Why lend to a shorty?

Following on from my last post I now want to explore the murky world of short selling.  I think the principle of how short selling works is pretty straightforward, in a few words it is taking a bet that the value of an asset is going to go down.  The short sellers (shorties or shorters?) borrow the asset from an owner and sell it with the expectation that they will be able to buy it back more cheaply and return it to the lender,  the shorter makes money by pocketing the difference.  Wandering around the blogoshpere you can find numerous more detailed explanations than this, you can also find plenty of people who think that shorters are evil incarnate.  I’m not sure entirely agree with them as it seems to me that if you honestly believe an asset is overvalued you are applying market principles by betting it will go down.  Of course if you short a stock by starting dodgy rumours then you are morally bankrupt and deserve all you get.  But I am not really interested in the shorters motivation, that is obvious as they stand to make a lot of money out of the transaction if they get the bet right, what confuses me and it seems lots of other people is why would the owner of an asset lend it to someone who is trying to make sure it goes down in value?

There seem to be a number of transparent reasons why the lender would provide the service including either they are paid a fee and/or can get some short term cash.  Both of which are very plausible but I feel like I am missing something because although the fee and cash means you are making money out of what is probably an inactive asset you are allowing someone else to potentially destroy a substantial part of the value of that asset.  According to the information on the International Securities Lending Association suggests that a ‘typical’ trade might look something like this,

A shorter borrows 100000 shares at £10/share, giving a loan value of £1M.

The lender might expect to earn a profit in the order of 5% on the loan so if the transaction lasts a month they  could earn 5% * 30/360 * £1.05M = £4300 (approximately).

This all seems straightforward except if the shares are shorted by the borrower and drop by 10% the lenders asset is now worth 10% less or £100,000.

And it’s this discrepancy that I can’t understand, it could be as simple as the lender not knowing or paying attention to who their assest get lent to – but this would be dissapointing.  Or more likely there is something I have missed about how this all works becuase it doesn’t seem like good business on the face of it.

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One Response to “Why lend to a shorty?”

  1. erewhon Says:

    Two alternatives off the top of my head, possibly demonstrating my naiveté:

    1. The owner of the shares has no intention of selling them anytime soon.
    So they’re worth less on paper. Not a problem, if the price loss doesn’t affect the ability of the company to generate dividends – the real prize.

    Assuming possible foul play on the part of the shorter:

    2. The owner is happy for the price to go down, as they want to buy more shares and consider the current price too high.

    The deal is even sweeter if any losses can somehow be offset on a balance sheet.

    What do you think? It’s manipulative, but less direct than typical insider dealing.

    Oh, here’s another, slightly weirder one:
    3. the current owner stands to make a packet/get a critical share of another company if there’s a merger, but the price is just a bit too high right now for the deal to go through…

    Give me a minute and I’ll think of another evil use for evil shorters 🙂

    Cheers

    (arrived via fleshisgrass – another great blog 🙂

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