatives. Richard Baker, head of the Managed Funds Association, a hedge fund lobbying group, argued that hedge funds short because they identify fundamental problems with a company. “If in fact a company does fail, it will have nothing to do with the fact that someone on the outside noticed these deficiencies.”4 Additionally, financial economics researchers commonly believe that short sellers are active, rational, and even informed traders that help facilitate the price discovery process (Boehmer and Wu, 2013) and keep price in line with the fundamental or intrinsic values (e.g., Dechow et al., 2001). Short-sale constrained stocks, on the other hand, may be traded at a price above their fundamental values, and therefore may underperform in the future (e.g., Miller, 1977, Boehme et al., 2006, Asquith et al., 2005).

This paper investigates whether investors rationally anticipated and traded on certain types of fundamental information that affected future returns, and we are specifically interested in over-investment in risky assets and overall insolvency risk exposure. Given the controversies regarding the short ban, this is an important research question for both researchers and regulators. First, financial institutions’ excessive exposure to risky assets—specifically subprime assets—is believed to have been one of the major causes of the 2007–2009 crisis. The question of whether and how these types of risk exposures affected short selling activity remains unanswered in the literature. Second, if companies with greater exposure to risky assets were actually sold short to a greater degree, then opposition to the SEC’s ban on short selling would have been reasonable. Indeed, as has been shown in a more general context, short selling activity enhances the informational efficiency of asset prices (e.g., Boehmer et al., 2008, Boehmer and Wu, 2013). That is informed traders inject additional information (and potentially more accurate information) into the marketplace by short selling.5 Thus, banning short selling could have had unfavorable informational consequences. Stock prices, for instance, might no longer be an accurate reflection of the full information set in the marketplace, especially with regard to a financial company’s investment in subprime assets. Such “inefficiency” effects may be perceived as offsets to any potential macro policy or systemic risk reduction benefits from such a ban.

There have been a number of papers that investigate the impact of the short ban on different markets. For example, Boehmer et al. (2013) show that the ban lowered market quality as measured by spreads, price impact, and intraday volatility for affected stocks. Gagnon and Witmer (2009) have demonstrated—via a natural experiment crafted around cross-listed stocks between the Canadian and U.S. markets—that the 2008 short selling ban actually caused stock prices to trade above their fundamental values. Beber and Pagano (2013) find that short bans around the world during the 2007–2009 crisis were detrimental for liquidity, slowed price discovery, and failed to support prices. Kolasinski et al. (2013) find that short bans result in more informed trading. Battalio and Schultz, 2011, Grundy et al., 2012 focus on the impact on the option market. Danciulescu, 2009, Choi et al., 2010 examine the impact on the bond market. However, the heterogeneity of market quality deterioration within stocks affected by the short ban has been relatively under-researched. This paper further investigates whether financial firms with greater subprime asset exposure experienced a higher or lower degree of market quality deterioration when the ban became effective.

This paper complements the existing literature by answering the important question of which type of financial stocks were more likely to be short sold during the subprime crisis. Our results underscore the important role of short sellers in incorporating financial companies’ subprime exposures into their stock prices, and in monitoring and disciplining the targeted companies by discouraging incautious, value-destroying investments.6 Lorenzo Di Mattia, the manager of the hedge fund Sibilla Global Fund, argued at the time of the ban: “Funny they don’t understand that it is because there is short selling that the market didn’t crash. If there were no shorts in this market, there would be only sellers.”7 Moreover, banning short selling limits investors’ hedges against their market risks, as short selling financial company stocks with significant exposure to risky assets might be viewed as a crucial “self-rescue” strategy for some institutional investors.8

To address these research questions, we conduct three different sets of tests. First, we examine whether short sellers actually differentiated between financial companies with substantial exposure to subprime and related assets and financial companies with little exposure over the period prior to the SEC’s short sale ban. To examine the extent to which financial firms were exposed to risky asset investments, we use a unique data set of subprime activity at the financial company level by collecting subprime-asset-related accounting information from financial company annual reports during the year prior to the 18 September 2008 short selling ban. Since there is on average 3 months lag between a company’s financial statement filing date and its fiscal year end date (following Compustat’s definition of the fiscal year end date), our sample of financial report filings during the year prior to September 2008 covers the 2007 fiscal year. Thus, for example, the 2007 fiscal year end for Meta Financial Group Inc. of NASDAQ was 30 September 2007; however, the filing date for its fiscal year-end report was approximately 3 months later, on 11 January 2008. Thus, Meta’s financial reporting disclosure at the time of the 18 September 2008 ban would not have included fiscal year 2008 data, since this had been unavailable until December 2008. It should also be noted that prior to 2009, the subprime asset holdings of financial companies were primarily reported in footnotes to annual financial statements. We compare short selling activities between financial stocks with subprime assets and those without subprime assets over the window (−10, +10) and (−10, −1) surrounding the 2007 financial report filing date.

Second, we examine Credit Default Swap (CDS) spreads as an alternative but broader measure of a financial company’s insolvency risk exposure. Acharya and Johnson (2007) argue that CDS spreads may contain private information such as bank lenders’ assessment of the underlying companies’ prospects.9 If short sellers are rational, we might expect that companies with greater risk exposure (measured by their risky asset exposures and CDS spreads) were sold short more. Thus, in our analysis, we investigate how Lagged Daily CDS Spreads affected short volumes over two periods: the windows surrounding the 2007 financial report filing dates, and the one-year period preceding the 2008 short sale ban (from 18 September 2007 to 17 September 2008). We also compare short volumes on financial companies’ stocks with those on non-financial companies’ stocks after we match the two groups on size and CDS spreads.

Third, we investigate the changes in Daily Bid/Ask Spreads of stock prices before and after the short ban went into effect on 19 September 2008. More importantly, we utilize a difference-in-difference approach to compare the changes in bid/ask spreads between financial companies with subprime assets and those without subprime assets.

Importantly, in this paper we only focus on whether short selling activity was a reaction toward financial companies’ subprime and insolvency risk exposures. We do not directly examine whether the short sale ban was an attempt by regulators to restore investor confidence or to prevent the financial market meltdown during the peak of the financial crisis. Our results show that the greater a financial company’s exposure to risky assets, the greater the short selling activity of its equity around the filing date of its 2007 annual report. Our results suggest that short sellers were playing a crucial role in incorporating some important pieces of fundamental information into stock prices during the period leading up the September 2008 short ban.10

Our results using CDS spreads provide further confirmation that short selling prior to the ban reflected financial companies’ asset risk exposures. We find that short volume was positively correlated to Lagged Daily CDS Spreads and change in average CDS spreads, both of which can be viewed as reflecting a financial company’s overall default or insolvency risk. As a robustness test, we also investigate whether the 19 major financial firms that went on the naked short selling list on 15 July 2008—before the more general and comprehensive September ban—were driving our results. In all tests, our results stay qualitatively the same as those in the broader sample. Since the short selling ban was imposed only on financial companies, we also test whether there was any abnormally high short selling activity on financial stocks in comparison to non-financial stocks. We match these financial firms with non-financial firms based on two dimensions: credit risk exposure and firm size. We find that there was no significant difference between short selling activities for financial and non-financial firms prior to the 2008 short selling ban. These results suggest that short selling activities were not excessive for financial firms relative to non-financial firms prior to the imposition of the ban.

In sum, our results suggest that short sellers differentiated between those financial companies with substantial asset and insolvency risk exposure and those with little exposure. Our results are economically significant as well. For example, over the window (−10, +10) surrounding the filing date of financial companies’ 2007 annual reports, the average abnormal short volume of the group with subprime assets more than tripled the average of the group without subprime assets. Over the 1 year period before the short ban, the tercile group with the highest changes in CDS spreads (worst deterioration in credit quality) had 10 times as much abnormal trading volume as the tercile group with the lowest changes in CDS spreads.

During the period in which the short ban was in effect—19 September 2008 to 8 October 2008—we find the bid/ask spreads of stocks widened to a larger degree for financial companies without subprime assets relative to companies with subprime assets. The market quality of affected stocks in general had deteriorated during the ban-in-effect period because of reduced competition among liquidity providers (Boehmer et al., 2013). This “competition effect” predicts that market quality deterioration should be relatively more profound in the group with subprime exposure, since it had greater short volume prior to the ban. However, market makers arguably faced a relatively more severe adverse selection problem that was created by informed short sellers in companies with subprime assets before the short ban was imposed. The short ban eliminated the adverse selection problem due to short selling activities in all stocks listed by the short ban. Such an alleviation of adverse selection, which tends to narrow the spreads, should be more profound in companies with subprime assets. Our result is more consistent with the “adverse selection effect” rather than the “competition effect.” This finding highlights another possibly unfavorable consequence of the short ban: the relatively more innocent financial companies that had no subprime investments suffered more in market quality deterioration during the ban-in-effect period than those with subprime investments. This paper is directly linked to the literature on the informational role of short sellers. This strand of literature generally links short selling activity with different pieces of information of the target companies, such as earnings surprises (Christophe et al., 2004), the ratios of fundamentals to market values (Dechow et al., 2001), and earnings quality (Desai et al., 2006). This paper differentiates itself from the existing literature by identifying some specific yet important types of information that drove short selling activity during the 2007–2009 subprime crisis. To the best of our knowledge, this paper is the first to explicitly investigate the effect of subprime exposure and CDS spreads on short volume. Last but not least, even though some previous research has already shown that CDS spreads (Acharya and Johnson, 2007) and short selling activity (e.g., Asquith et al., 2005, Boehmer et al., 2008, Desai et al., 2002) have predictive power over future stock returns, this paper is one of the first to provide direct evidence of an information flow from credit derivative markets to short sellers.

The rest of this paper is organized as follows. In Section 2, we discuss related literature and develop our hypotheses. In Section 3, we describe our data and variables. In Section 4, we present our empirical results. We conclude in Section 5.

Section snippets

Literature and hypotheses

Anecdotal evidence and the financial economics literature both generally view short sellers such as hedge funds as sophisticated, rational, and informed market participants that can facilitate the price discovery process. For example, Dechow et al. (2001) find that short sellers target companies with weak fundamentals such as low earnings-to-price ratios, with the expectation that the ratios will mean-revert in the future. Desai et al. (2006) find that short sellers accumulate their short

Data and sample construction

In this section, we discuss the construction of our sample and data sources. Initially our sample consists of the 797 financial companies that were put on the no-short-sale list by the SEC in September 2008. We then hand collect detailed accounting information on financial companies’ exposures to risky assets, primarily subprime mortgage related loans and securities and the filing dates of that information from annual reports (10-K).

Empirical results

In this section, we discuss our empirical results as related to Hypotheses 1-3. We first make a comparison of firm characteristics for financial companies with subprime exposures versus those without subprime exposures. Then we examine how financial companies’ subprime exposures and CDS spreads affect short selling activity. Last, we examine whether financial companies’ subprime exposures affect the degree of deterioration in market quality when the short ban is in effect.

Conclusion

The results of this paper provide evidence that short sellers clearly differentiated among financial firms according to their assets and insolvency risk exposures. More specifically, the greater a financial firm’s exposure to the subprime mortgage market during the financial crisis, the larger the amount of short selling of the equity of that firm around annual financial report filing dates. Using different measures of short selling activity, we also find that the higher the Lagged Daily CDS

Acknowledgements

We would like to thank two anonymous reviewers for helpful comments. We are also thankful, to Frank Heathway, Chief Economist at NASDAQ OMX, for providing the proprietary daily short selling data for the period post REGSHO; to Markit for providing the CDS Database. Massoud would like to acknowledge funding from Schulich School of Business, York University and to acknowledge financial support from the Social Sciences and Humanities Research Council (SSHRC) of Canada.

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    Hasan is from the Schools of Business, Fordham University and Bank of Finland, Massoud is from Melbourne Business School, University of Melbourne, Song is from Rowe School of Business, Dalhousie University and Saunders is from Stern School of Business, New York University. We would like to thank two anonymous reviewers for very helpful comments. We are also thankful, to Frank Heathway, Chief Economist at NASDAQ OMX, for providing the proprietary daily short selling data for the period post REGSHO; to Markit for providing the CDS Database. Massoud would like to acknowledge funding from Melbourne Business School, University of Melbourne as well as financial support from the Social Sciences and Humanities Research Council (SSHRC) of Canada. Song would like to acknowledge funding from Rowe School of Business, Dalhousie University and to acknowledge financial support from the Social Sciences and Humanities Research Council (SSHRC) of Canada.

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