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October 31, 2008

Naked Short Selling

Recently a poster asked on TMF forums: "Has this afected your portfolio?" as the subject line for a link to a video by Patrick Byrne, CEO of overstock.com, about naked short selling. Here is the link:

Destroying Companies For Profit

My reply on TMF forum:

I think it has. OmniVision is a case in point, the same people who were killing overstock.com were working on killing OVTI. That's how I found out about Patrick Byrne.

It is easy to believe that corrupt hedge fund managers and their journalist friends would deny naked short selling. What is amazing is that people one thinks of as honest folks dismiss the short selling accusations as simply some losers trying to pass the blame for their failure to the phantom of naked short selling. Naked short selling is no phantom, it is documented:

Naked Short List

Right here on TMF I have had Fools dismiss short selling and even cherry picking to show that it can be legal as in this paragraph from the SEC's Regulation SHO:

From Key Points About Regulation SHO

Naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules. Indeed, in certain circumstances, naked short selling contributes to market liquidity. For example, broker-dealers that make a market in a security4 generally stand ready to buy and sell the security on a regular and continuous basis at a publicly quoted price, even when there are no other buyers or sellers. Thus, market makers must sell a security to a buyer even when there are temporary shortages of that security available in the market. This may occur, for example, if there is a sudden surge in buying interest in that security, or if few investors are selling the security at that time. Because it may take a market maker considerable time to purchase or arrange to borrow the security, a market maker engaged in bona fide market making, particularly in a fast-moving market, may need to sell the security short without having arranged to borrow shares. This is especially true for market makers in thinly traded, illiquid stocks such as securities quoted on the OTC Bulletin Board,5 as there may be few shares available to purchase or borrow at a given time.

Here is a knowledge@wharton whitewash of naked short selling. This looks like a deliberate attempt to evade the real problem by tiptoeing around it, by citing a case where it is "not a problem." But what about the shares that are never delivered and wind up on the Regulation SHO list?:

From Does Short-selling Need the SEC's Oversight?

Blume: A naked short is sort of a pejorative term. A naked short means that I sell a stock and I don't borrow it first. Now, if I do this within a day, there's no real problem because I short the stock and then I buy it back -- and there's a "netting" -- so I never have to deliver the stock.

By what miracle of mathematics can institutions own more than 100% of the shares of a company?

104.60% - OfficeMax
126.90% - Chipotle Mexican Grill
156.00% = Blue Nile Inc.

This is in addition to the shares held by individual investors and insiders. The only way that I can think of is that fake, counterfeit, shares are circulating, naked short shares that were never delivered but which are, all the same, registered as owned by somebody who bought them.

Since most shares are held in street name, you never notice if a share was delivered or not. You would have to ask for the share certificate, something that naked short sellers know most of us will never do. So we don't notice that we have been sold fake, nonexistent shares.

Why is this important? The law of supply and demand says that these two forces must meet at a point of equilibrium by raising or lowering the price until the market clears. Now suppose that naked short sellers add 27% fake, counterfeit shares to the market. The only way they can clear is by lowering the price OF ALL THE SHARES. Now suppose you have some CMG or NILE on margin -- you could easily get a margin call and be wiped out. For companies and institutions that have to mark-to-market their asset values, they might run afoul of reserve requirements and the rating agencies may cut their ratings.

Naked short selling is a cancer in the financial system that is killing not only the companies under attack but also anyone who happens to own securities of these attacked companies.

Stock Brokers and Naked Short Selling

Why would a stock broker cooperate with naked short selling? If there is no risk in the operation for the broker, the commissions and fees are tempting, that would be a good reason. If you just short a stock and it goes up, the broker is underwater and must ask you for more margin coverage. If you don't have it, the broker might lose money. But what if in addition to shorting the stock you also buy call options? Now your and your broker's backsides are covered! If the stock goes down, you make money on the short and if it goes up, you get to buy them back at the call strike price. This is called a hedge and this is one of the things hedge funds do for a living. But the broker knows there are no shares he can borrow to cover the short sale. The broker is protected by the call option so what does he care? He got two commissions, one the short sale and another for the options trade and will get a third commission eventually when the hedge is terminated. But the buyer of the shares is being defrauded! And all the shareholders are being defrauded as well because stock prices are set at the margin -- remember mark-to-market!

The solution to naked short selling is stiff fines for both the naked short seller and his broker. As soon as the broker knows he will lose money on the naked short sale, he will stop the practice. The fine could be 50% of the face value of the transaction, payable 50/50 by the broker and his client on the day they fail to deliver, max 3 working days after the trade.

Denny Schlesinger

Re: Has this afected your portfolio? TMF discussion board.

Naked short selling explained An excellent explanation of the mechanics of naked short selling, how they they hurt us and how the regulators are aiding and abetting the naked short sellers.


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