Short sellers are usually hated by everyone—general public, politicians, regulators, etc. Who would like someone who profits from loss in value of assets held by others? The more the loss in value, more is the profit for the short seller. I guess the worst opinions are reserved for the short sellers who betted against rising housing prices and thus profited enormously from the fall in the housing market. When millions feared to be homeless, the short sellers who bought the credit default swaps (CDS) on those housing mortgage backed securities (MBS) and collatarilized debt obligations (CDO) made billions. So why should anyone like them?
This is the same reasoning that we see day in and day out in the popular media and on blogs when the topic of the discussion is John Paulson—the hedge fund manager of Paulson and Co. I, however, take a different view. It is true that I don’t have any specific argument for the social benefits of CDS. In fact, CDS has, by design, a great potential to induce moral hazard among its buyers. It is exactly like buying insurance on the asset that you don’t own. But, given that this is legal, John Paulson did not do anything that broke any law. He bought CDS on the CDOs he thought were going to fail for sure and that is even today not illegal.
Short sellers are required for markets to be efficient. I don’t know whether the same argument can be made for the CDS buyers, however. It is still not clear whether the John Paulson and similar bearish investors made the housing markets more efficient. But before we claim that Paulson was responsible for the collapse of the housing market, it should be understood that Paulson did not make the subprime loans, nor did he rated the CDOs. I can understand the anger if he bought the CDS on the CDOs of the mortgage pools with houses of his own employees and then fired all those employees! That would mean that Paulson caused the decline in the value of CDOs to benefit from it. But, in reality, he just spotted the CDOs that were most likely going to decline in the value and profited from them. That’s not the same as causing the crisis.
I think it is prudent to study the fraud in the housing loans, rating agencies, and CDOs rather than going for Paulson’s head.