Ep17 “Can The Free Market Discourage Fraud?” with Marc Cohodes

foreign [Music] Burke professor of Finance at The Graduate School of Business at Stanford University and I'm Jules van binsbergen a finance professor at the Wharton School of the University of Pennsylvania and this is the all else equal podcast alright welcome back everybody in today's episode we're going to talk about short selling regulation and before we dive into the specifics of Short Selling it's probably a good idea to first talk about what is it about regulation that we see it fail so often and makes it so hard what do you think Jonathan well you know Jules when the 2008 crash happened it was all this regulation I couldn't help but think what were the legislators passing the regulation thinking were they just thinking well the reason the regulation didn't already exist as the past Regulators were just not as bright as they were that these new Regulators they understood the world much better and they're going to pass these new laws and then there was never going to be another crash and you know I think that's a pretty naive view because if you look in history you'll find that after every crash legislators tend to pass a lot of legislation and then we have crashes again yeah so in many ways they think the problem is that Regulators who are just spending effort regulating the previous crisis in the theme of our podcast I think that regulating the previous crisis and thinking that it will never happen again is an all else equal mistake if it was so easy to make sure it would never happen again then why has it happened so many times in the past after the 1929 crash there was a lot of legislation passed and that didn't seem to work and why is that and so I think for that reason the next Crisis that we're facing is almost by definition going to be through things that you didn't regulate the last time because of the regulation that you pass you're changing people's behavior because they are changing your behavior in response to the regulation that you put in place and that changed Behavior May in fact contribute to the occurrence of the next crash so yes you may have prevented as exactly similar crashes you had the last time but what about all the other things that you've changed that may actually increase the probability of a different type of crash or crisis in the future yes Jules I would say it's a classic all else equal mistake they passed regulation for the current world assuming the world isn't going to change but of course the world changes and in particular World changes in response to the regulation and so the new crash looks different to the old crash precisely because that regulation is passed it's a dynamic game between regulators and The Regulators The Regulators Parts regulations of the people who are being regulated now can't do what the legislation says so they actively search for other things to do and their behavior changes and so we need to think about is there a better system can we set a set of rules in such a way that the market does the enforcement for you to the largest extent possible so you don't have to interfere with it the whole time exactly so as you've already alluded to the point is you need to design a system that dynamically changes in response to the Chinese Behavior by allowing Market forces to act since those are always reacting to current situations it automatically adapts and so today what we want to talk about is one of the most effective Market systems and that's the ability short sale a short sale is selling a share of stock that you do not own and I think at this point it's fun to go through how I used to explain this to undergraduates how can you sell something you do not own and so my fun little story went like this I would say to them okay guys your next name is going on vacation and you there's a chair in your master neighbor's house that you've always liked and you take the chair out of their house and you put it in your house now your next baby's on vacation they don't know that the chair is gone nobody misses nobody is worse off and so long as you replace that chair in exactly the same condition as it was before they left no harm is being done and that's essentially how short something works now what happens when your next door neighbor comes home you've got to make sure that that chair is still there but let's say wait a minute do you want the chair in your house well you don't actually have to replace the chair that came out of your next door neighbor's house if you can find somebody else's house who's on vacation and take that chair exactly the same chair and put in your next door neighbor's house no harm is done and that's the analogy for stock so what you do is I say have a share of stock in my account I give it to somebody so they borrow my share of stock and so long as whenever I need that stock it's replaced in my account I don't care and so the two places where I might need to start anytime I wish to sell the stock the person that's borrowed has to give the stock back to me or if the stock pays a dividend the person who borrows it must make up the dividend for me but subject to those conditions it doesn't matter and so there's a market out there for borrowing stocks I really like the furniture example that you gave Jonathan so there's something else that I can do with the chair if I think that the chair is too expensive in the marketplace right now and your neighbors on vacation anyway can you not just take the chair sell it on the market for the high price what you hope for is that before your neighbor comes back the price of the chair is dropped you quickly buy it back from the market you put it back in your neighbor's house and then you've made a profit off the fact that the price of the chair just dropped and your neighbor never really noticed a difference in fact we don't have to be so secretive about it right Jonathan you can just tell your neighbor can I borrow your chair and pay you some convenience fee for using it and then do the exact same thing right in reality with stocks you just go to somebody and you say can I borrow your share and in you don't opt to pay anything because if there are lots of people not using their chairs there'll be a big supply of these chairs for sure right yep okay so now we understand how you could borrow the chair and sell it and your neighbor will never miss it and you can make money if the chair goes down so how does that translate into stocks well so suppose that Tesla is a stock that you think is overvalued and it's trading at way too high a price now how could you benefit from that high price how could you bet on the price going down well the first thing you need to do is borrow the stock and so I come to you Jonathan you run an index fund and you have tons of Tesla shares anyway lying around and I say to you Jonathan can I borrow the Tesla stock from you and you say sure here's the stock and what I do with the stock is I go to the market and I immediately sell it so that I get the money from the stock now I've agreed with you that I returned a piece of paper that is the stock of Tesla to you in a year from now and what I'm hoping for is that in that year the price of Tesla will go down so that I can buy it back from the market a year later at a much lower price you will never notice the difference because you had the same piece of paper in your hand before and after I've made money from the fact that the surprise for Tesla has gone down and Jules you use the year as a example but it could be any period of time if I don't need to start up for five years you can keep it for five years if I need to start the next day though you have to give it back to me and the way you do that is you find somebody else and you borrow the stock from them and you give me the share of stock or you buy it back in the market it's up to you it's exactly like when your neighbor comes back from holidays earlier or later when you find another chair the exact same thing is true with the shares that's basically how stocks work right when a short seller wants to sell a stock they borrow the stock from somebody they sell the stock with the idea that the stock will go down in price and when it goes down in broth I buy it back and return the sheet and they make a profit of course if the stock does not go down it goes up you lose a lot of money because you have to buy back the stock at a much higher price I mean if you buy a share the worst thing that can happen is that the price goes to zero but if you're sure the share then you know it can go up to really high levels and you can lose and it's a potentially infinite amount of money so it's a very dangerous activity but it still allows you to bet against a stock now why is that a good thing well I think the first thing that we need to recognize is that prices serve an important role in the economy because stock prices give us signals about what activities are valuable and what activities are not so valuable and the stock price of the firm tells us exactly how valuable Society thinks a particular activity is and so if a particular activity is overvalued say the price is too high that gives the wrong signal to other agents in the economy wouldn't you want somebody to step in and fix that problem and that's what a short seller does it's a dynamic form of Regulation so let's imagine you have a company where there's fraud going on and the people committing the thought are really smart all the accounting rules that are in place for the purpose of detecting fraud they make sure all look good because they figure out a way to commit the fraud without it coming out on the accounting statements so if you just rely on regulation the floor doesn't come out but let's say you allow Short Selling and let's say they have a particularly smart short seller who can see through the fraud that short seller will say to themselves look I can make money here because eventually the forward's going to come out so if I short sell the stock I can make money and in fact the ability for that short seller to make the money is the motivation to do the research into which firms are committing fraud to begin with so if you want to have a market disciplining Force where people can benefit from detecting fraud you want to give them an incentive to go after fraud so suppose that you would say let's stop Short Selling altogether we're going to ban it that means that you're taking away the incentive for people to try to discover fraud and fraud us we can all agree is a bad thing that we need to try to prevent yeah I mean what's fantastic about the system is it is a system that automatically adjusts because you've set up the incentives for somebody to look for fraud once you've short sold the stock your incentive now is for the stock to fall in price and that occurs if the fraud comes out so not only are you going to sell the stock but then you're going to publicize what is wrong with the company yeah you have an incentive you have an incentive to bring the fraud out into the open and that is a very very effective way to discipline companies couldn't agree more I think that's one of the most misunderstood things about this we spoke earlier about the risks involved in Short Selling you can lose an unlimited amount of money which tells you that when somebody chooses to short sell they really have to do their due diligence remember most stocks rise in price because it most companies are not fraudulent they make money so when you bet against the company you're kind of betting against the tide and so you really have to be careful and you have to do your due diligence so even in that situation when somebody decides to short sell that is a big signal and we should certainly encourage that behavior and it certainly it can be very effective too right I mean if you see how companies go out of their way to prevent Short Selling or how much they're trying to discredit the motives of the person that is doing it I think it's clear that companies do not like this but you know sometimes it's just necessary and companies deserve to be exposed to it so Jules I think this is a good time to introduce Our Guest what are the most notorious examples of short sellers finding out about fraud long before The Regulators figured out the fraud was wirecard I think the wirecard example is a great example Jonathan because people even try to co-opt the German government to ban Short Selling so that wirecard wouldn't be exposed to these short sales and as I think what we're going to hear is uh how effective the short selling has been and how important it was a guest today is a veteran short seller Mark CODIS welcome Mark to the show and thank you so much for being here yeah thanks for having me where we'd like to start is wirecard and the circumstances around there so can you give us some background about why I called and how you figured out that it was a fraud and how you took advantage of that wire card is something like I've never seen before I mean I knew all the players involved in wirecard and I was always watching I knew Dan mccrum forever I knew Fraser pairing a new Fami khadir I knew all the people who worked on wirecard sort of for years and years and the story was great I mean the people had wirecard figured out as a fraud the problem was the German regulators including the guy who is now the new chancellor who was the Finance Minister they were all in on it and was in on it and the company used extreme tactics to quiet the Skeptics I mean I think at one point they got a hold of Fraser pairing and shoved them in a trunk of a car to scare the living out of him they had macrame you know the writer for the Ft followed and I spoke out and I said this just can't be and you can't threaten the Free Press or the people who speak truth to power otherwise this stuff will never come out in the open so then I grabbed a baton started going after and simply explaining what was going on so mark So when you say that these people were in on it do you mean that they were just invested in it and believed in it or you mean in on it they were aware of the fact that this was a fraud I think it's all of the above I mean I think at the end of the day there's so much money involved everyone is co-opted I mean it was obvious that this thing was a complete scam all you had to do was check the account so I think the German government's complicit I think Olaf Schultz is complicit I think Baffin is complicit with their short sale ban they went after shorts for no reason and no one's ever said they're sorry and no one's ever said they really got it wrong and no one ever said we have to learn from this and no changes have been made just to fill our listeners in uh what the German government did was when they banned Short Selling in wirecard to try to stop the short sellers there they banned Short Selling in a single stock which I'd never seen before I've seen it a short sale ban on an industry I've seen Short Sale ban in general but I've never seen it on a single stock and to take such action in the face of significant questions you know to me puts everything in into question and nothing's changed that's the terrible part of this whole thing is nothing's changed no one's learned a lesson no one's put systems in so this wouldn't happen again no same thing with FTX I mean if you uncover something that's rotten to the Core in a healthy system you fix it or you should fix it or you should take steps so this doesn't happen again I mean I'm sure guys were paid off I'm sure guys had stock I think it came out that people in Baffin were trading wire card stock it's like the politicians here are trading stocks in front of bills and in front of legislation and in front of knowing things with covet there's a huge failure of disclosure there's a huge failure of right or wrong and if you're a regulator to completely fail and to completely look the other way and completely screw it up is to me not okay and so Mark tell us about the risk you took shorting wire card because you know there was this company you were showing the company clearly company was a fraud there were various forces hiding that fraud and you had to sit there with a short position waiting eventually for the fraud to come out so that was a pretty risky position for you yeah I don't mind taking risk and I don't mind shorting stocks I have a huge genetic defect that I actually enjoy doing this or you know I've done this for a very long time but yeah there's rest I mean the the real risk here that drove me crazy is the stock was so separated from reality when all this was going on including their offices getting raided the stock still traded it north of 100 euro and it not only traded north of 100 euro there was a story that their offices were rated it went down 15 percent and closed the day flat so clearly the stock was manipulated the question is by who and when you're short of manipulated stock it always makes them more difficult because the fundamentals which should Rule the Day don't rule the day which makes it very frustrating and more dangerous but I don't mind danger in this I've been doing this for a very long time so I've seen a lot of stuff and it's not the first time something was highly manipulated I was short learned out in house B which up until recently was the largest fraud in Europe that I exposed and that had similar tactics but once wirecard broke the money that I made on the short side was I kept shorting it on the way down no matter what the price was I mean I shorted it anywhere from 86 when it resumed trading down to 19 and it went to uh single digit Euros it went down to cents actually you know it's you make all your money in a very short period of time but you have years and years of frustration it's a mental game so Mark to take a step back why do you think it is that short selling with the public has the bad reputation that it has where do you think that bad reputation comes from that's a really good question and it's a multi-prong answer certain of people who short stocks are Bad actors or bad operators where they put out a story to get people scared so they sell the stock what people would call short and distort or I call these Smash and grab guys who put out articles or blogs or whatever and they write all this crazy stuff about a company they get people scared the stock goes down they cover it the same day those guys I can't stand so those guys I think give people a bad rap two people like me who who don't really exist anymore go after these bad companies and sometimes if it takes years it takes years months whatever and you get the job done and exposing it so you have no natural allies no one's you're a fan the company hates you analysts hate you guys go on the stock hate you the retail hates you and I call it really in general messenger shooting they don't listen to the message they'd rather shoot the messenger and shoot the messenger to just credit me or someone who has the story and people don't want to listen to the message I mean if you two are perpetrating a fraud you would rather poke fun at me than have my story come out and you're not going to say this guy's right because the money involved here is huge people with real money want to see stocks go up they don't want to see things in general go down and if you bring things up and you expose things as fraudulent or corrupted or people on the take it gives people less confidence in the system they don't want to hear from me I mean Twitter has me shadow banned and she has me search blocked on everything FTX and SPF related right now if you go on Twitter and search me and search SPF and search FTX you'll find nothing they have all my tweets and blocked because someone got to somebody and said you can't have this guy speaking out they can't block me on what I said but they're limiting on who can see what because I have journalists going back and saying they can't find my tweets and someone looked at it they have me shadow banned and they have me blocked and they have me search blocked you know by and large it's a dangerous ass game I mean I expose this fraud in my medics which happened a couple years ago and the CEO bribed the senator and got the FBI to come to my house and tell me to quit tweeting and quit talking about it and the FBI told me in front of witnesses if they have to come back there's going to be consequences and that's been publicized and the CEO of my Medics was indicted and he went to prison and the whole thing wouldn't have happened if it wasn't for me speaking out so I've been investigated I've been threatened I've been bullied I've been pushed around you know the whole thing and not once on this visible stuff that a I've been wrong or B I've been investigated plenty of times but no one's ever had anything on me and I'm 62. it is puzzling to me that linking people in in high positions don't fully appreciate how important having a vibrant Short Selling sector is to keep the economy honest and keep the lip playing field level I agree I think one of the problems is the guy setting the rules are politicians and people who take you know an extraordinary amount of money from interest other than skeptical forces they take huge money from Citadel and even FTX to keep things status quo and or make things more difficult for me or people like me than need be because if you listen to me the X goes from 32 billion to zero so a lot of people lost on that a lot of people are pissed off but when I warn people of FTX a lot of people took their money out of there and good thing they did otherwise they would have had nothing they would have lost it all and they think that especially with FTX that this is an outlier and people are still apologizing for them I mean how this guy is not locked up is a miracle to me but he's not he he's definitely gonna get locked up that's certainly gonna happen but the extent to which the fraud comes to light sooner protects people more and so Mark's absolutely right the SEC could do much more work and I don't expect them to have a parade for me I don't expect anyone to say what I do is great but I should at least be allowed to be left alone and not be hassled constantly there's a lot of problems in this but you know the trick is to get the solution and get a solution that can actually stick well Mark thank you so much for coming on the show well let me know when it comes out and I'll try to spread it around on Twitter if I'm not Shadow banned from that but no static guys keep up the good work YouTube thank you so much this episode concludes this season of the all else equal podcast and I don't know about you Jonathan but I think we did not expect that things would go as well as they did we recently reached over 120 000 listens across all platforms so we want to thank our listeners and particularly our repeat listeners for consistently tuning in to the show if you're a new fan of the show Please Subscribe and leave us a review on Apple podcasts we have a very exciting new season coming up in January so Jules you know 10 months ago when we started this if you told us we would have had 120 000 lessons I think we would have been very excited the podcast certainly has exceeded our expectations and that's great no next season we're looking forward to doing what we've been doing up to now which is talking about Better Business decisions thinking about less obvious mistakes that people make and New Perspectives on mistakes that people talk about one of the things we'll be talking about is digital currency and price bubbles it's on the Forefront of the news of many people's thoughts and finally another topic that's been of Interest especially to the two of us which is how do you tell when it's worth investigating an implausible Theory when you're in business obviously it's the implausible theories that turn out to be correct that give you in a competitive Advantage but you can't investigate all implausible theories because most people turn absolutely wrong and so the question is when is it worth investigating any plausible Theory so those are some of the topics we'll be talking about in the new season in January and thank you all for this please leave us a review at Apple podcasts we love to hear from our listeners and be sure to catch our Next Episode by subscribing or following our show wherever you listen to your podcasts for more information episodes visit all elseequalpodcast.com or follow us on LinkedIn the all else equal podcast is a production of Stanford University's Graduate School of Business and is produced by alumni FM foreign

2022-12-11 12:28

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