September 19, 2008 / 11:53 PM / 11 years ago

Morgan Stanley, Goldman love shorts...and hate them

NEW YORK (Reuters) - Morgan Stanley (MS.N) and Goldman Sachs (GS.N) blamed short sellers for their problems this week, an interesting twist for two investment banks known for making money from short sellers and even betting on weakening shares themselves.

Shares of Morgan Stanley and Goldman took a real beating in the middle of this week. The market activity seemed to threaten Morgan Stanley’s survival, forcing the investment bank to consider selling itself. If Goldman’s shares had fallen long enough, it could have looked at similar measures.

But while pursuing capital, Morgan Stanley Chief Executive John Mack also lobbied the government for relief, which arrived on Friday, when the Securities and Exchange Commission took the highly unusual step of banning short-selling in 799 financial stocks, including Morgan Stanley and Goldman.

The overall market cheered the move, but some investors were not pleased.

“I did not hear the big Wall Street banks complaining until short sellers began shorting the financial stocks,” said Harry Strunk, partner at Treflie Capital Management, which invests in hedge funds that short, among others.

Morgan Stanley and Goldman Sachs believe there is a difference between the shorting of their shares, and the shorting they facilitate for clients.

Both banks believe they are the victims of “bear raids,” where short sellers gang up on a stock to try to push its shares lower, rather than having a considered investment thesis. Short sellers bet a company’s shares will drop.

“What’s happening out there? It’s very clear to me — we’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down,” wrote Morgan Stanley CEO John Mack in a memo obtained by Reuters on Wednesday.

Conspiring with other investors to manipulate a share price is illegal, as is knowingly spreading false rumors to move a stock price. But so far no evidence has emerged publicly that any such thing has happened.

Some hedge funds believe that Morgan Stanley and Goldman were not victims, but were instead legitimately reevaluated by a world where investors are increasingly skeptical.

“We get very little disclosure from investment banks about their positions, and when savvy banks looked inside Bear’s and Lehman’s kimonos, they didn’t like what they saw,” said James Ellman, president at hedge fund Seacliff Capital. “It’s rational to lose faith.”

A spokesman for Morgan Stanley said the bank has been fully transparent about its mortgage-related exposures and has broken out the write-downs it has taken on each asset category within its mortgage business.

Skepticism about investment banks has run high for some time, reaching a fever pitch this year as Bear Stearns faced a run on the bank, Lehman Brothers filed for bankruptcy, and Merrill Lynch & Co MER.N agreed to sell itself to Bank of America Corp (BAC.N).

Short sellers are key clients for Goldman and Morgan Stanley, but quantifying their importance is difficult.

There are some clues as to the importance of short sellers to both firms. Morgan Stanley and Goldman are top firms in prime brokerage, which entails trading and financing securities for hedge funds, including helping them short.

Advisory firm TABB Group estimated earlier this year that prime brokerage in the United States alone would generate $11.5 billion of revenue for banks. The group surveyed 61 hedge funds with an average of $4.3 billion under management, and more than half had a prime brokerage relationship with either Goldman or Morgan Stanley or both.

OVERSTATED ASSETS

Faith is in short supply after Lehman Brothers Holdings Inc LEHMQ.PK filed for bankruptcy on Monday. That investment bank had sparred for months with short-sellers who accused the firm of understating its bad assets, even as Lehman said it was strong.

The short sellers turned out to be right — last weekend, prospective buyers that scrutinized Lehman’s books refused to buy the firm because there were too many toxic assets, according to people familiar with the matter.

Morgan Stanley and Goldman have successfully fended off short sellers for now. Their shares surged 20 percent on Friday.

And ticking off some of the short-selling clients may be a small price to pay, said Brad Alford, president at investment advisor Alpha Capital.

“Hedge funds are getting nailed today, which will hurt Morgan Stanley and Goldman Sachs, but at least their shares won’t go to zero now,” Alford said.

Additional reporting by Svea Herbst in Boston and Michael Flaherty in Hong Kong; Editing by Gary Hill

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