In recent years, short selling has received negative attention and was temporarily banned in the U.K. and U.S. stock markets. This practice involves investors borrowing stocks and selling them on, in the hope that the price will fall so that they can buy them back later and make a profit. Success, therefore, is based on the assumption that certain stocks are overpriced. If that’s the case, then some would argue that short sellers are actually doing the public a favor by revealing these stocks’ true value.

Cynics, however, point out that if a particular company is aggressively besieged by arbitrageurs, then the price of its shares could be lowered unfairly. This is what some think happened in Britain with the mortgage lender, HBOS, and it’s why short selling is suddenly in the spotlight at the moment.

But arbitrageurs aren’t the only ones involved in short selling. Investors themselves make decisions about how much stock to lend, which could be used by short sellers to bet on a price decrease. Why would they do such a thing, since this could reduce the value of their investments? More to the point, why would “sensible” institutional investors, such as pension funds and insurance companies with long-term investment horizons, want to loan their shares? One answer is that, with portfolio turnover so low, an institutional investor needs to generate cash somehow. The fees they can command by lending their stock provide a nice little earner.

Nobody, however, has yet thought to look into which institutional owners actually choose to lend stock, and what impact this has on the market for short selling.

This is the focus of the paper “Equity Lending Markets and Ownership Structure.” The authors, Pedro A.C. Saffi and Jason Sturgess, find that the concentration of shares in the hands of only a few institutional investors is associated with higher barriers for short selling.

Taking Stock
To find out how the ownership structure of a company affects the market for equity lending, the authors used a set of proprietary data on lending supply, loan prices and quantities between January 2005 and June 2008. They were not simply interested in the effect of an institution owning stocks in a company, but also the effect of the concentration of this ownership.

A company with high ownership concentration has a few investors owning large blocks of the company, rather than lots of investors with a few shares. Investors with a large slice of the company pie are likely to be a little more controlling, so a company’s concentration should play an important part in its lending practices. The authors prove the following hypotheses.

1. Concentrated institutional investors keep a tight hold on their stocks. It tends to be assumed that institutional investors are passive in nature and unlikely to meddle with management. This may be true when they own just a few shares in a firm. But, as the authors point out, when ownership is concentrated among a few investors, they do indeed constrain lending supply to keep stock prices high.

2. Investors pay more to borrow shares in firms with concentrated institutional ownership. The amount of shares available to borrow will only matter for selling short if it affects the cost of borrowing these shares or the demand for them. Some stock can become “special” in the market, with particularly hefty loan fees. For example, the cost to borrow shares in Northern Rock – a British mortgage institution that went bankrupt in 2007 – reached more than 20 percent for a small period of time. Other constraints include the volatility of the stock and the risk arbitrageurs face when borrowing it.

Stocks can be lent through fixed-term or open-term contracts. With the former, the short seller knows for sure that he will not have to return these shares before the loan maturity unless he desires to do so. However, the latter could pose a problem for short sellers, as lenders can ask for their shares back at any time. If this is done at times in which there is a shortage of shares purchase, arbitrageurs could lose money.

The authors find that, not only are loan fees higher when institutional ownership is concentrated, but all other short-sale constraints increase, too. Stock tends to be more volatile, and fixed-term contracts are less likely. In general, stocks borrowed from highly concentrated institutional investors are much riskier to borrow, as their costs fluctuate more.

3. The pricier they come, the harder they fall. Although demand is lower for stocks owned by concentrated institutional investors, some arbitrageurs do borrow them. Why?

The authors suggest that, when such stock is borrowed, it must be on the premise that the price will fall significantly, giving the short seller some profit to compensate for the risk and expense of borrowing.

They find that negative returns following a demand shock were more negative for shares owned by concentrated institutional owners.

The authors conclude that ownership structure is an important determinant of equity lending supply and short-sale constraints. Concentrated ownership of a company tends to be bad news for short selling, as it reduces the supply available for lending and overall equity lending activity.