Can rumors lead to firm collapses?

I  had pointed to Senate hearing on Lehman and AIG.

I was reading testimony of Richard Fuld, ex-chief ex- Lehman. He says:

The second issue I want to discuss is naked short selling, which I believe contributed to both the collapse of Bear Stearns and Lehman Brothers. Short selling by itself can be employed as a legitimate hedge against risk.

Naked short selling, on the other hand, is an invitation to market manipulation. Naked short selling is the practice of selling shares short without first borrowing or arranging to borrow those shares in time to make delivery to the buyer within the settlement period – in essence, selling something you do not own and might not ultimately deliver to the buyer.

Many of the firms that have recently collapsed or have been forced into emergency mergers, takeovers, or government bailouts – Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, AIG – did so during the gaps of time in which there was no meaningful regulation of naked short selling.

It is an old saying that one only feels the brunt when he faces it himself. In times of Asian crisis when short-selling etc was banned I am sure Lehman along with other wall street firms would have cried hoarse.

Actually, I have never really understood the stance over short-selling. It looks good in theory but there seems to be a problem in its application. Especially, no firm likes it if it is being shorted. SEC and others banned short-selling in a big way. As Indian markets have collapsed debates have begun whether similar steps need to be taken here. In all, academicians like it, the practitioners like it only in good times and detest it in bad times. Earlier, these policy measures were seen in emerging economies but we can’t say the same anymore.

Further, Fuld blames market rumors:

Naked short selling, followed by false rumors, dealt a critical, if not fatal blow to Bear Stearns. Many knowledgeable participants in our financial markets are convinced that naked short sellers spread rumors and false information regarding the liquidity of Bear Stearns, and simultaneously pulled business or encouraged others to pull business from Bear Stearns, creating an atmosphere of fear which then led to a selffulfilling prophecy of a run on the bank.

 And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers. In our case, false rumors were so rampant for so long that major institutions issued public statements denying the rumors.

Can rumors (even as other factor) really lead to a downfall of giants like Lehman? Is this a case of smoke without fire? Lehman was clearly highly overleveraged and was bound to fail.

But then, this rumor problem was even seen in the case of ICICI Bank, which led to numerous clarifications from the bank officials and several policymakers. And ICICI Bank is pretty well capitalised and can’t be compared to Lehman at all. There are so many firms like ICICI Bank which have felt the brunt.

So, how does one manage the rumors?

The movement in financial markets is because of information. A person who acts first on the news gains and other loose out. So market participants have various ways to get news- newswires (Reuters, Bloomberg etc), Business TV channels, own market networks etc. Now, how does one separate a rumor from an actual development? For instance, suppose there is a news over a problem with a bank, there is little time to check whther it is rumor /true news and what follows is a run. And before bank officials and policymakers clarify much of the damage is already done.

All this makes things very complicated and there are no easy answers. You can’t prevent information from flowing as then the question of more efficient markets does not arise. And if information flows easily, the separation of rumors and actual news is no easy task. Moreover, positive rumors are good and no one objects to it but negative rumors can really wipe out the company and very large ones at that.

What do you do as a policymaker?

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2 Responses to “Can rumors lead to firm collapses?”

  1. It could be structured by cows and we would rate it! « Mostly Economics Says:

    […] be structured by cows and we would rate it! I had pointed to the Lehman and AIG Hearing and had also summarised Richard Fuld’s […]

  2. Financial Crisis curtails freedom of speech! « Mostly Economics Says:

    […] Latvian case reminds me of allegation by Richard Fuld (ex CEO, ex Lehman) that rumors led to collapse of Lehman. I thought that was pretty absurd and […]

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