Continued: Short-sale ban frustrates Prior Lake trader

One of the stock market's latest villains is a 32-year-old self-described math geek from Prior Lake who won't move to Wall Street unless they let him wear flip-flops.

Matthew Paschke, who manages the $165 million Grizzly Short Fund at the Leuthold Group, says short sellers like him have become scapegoats for the financial crisis that's wiped out $20 trillion from stocks and brought down Bear Stearns Companies and Lehman Brothers Holdings Inc.

Wall Street chiefs blame those who sell borrowed stock and profit when prices decline for driving shares down as the credit crunch unfolded. After wagers against Morgan Stanley, Merrill Lynch & Co. and Citigroup Inc. surged to records, the Securities and Exchange Commission last month banned short sales of almost 1,000 companies. Paschke said that was the wrong move.

"The whole witch hunt is unfounded, and it's frustrating," said Paschke, a father of three, in Leuthold's 46th-floor offices in downtown Minneapolis. "They're changing the rules on the fly, so for those of us that make our livelihood in this business that becomes a very, very difficult proposition."

Moreover, the ban may prolong the downturn by propping up companies that borrowed heavily and took on too much risk, he says. The Grizzly Short Fund has returned 41 percent this year. Through August, it almost tripled the average gain for hedge funds specializing in bearish bets. Paschke declined to identify any companies his fund shorts.

James Angel, a finance professor at Georgetown University in Washington who studies short selling, says the practice may have accelerated some companies' declines by undermining investor confidence.

"There was a financial panic going on," Angel said. As a result, there was "the behavior of crowds going, 'Who's next?' It's only human instinct to ask." At the same time, he said, "when the shorts are circling around, on average they are right."

The ban should continue until the SEC stiffens the rules deterring naked short sellers, according to Robert Brooks, a professor of finance at the University of Alabama in Tuscaloosa. Such traders never borrow shares and flood markets with sell orders, driving down prices.

On Wednesday, the SEC extended its prohibition until lawmakers pass a proposed $700 billion financial bailout package.

"Short selling is out of control," Brooks said. "There should be a huge economic cost to the hedge fund [that] decides they shouldn't borrow the shares."

Short sellers such as David Tice, who runs the $1.08 billion Prudent Bear Fund, and James Chanos, president of the $7 billion hedge fund Kynikos Associates Ltd., say their funds don't engage in naked shorting. Paschke says his firm doesn't either.

Paschke was born in Minnesota and married while attending the University of Northern Iowa in Cedar Falls. He says he's "Midwest-rooted." Working at Leuthold, which advises two-thirds of the biggest U.S. money managers, allows Paschke to wear shorts and sandals to the office and spend weekends with his family on Prior Lake near his home, about 20 miles southwest of downtown Minneapolis.

"The dress code is worth a great deal," he said.

Living more than 1,000 miles from Wall Street also provides perspective on the crisis that has spurred almost $600 billion in write-downs and credit losses tied to subprime mortgages, he said.

The Grizzly Short Fund, which is always 100 percent short and usually bets against 60 to 75 companies, trimmed its holdings in financial companies to about 16 percent of its balance four days before the SEC banned short sales, Paschke said. The proportion has since fallen to 12 percent. On Sept. 2, financial shares accounted for 26 percent of the fund, Leuthold's website showed.

Paschke, who has a bachelor's degree in finance with a minor in math and earned a master's in business administration from the University of Minnesota, doesn't visit companies and rarely goes on earnings calls to decide which stocks to short.

He relies instead on mathematical models he helped develop that use 17 measures. The quantitative-based strategy, Paschke says, keeps him from getting "emotional" about individual companies and holding onto short positions that lose money.

"Money managers tend to get married to a name," he said. "They fall in love with all these things that take their eye off the ball. We strive to avoid that."