By Jim Woods, Investorplace.com

Short selling has become a hotly debated topic these days.  Some say the practice puts artificial downward pressure on stocks, while others argue short-selling’s virtue as a mechanism for determining a stock’s real value.  The Securities and Exchange Commission (SEC) recently voted 3-2 to impose new limits on short selling; a move that SEC Chairman Mary Schapiro claims will “preserve investor confidence.” 

But thanks to new revelations surrounding the Lehman Brothers collapse, as well as Michael Lewis’ new book, The Big Short, those who defend betting against the house are finally starting to get some respect.

On the Lehman front, the recent release of the bankruptcy examiner’s report alleges that Lehman executives manipulated the balance sheet, withheld information from its board and inflated the value of real estate-related assets.  The report also alleges that Lehman essentially sequestered approximately $50 billion of assets from its balance sheet to make it appear as though the firm had much less debt on its books.

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In 2008, well before Lehman’s collapse, many people were suspicious of Lehman’s situation, and many shorted the stock in anticipation of its downfall.  Perhaps the most vocal of Lehman’s critics was David Einhorn of Greenlight Capital, who frequently called the firm out for its questionable accounting practices, and who announced he was short the stock.

Later that year, former Lehman chief executive Dick Fuld blamed short sellers for spreading rumors about his firm, and he accused them of basically manipulating the shares into freefall.  Fuld even made the following statement to Congressional concerning this issue, “The naked shorts and rumor mongers succeeded in bringing down Bear Stearns. And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers.”

Well, now that bankruptcy examiner’s report is out, you can score one for Einhorn and the shorts. 

Perhaps an even bigger vindication for short sellers comes from Michael Lewis’ new book, The Big Short.  In his latest work, the author tells the story of several fund managers who saw the financial crisis coming long before the rest of Wall Street.  These prescient individuals bet big on the short side through various financial instruments, and the result was they earned billions of dollars in profits while the rest of the world saw a good chunk of its wealth evaporate.

In a March 16 appearance on MSNBC’s Morning Joe, Lewis defended short selling by saying, “Shorting, generally, is a very healthy part of the economy.”  Although Lewis does argue that shorting mechanisms such as credit-default swaps can cause a lot of downside damage to the market, he argues that there must be “an incentive for negative information to get into the market.”

For retail investors, that mechanism is short selling in the traditional sense via borrowing shares from your broker, selling them in the open market and then hoping the value of the stock will decline so you can replace the shares at a lower price -- and keep the difference as your profit.  For options investors, it means buying puts and/or employing one of a slew of bearish options strategies designed to profit when a stock’s price declines.

Whatever method an investor employs to bet against the house, shorting should be looked upon as Lewis says -- a very healthy part of the economy, and not some kind of pernicious activity in need of further restrictions by the SEC.

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