I'll gladly pay you Monday for a gigantic profit on Friday.

September 22, 2008 9:15 PM

Why do the lenders give short sellers the stock?

So there has been much talk over the past week or two about short selling. As I understand it, two parties are involved, provided we are talking about regular short selling and not naked short selling. Person A (Andy), calls up Person B (Bill) and asks to borrow some stock for the week. No problem says Bill, just pay me $5 and have the stock back on my desk by Friday. Andy goes out and sells the stock right away, getting $100. Friday rolls around and sure enough, partly due to Andy selling his share(s) and driving down confidence in others, the stock is only worth $20. Andy buys back the stock and delivers it back to Bill's desk, along with the $5 he agreed to pay for borrowing it. He sold it for $100 and bought it back for $20 so he makes $80 - $5 in commission for a total of $75 profit.

My question then is, why on earth would Bill lend out this stock in the first place. After all, he ends up holding a stock on Friday worth much less than it was worth on Monday. When he saw the price dropping on Wednesday, he couldn't do anything about it because he didn't even have the stock to sell if he wanted to. In particular, I have heard that many of the people lending out stocks are mutual fund managers who have large portfolios of many stocks. It seems like there is a huge conflict of interest here because the manager should want to see his fund go up and by lending out his stock to shorters he is driving down the price of the very stocks he is supposed to be managing when some hedge fund borrows thousands of his shares, screams "Sell, sell, sell" on the open market and the shares tank.

posted by sophist to work & money (9 comments total)

Bill is betting the other way.
posted by Fuzzy Skinner at 9:22 PM on September 22, 2008 [1 favorite]

First of all a person long a stock that has allowed it to be hypothicated can still sell it long. It is up to his prime broker to get it back and deliver it. A brokerage firm cannot lend out a customer long if it is fully paid for in cash. If the customer is on margin, the broker can lend out the long. Lending a long raises cash for the broker.

If you have done your homework and think a stock is worth $XXX then why would lending it out make it worth any less. In fact you might think that it would go up by lending it because the short would have to buy it back presumably higher because you purchased it undervalued to begin with.

When a stock drops, the people who purchased on margin are forced to sell. When you borrow money to buy an asset and the value of that asset is worth less than the cash paid, you either put up more money or sell and pay the difference.

A portfolio manager lending his stock makes very good return on the cash he gets in. He can either invest it or use it to lever his position.
posted by JohnnyGunn at 9:38 PM on September 22, 2008

Person B is the owner of the stock, but it's the brokerage that is doing the lending. The broker gets interest on the loaned stock. You can't really decline consent to have your shares lent out to people who will short them. If you go to sell shares that have been lent to someone else, the brokerage can force the borrower to 'cover', that is, buy the shares on the open market and give them back to you. As far as I know, that doesn't often happen. The brokerage will just lend them to the seller from someone else's account. It's all transparent to you.

It is true that the owner of the shares doesn't have any incentive to lend them out to be sold. All it does is increase the number of shares on the market. Them's the breaks. The brokerage will do it regardless because they make money on it.

If, like on Friday, the market is going way up, short sellers worried about rising prices might cover. The increased buying by short sellers, and the effective shrinking of supply can exaggerate the upward movement of the stock. (Look at Citibank on Friday, up more than 20%) In this case, the 'short squeeze', as it's called can give the price some upward momentum. The knife cuts both ways. Shorting is generally riskier, as your potential return is at most 100% (stock goes to zero). Your potential return is more than 100%, if the stock price more than doubles. Also, the broker can make a 'margin call' and force you to cover if your account is overleveraged. You're paying interest on the borrowed stock as well. Shorting is generally a short term strategy.
posted by thenormshow at 9:54 PM on September 22, 2008

For the extra yield. Imagine an index-following endowment (which are huge sources of short locates) that is not selling anytime anyways; they get to increase their yield.

For an SP500-following fund it might add a percent or so. For more exotic stocks it can get truly nutty with borrow costs in the 20-30% not uncommon. Yes, its like an extra 20-30% dividend on the stock. Of course, these are only for the most sought after shorts where there is generally something really wrong. You can think of it as stock yield + locate yield ~= bond yield, ie a distressed company's debt can easily trade at levels giving it 20-30% yield.
posted by H. Roark at 9:59 PM on September 22, 2008

Your story has a number of awfully large leaps of faith, but the incentive for a portfolio manager to lend stock is securities lending programs. They let investment managers collect fees for lending their shares. Some of it goes back to the fund and the company running the program keeps the rest. If you don't like it, you need to start demanding more from mutual fund boards (which are some of the phoniest institutions in America - read The Investor's Dilemma).

* - Example: iShares Emerging Markets (PDF): "Pursuant to an exemptive order issued by the U.S. Securities and Exchange Commission (“SEC”), the Fund is permitted to lend portfolio securities to Barclays Capital Inc. (“BarCap”).... As securities lending agent, BGI receives, as fees, a share of the income earned on investment of the cash collateral received for the loan of securities. For the six months ended February 29, 2008, BGI earned securities lending agent fees of $11,157,507."
posted by milkrate at 10:33 PM on September 22, 2008

Everything said so far, plus the following wrinkles:

Person B might be hedged anyway: perhaps he owns a put contract on his stock to protect his losses in case of sharp declines. In order for a market maker to sell person B such a put, he (the market maker) often needs to be able to get short the stock. Hence: this short selling ban is some shameful shit.

Please realize that while person A is short, he has to pay any dividend issued by the company in question.

If you own stock in a margin account (as opposed to a cash account) with a broker, then your stock is borrowable by short sellers. You will not see a penny of interest from this, nor will you know when/if your stock has been borrowed. You may sell at any time; your broker will borrow back shares for you to sell if your stock is indeed borrowed. What's your incentive? In a margin account, you can buy stock with borrowed funds (on margin) or short stock yourself, and likely earn interest on a cash balance.
posted by fatllama at 2:57 AM on September 23, 2008

Please realize that while person A is short, he has to pay any dividend issued by the company in question.

But the price of the stock goes down by the amount of the dividend (ceterius paribus), so for the short seller, it's really a wash.
posted by JackFlash at 11:53 AM on September 23, 2008

Some pension funds lend their stocks for this purpose. Let's say the pension fund is not interested in short-term volatility in the market; it's holding onto the stock for 10, 20, 30 years to make a profit over the long term. Lending the stock out in the interim is a way to profit from short-term volatility.
posted by bananafish at 2:01 PM on September 23, 2008

Agreed- the stock lender is doing it because he wants the extra money. The choice is-

a- hold an asset and leave it alone.
b- hold an asset, retain all the benefits of ownership, and make an extra $5 with no added risk.
posted by gjc at 7:27 AM on September 24, 2008