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The New York Times - Business

By LOUISE STORY
Published: September 14, 2008

In May, David Einhorn, one of the most vocal short sellers on Wall Street, made no secret he was betting against Lehman Brothers. Now, some investors are afraid that fund managers like him will take advantage of the climate of fear stirred up by the troubles of Lehman to single out other weak financial firms whose declining share prices would bring them rich rewards.

At emergency meetings over the weekend, the heads of major financial institutions urged Timothy F. Geithner, the president of the New York Fed, and Treasury Secretary Henry M. Paulson Jr., to consider having the Securities and Exchange Commission reinstate a temporary rule to limit the risky but potentially lucrative practice of betting on a firm’s falling share price, according to two people who were briefed on, but did not attend, the meetings.

They are concerned that short sellers might fix their gaze on other big financial institutions. But Wall Street may be breathing easier after one company frequently mentioned, Merrill Lynch, began advanced talks on Sunday to sell itself, and another, the insurance giant American International Group, moved toward a restructuring in an effort to strengthen its financial position.

In July, the S.E.C. briefly halted a practice known as naked short selling after speculators placed large bets that shares of Fannie Mae and Freddie Mac, the troubled mortgage giants, would decline. That also made it harder, though not impossible, to short the stocks of 19 financial institutions, including brokerage firms like Lehman Brothers and Morgan Stanley.

The investment tactic of betting a stock will slide is not new, of course. But it has become particularly controversial in the last year, when Wall Street firms started to be singled out as the credit crisis turned the financial sector upside down.

Short sellers and their free market supporters say they have done nothing wrong. If anything, they say, they have merely spotted problems at financial institutions ahead of everyone else, making them a useful early warning system for the rest of the market. Critics believe they have contributed to the speed of the decline of any number of financial shares.

Short-selling against financial institutions has proved particularly lucrative for hedge funds. Mr. Einhorn’s accusations included a complaint that Lehman had been failing to properly account for its marks on troublesome holdings.

Lehman’s shares were already under pressure when he took the microphone at a large industry gathering in May to lay out his case against the investment bank. The firm, he told the crowd, had used “accounting ingenuity” to avoid large write-downs and remained tainted by bad commercial real estate investments.

Mr. Einhorn stood to profit by convincing people of his view: He had been betting against Lehman’s stock — it stood at around $40 when he spoke — since July 2007, when it traded for around $70.

While Lehman’s shares have declined as investors lost confidence in its ability to repair its balance sheet, in the four months after Mr. Einhorn’s remarks, short-selling played a role in the erosion. A rapid plunge in the shares to below $4 last week created the conditions that brought the 158-year old firm to its knees on Sunday.

For all his boldness, Mr. Einhorn is aware of the havoc that bank failures can create. “We would not win if Lehman went down and took the whole financial system with it,” Mr. Einhorn said in an interview in June. “An actual collapse of Lehman — that would not be a good thing.”

Other hedge fund managers recognize the dangers and the harm that is befalling bank employees who have been paid in their companies’ stocks. “My children, their playmates’ fathers work at Lehman,” said one manager who is short Lehman and asked to remain anonymous, citing the fragility of the situation. “Obviously I had nothing to do with what happened, and the idea that I profited, and they got clobbered, and I’ve got to see them on Monday is awkward. I feel badly for them.”

Mr. Einhorn was never shy with his criticism of Lehman. He pointed to the bank’s investments in two real estate companies, Archstone and Sun Cal, and said Lehman had not marked its mortgage assets down enough. “Lehman is one of the deniers,” he said in the June interview.

To many, Mr. Einhorn simply saw the writing on the wall early. And, hedge fund managers say, Lehman executives failed to realize how much credibility Mr. Einhorn has in the investor community. Lehman might have fared better if it had raised capital or taken write-offs far earlier, as Mr. Einhorn suggested.

But to some in the world of finance, Mr. Einhorn and investors like him are dangerous.

“It is really like taking a baseball bat to someone who is down,” said Jim Hardesty, president of Hardesty Capital Management in Baltimore. “A bunch of these guys with very large bats are circling around certain companies and banging them over and over again. It is unsportsmanlike conduct.”

“My worst nightmare would be waking up one day and listening to David Einhorn talk about our company and wanting to short myself,” said Larry Robbins, chief executive of the hedge fund Glenview Capital, as he started his own speech at the May conference, the third event that included Mr. Einhorn’s criticisms of Lehman.

Hedge fund managers who focus on shorting companies stand out in the industry in an otherwise terrible trading year. Hedge funds are down more than 4 percent but short-focused hedge funds are up 9.76 percent, said Hedge Fund Research.

By coincidence, Mr. Einhorn’s fund, Greenlight Capital, is down 4.3 percent this year through Aug. 22, according to HSBC (he also invests in stocks, as well as shorting them).

His is a so-called long-short fund, which means he invests $2 buying shares in companies for every $1 he places shorting other companies. One company he took a positive view on was New Century, one of the first mortgage lenders to file for bankruptcy.

Mr. Einhorn said in June that he receives far more criticism for his short positions than he does for the positive bets he makes, which he also sometimes discusses publicly. And, he said, executives at companies are biased in the views they provide because they own so many shares of their companies’ stocks.

Mr. Einhorn declined to comment for this article and a spokesman would not say if he was still short Lehman’s stock or on what day he sold his position.

Eric Dash contributed reporting.

A version of this article appeared in print on September 15, 2008, on page C1 of the New York edition.