Hedge funds' misery as FSA bans short-selling on 32 firms

By David Prosser, Deputy Business Editor

Saturday, 20 September 2008

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The short-sellers accused of bringing the global banking industry to its knees have found themselves at the mercy of their victims. The unprecedented gains made by banking stocks left hedge funds with short positions facing large losses, as regulators turned their fire on the sector.

Yesterday, the Financial Services Authority (FSA) named 32 companies in which short selling will now be forbidden until the middle of January. And to add to the hedge funds' misery, any existing short positions in the companies listed that were still outstanding last night must be publicly disclosed, forcing many short- sellers to dump their positions yesterday at the worst possible time.

Tom Hougaard, a market strategist at the spread betting firm City Index, said the FSA's sudden announcement was disastrous for some hedge funds. "The short-sellers have just been handed a death sentence," he warned.

The losses could be horrendous. Shares in Barclays rose 29 per cent yesterday. Some 5.18 per cent of its stock was out on loan at the close of trading on Thursday evening, according to the market analyst Data Explorers, most of which would have been held by short-sellers. The gain would therefore have left hedge funds facing a loss of £367m on Barclays alone.

Add in the gains made by the other three big four banks yesterday and hedge funds' total losses, based on stock-lending figures from Data Explorers, would have totalled just short of £1bn. That's before taking into account losses on short positions on the remaining 28 financial institutions on the FSA blacklist.

Nor is Britain alone in attacking short selling. The FSA's initial announcement of a ban on Thursday evening was followed yesterday by the Securities and Exchange Commission (SEC) in the US, which announced a 10-day ban on the short selling of shares in 799 financial institutions. The veto, which includes a ban on shorting Morgan Stanley and Goldman Sachs, widely thought to have been targeted by hedge funds, may subsequently be extended until at least the end of October.

There have been similar actions in Switzerland and Ireland, with the Committee of European Securities Regulators adding that it is now considering a European Union-wide crackdown. And though regulators such as the FSA and the SEC are insisting the bans are temporary measures and that they believe short selling is a "legitimate trading investment technique in normal market conditions", the hedge fund sector thinks it is being scapegoated.

"The knee-jerk reaction of politicians is just mind-blowingly stupid," said one short trader. "Obvious pressure has been applied on the FSA to be seen to be doing something and they have come up with this little gem – the problem in the markets is nothing to do with short selling."

Suddenly, the hedge fund sector is under attack from every direction. Having been branded as greedy pigs in the media and targeted by regulators, even its trading partners are turning on it. Many of the pension funds that have facilitated short selling by lending their stock to hedge funds are not refusing to do business with the sector.

Hermes, which runs BT's pension scheme, said yesterday that it would no longer lend shares in 20 financial institutions worldwide. It follows Calpers, the giant US local authority pension fund, which has announced similar steps. The Investment Management Association also said yesterday that it was asking members to think carefully before lending stock in UK banks.

However, Florence Lombard, the chief executive of the Alternative Investment Management Association (Aima), said a crackdown on short-sellers would do little to restore confidence in the banking sector. "We are not alone in doubting whether the recent bans on short selling of financial stocks taken by financial regulators are likely to achieve the intended results over time," she said.

Ms Lombard pointed out that just 3.5 per cent of HBOS shares were available on Monday for stock-lending purposes. That was nowhere near enough for short-sellers to have been responsible for the havoc on the bank's share price seen at the beginning of the week.

In fact, Ms Lombard insists that the image painted of hedge funds as irresponsible short-sellers is utterly at odds with reality. "The vast majority of people are both long and short investors. I am not aware of a single pure short-seller in Europe and there are only a handful in the US," she said.

The hedge fund sector is also furious that there was no consultation on the FSA crackdown and that it has been introduced so suddenly. James Perry, a corporate partner at the City law firm Ashurst, added: "We've been besieged by calls – when something like this is rushed through, there are always points that are unclear and room for doubt."

Some analysts warn that the regulators' moves against short selling may actually damage the intended beneficiaries of the crack-down, with the prime brokerage units of banks suffering a sharp fall in revenues. "The ban on short selling will mean some hedge funds will not be able to execute strategies they want to do," Andrew Shrimpton, a partner at the hedge fund consultants Kinetic Partners, said. "It is going to impact the profitability of prime brokers, there is no question of that," he warned.

Nevertheless, the hedge fund sector's biggest critics are jubilant about its comeuppance. Lord Oakeshott, the Liberal Democrat Treasury spokesman, for example, said: "The hedge fund wolf packs must never short British banks again."

A permanent ban is unlikely, but many hedge funds are now thinking about where else to turn their attention. The Real Estate Investment Trust Association, which represents the property sector, fears it could be a target and is appealing for help from the FSA. The retail sector could also be a target, said hedge fund experts.

Who's on the list

The financial institutions which the FSA says are off-limits to short-sellers

Admiral Group

Alliance & Leicester

Alliance Trust

Arbuthnot Banking

Aviva

Barclays

Bradford & Bingley

Brit Insurance

Chesnara

Close Brothers