Editor's note: Richard Sauer is the author of "Selling America Short: The SEC and Market Contrarians in the Age of Absurdity." Sauer was an administrator with the Division of Enforcement of the Securities and Exchange Commission, a partner in an international law firm and an analyst with a Northern California hedge fund. He holds a doctorate in law from Harvard Law School.
(CNN) -- Pity the poor short-seller. Seriously. That much-maligned creature gets no love at the best of times, and these days are more like the worst.
This, despite the irreplaceable benefits he brings to the financial markets. Short-selling in the conventional sense involves borrowing stock, selling it and, at a later date, replacing the borrowed shares though market purchases. If, in the interim, the shares have declined in value, the short-seller prospers. If not, he doesn't.
The term "shorting" is also loosely applied to any investment that depends for its profitability on someone else's pain. Thus, any bet, however constructed, that an asset will decline in value may be referred to as shorting that asset. This would include, for example, purchasing credit default swaps on corporate bonds, which will pay off in the event of default. "Shorting" in the broader sense has recently come in for a strong dose of popular opprobrium.
Earlier this month, as the world knows, the SEC sued Goldman Sachs for allegedly hiding material information about a financial instrument it had constructed for the specific purpose of allowing one of its clients, Paulson & Co., to bet against the performance of certain mortgage-backed bonds. Paulson used this device as a means (broadly speaking) to short the housing market, which it correctly viewed as due for a fall.
Now Goldman has made a further bid for unpopularity in connection with its shorting activities. In e-mails recently disclosed to the public, its traders celebrate their winning bets against a declining housing market and, more specifically, against the rickety edifice of asset-backed and synthetic derivatives Goldman had, just as gleefully, helped construct while the constructing was good.
One might question the social utility of such transactions. And, indeed, it is hard to see any except in their Darwinian effect of helping less astute economic actors toward their career extinction.
Goldman may contend that its proprietary shorting of the housing market served as a hedge against exposure to that market elsewhere in its portfolio. Often, however, such transactions represent nothing more than zero-sum wagers among large financial entities. In most cases, they are no one else's concern, but if the losing players badly miscalculate their loss exposure, as some have done, they may compromise their financial soundness and cause problems well beyond their own doors.
Compare this with conventional short-selling, an activity beloved by nearly all economists with an opinion on the subject. The main virtues of short-selling are these. It adds liquidity to the market by increasing transaction volume. It provides a hedging mechanism necessary for many other types of investment activities, including some conducive to capital formation. Most important, it injects into the market a healthy skepticism to counter the blind enthusiasm, ignorance and occasional fraud that otherwise may run unchecked.
The great majority of investors stay exclusively on the long side. They have limited incentive to seek out (and less to publicize) negative information about public companies. Professional shorts, however, have both the motivation and the skill to look beyond the happy talk of company management and sell-side analysts.
These bear investors have provided early warnings of such corporate blowups as Enron and deflated many a pump-and-dump scheme. More generally, they help true up the value of publicly traded securities by making certain their negatives do not go unseen.
Despite all this, however, short-sellers are often targeted for blame when the market disappoints. Bear raids and "short and distort" schemes are commonly alleged, however rarely proved, by troubled companies eager to displace blame for their failures.
They have sometimes won the ear of regulators. During the 2008 market meltdown, as one of many examples, the SEC imposed ill-considered rules that imposed severe losses on short-sellers while doing little to stabilize the market.
In his 2008 presidential campaign, Sen. John McCain charged that the stock market had been turned into a giant casino by short-sellers -- apparently unable to distinguish the conventional practice from the novel and complex forms of straight-out gambling on market declines that have flourished in recent years.
This is a common mistake. In many years in the SEC's Division of Enforcement, I learned to value the contribution made by short-sellers toward keeping our markets honest. It would be unfortunate should this dwindling subculture be further diminished through the confusion of their role with that of others who provide none of the same benefits.
The opinions expressed in this commentary are solely those of Richard Sauer.