Pershing Square Capital Management’s William Ackman recently made an “informed” short sale trade on Herbalife. His trade is backed up by a controversial thesis. Ackman believes that the Herbalife business model is an illegal pyramid scheme. According to the Federal Trade Commission definition, a company is a pyramid scheme “if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers.”
There is vehement disagreement with Ackman’s Herbalife thesis. Some, like activist investor Carl Icahn and world-renowned financier George Soros, bought millions of Herbalife shares to support a defense of the company and to force Ackman’s hand. Their buying activity forced the share price to rise instead and, so far, cost Ackman hundreds of millions of dollars. The trade is no longer about accounting information or the legality of the underlying business model.
The Credit Research Initiative (CRI) is a non-profit project at the National University of Singapore. It’s part of the Risk Management Institute at NUS and its goal is to promote unbiased and objective credit risk research. The main output of CRI is a model of the probability of default (PD) of corporates, developed using a database of about 60,400 listed firms in Asia Pacific, North America, Europe, Latin America, the Middle East and Africa. Individual RMI Probabilities of Default (RMI PDs) are used to develop a Corporate Vulnerability Index (CVI). That’s a bottom-up measure of credit risk in economies, regions and portfolios of special interest that is, unlike the commercial credit ratings agencies, driven by pure data versus fees.
Mark Maffett of Chicago Booth and his colleagues Edward Owens of the University of Rochester and Anand Srinivasan of the National University of Singapore looked at the CRI data and wondered whether the presence of pessimistic trading—short selling and the use of put options and credit default swaps—might influence how well market participants in several countries are able to accurately assess a company’s likelihood of default.
Their new research paper, “Default Prediction Around the World: The Effect of Constraints on Pessimistic Trading,” uses the CRI data and publicly available information about the laws in several countries regarding pessimistic trading to examine cross-country differences in the ability of market participants to accurately assess a firm’s likelihood of default. This research could not be more timely or important given recurring market concerns about the impact of short selling on prices.
Although short selling is legally permitted (in some form) in most countries, according to the researchers, significantly fewer markets commonly practice it. “Naked” short selling—selling short without having the shares available for delivery and intentionally failing to deliver the shares within the standard settlement period—is generally illegal and recognized to be detrimental to smooth functioning of the capital markets.
Chicago Booth’s Maffett and his colleagues come to three key conclusions in their paper on the market and social value of “pessimistic trading.” The accuracy of the RMI model in predicting corporate defaults improves, on average, in countries where “pessimistic trading” such as short selling is not prohibited or unnaturally constrained. When short selling constraints limit the extent to which prices reflect publicly available default risk information, model accuracy also improves if accounting information is incorporated in the default prediction model.
Policy makers are most concerned about the impact of short selling on prices when there is economic uncertainty. During the financial crisis some banks and investment firms blamed short sellers for what they believed was a disconnect between company fundamentals and share prices leading to quick downward price spirals in some issues. The Securities and Exchange Commission actually issued a temporary ban in September of 2008 on short sales of 799 financial stocks, according to the New York Times, because of widespread fears that traders “sought to profit from the financial crisis by betting against bank shares.” Many other countries followed the US lead then and again when their economies were distressed.
The researchers found that during periods of heightened macroeconomic uncertainty the model may unfortunately misidentify some companies to be at risk of default that will survive. But the research still concludes that fewer short selling constraints consistently leads to more accurate identification of actual defaults.
Efficient markets come with tradeoffs.