Naked Shorting: An IM Exchange

I've been rude about Gary Matsumoto's conspiracy theories in the past, and now he has a doozy of a new one: the bankruptcy of Lehman Brothers had very little to do with its management or its insolvency, and everything to do with naked shorting. Gary Weiss is one journalist who's convinced that naked shorting is not a problem: I had this IM interview with him this morning.

Felix Salmon: So Gary Matsumoto is out with 2,685 words of conspiracy-mongering on the subject of naked shorting and Lehman Brothers
Which I know is a subject dear to your heart

Gary Weiss: Yes, following stock market conspiracy theories is one of my favorite hobbies.

Felix Salmon: So, in a nutshell, what's the problem with this one?

Gary Weiss: Well, let's start with the lead paragraph. It says, "The biggest bankruptcy in history might have been avoided if Wall Street had been prevented from practicing one of its darkest arts."
My reaction was, "Is he serious?"

Felix Salmon: Well, is he?

Gary Weiss: Yes, that is what I find remarkable. He provides not a shred of evidence for his hypothesis, except for some warmed-over "fails" trade data that proves nothing, a quote from a former SEC chairman who has a vested interest in the subject, and he ignores little things like what Lehman Brothers did to cause its own demise.

Felix Salmon: Why does the failed-trade data prove nothing?

Gary Weiss: Fails to deliver can be caused by any number of factors, of which naked short selling is just one.

Felix Salmon: As for Lehman Brothers causing its own demise, well, yes, obvs. But if short-sellers hadn't driven Lehman stock down to the level at which the bank had to declare bankruptcy over the course of a fraught weekend, might not the authorities in the US and UK have managed to cobble together some kind of rescue package allowing Lehman to be sold to Barclays or Nomura or both?

Gary Weiss: You're talking about ordinary short selling driving down the price of Lehman stock. What he is talking about is fails to deliver, which is another issue entirely.
I agree that the unwise abolition of the uptick rule left open the possibility that shorting could drive down stocks.

Felix Salmon: Is there any real empirical data on what proportion of fails are due to naked shorting?

Gary Weiss: There is absolutely none. In fact, as the SEC enforcement division just pointed out, there are no studies indicating that naked shorting has any impact on the market whatsoever.

Felix Salmon: In that case, is there any evidence that the kind of things which cause fails (and aren't naked shorting) spiked around the time of the Lehman bankruptcy?
Matsumoto has one theory on the spike in fails: that it's due to naked shorting. Do you have an alternative explanation?

Gary Weiss: The problem with fails data is that you can't comb out fails that are unrelated to naked shorting. Since most fails are caused by things that aren't naked shorting, and since SEC Chairman Christopher Cox said that there was no significant naked shorting of bank stocks, including Lehman, I'd suggest that factors other than naked shorting were at work in causing the fails.
Actually Cox's exact words were that there has been no "unbridled" naked shorting of financial issues.

Felix Salmon: Matsumoto nods to this:
"The Federal Reserve Bank of New York lists several reasons for fails-to-deliver in securities trading besides naked shorting. They include misunderstandings between traders over details of transactions; computer glitches; and chain reactions, in which one failure to settle prevents delivery in a second trade."
Still, it seems like it's more than just coincidence that spikes in fails have coincided exactly with periods when the stock in question fell dramatically.

Gary Weiss: Then I guess Cox was lying. Seriously. I am no fan of the man, but if there was no "unbridled naked shorting" of financial issues, and if there actually was significant naked shorting of financial issues, than he should be strung up from the nearest lamp post.
I would suggest that he was not lying and that, as has been the pattern over the years when naked shorting is raised, it is a red herring.

Felix Salmon: But how would he know? And why can't we see the same evidence that he's seeing?

Gary Weiss: I would love to see the SEC release all the evidence that it has on naked shorting. As a matter of fact, I think they should drop everything else that they are doing, stop investing actual stock frauds and Ponzi schemes, and devote themselves entirely to disproving a conspiracy theory.
He would know, by the way, because all trades leave a paper trail, and if a fail to deliver is caused by naked shorting I would think it would be fairly easy to ascertain if that were happening.
And if it were happening, I am sure, given the pressure whipped up over this, that he would have been more than happy to say it was happening.

Felix Salmon: It is worth pointing out (a) that Cox's statement about unbridled naked shorting came in July, before Lehman collapsed. But also (b) the SEC has given no indication that it thinks there was a problem with naked shorts in Lehman's collapse.

Gary Weiss: Yeah, that too. Getting back to the Bloomberg story, that was omitted entirely from the article.
(Unless it was buried somewhere after the quote from the superb former SEC chairman Harvey Pitt.)

Felix Salmon: The article did quote Susanna Trimbath as saying this:
"Failed trades correlate with drops in share value -- enough to account for 30 to 70 percent of the declines in Bear Stearns, Lehman and other stocks last year, Trimbath said."

Gary Weiss: It may also correlate with the tides and the phases of the moon. The question is, where is the evidence of naked shorting actually taking place? The conspiracists' case depends entirely on statistical data related to a phenomenon ("failed" trades) that is almost always not naked shorting.
Where are the SEC enforcement actions?
Why did Cox say it wasn't a factor?

Felix Salmon: So what would constitute evidence of naked shorting actually taking place? Are we wholly reliant on the SEC to be able to see it and prosecute it?

Gary Weiss: We know that statistical evidence of "fails" data is meaningless, so yes, we have to rely on actual enforcement actions by the SEC and SROs. Heaven knows, they are motivated to find such things happening.

Felix Salmon: But the only evidence we have that fails spikes are meaningless is that there's no correlation between fails spikes and subsequent SEC actions
I mean, I'm sympathetic to what you're saying, but it is 100% reliant on the SEC.

Gary Weiss: And the SROs. Here's an analogous situation:
Occasionally there is statistical evidence of pre-announcement runups in volume and share prices before takeovers.
That is indicative of insider trading and, sure enough there are prosecutions and enforcement actions. It is something actually happening.
Here we have "spikes on charts" and consultants to parties engaged in litigation against alleged named shorters (Ms. Trimbath) finding "correlations" and we have absolutely no regulatory actions whatsoever.
Either the SEC and the SROs are corrupted, as the conspiracists suggest, or it ain't happening.

Felix Salmon: Still, if your argument that naked shorting isn't a problem is entirely reliant on (lack of) SEC activity on this front, then it seems hard for you to attack the SEC itself for releasing a report taking the issue seriously. Aren't they, by your lights, the exact institution which has to take such allegations seriously?

Gary Weiss: Absolutely not. If organized pressure groups and astroturf organizations are demanding disproportionate, unnecessary deployment of scarce SEC resources, the SEC has an obligation to reject those demands, and not pander to them.

Felix Salmon: What's more, we're in a bear market, and it can at times be hard to find a borrow (see eg Citigroup right now) and the temptation to engage in naked shorting must be high. You'd think that at the very least the SEC would have found some small-scale idiots who gave it a try.

Gary Weiss: As happens in all bear markets, there is historically enormous public and political pressure to target people profiting from share price declines.
That happened during the Great Depression, and it is happening now. That results in some good regulatory initiatives, such as the uptick rule, and it results in wastes of time, such as pandering to the naked shorting conspiracy theorists.
Remember: the SEC is often incompetent. I wrote a book in which that was one of the main themes. However, when it is reacting to a public problem, the SEC has the capacity to actually find things happening.
Here we have a campaign that has gone on for some years, backed by "statistical data" to "prove" that a problem called "naked shorting" exists. And the result: zip. Nothing.
My question is: when is the SEC going to have the guts to say, "Enough. It is not happening. We are not going to waste any more time on this."

Felix Salmon: So maybe we can agree about this:
The best-case scenario here is that the SEC should come out and say definitively that in the Bear and Lehman cases, there was no naked shorting going on.
It should make the data public, and explain how it came to that conclusion.
And if that's convincing, then I think allegations of naked shorting elsewhere will dry up.

Gary Weiss: Yes. In my last Portfolio piece on Madoff, I took the idea one step further and suggested that a 9/11 style commission should investigate the entire financial crisis. That should include naked shorting. The only way to combat conspiracy theories of any kind is with facts--not that it matters to the conspiracists, who will always be with us.

Felix Salmon: But maybe they won't get the opportunity to write long articles for Bloomberg.

Gary Weiss: There will always be conspiracists and there will always be bad journalism.

Comments

[Market Sniper:]

Surely you jest! Deepcapture has more than substantiated the horrendous naked shorting (FTD) problem in US markets! Some sectors are more prone to it than others (junior miners and exploration is most heavily involved). An estimated 37% of ALL stock traded is bogius stock! The SEC will not look into it as forced covering will lead some issues to literally go to infinity (there is NO price at which they can be covered). Market maker loophole insures that this problem will be with us always. All a hedge fund has to do is set up a market maker arm. No large problem. A number of good companies have been naked shorted to oblivion. Good thing this problem was not around when MSFT started up. You would have never heard of them! Also the reason why Gate's stocks are delievered to him personally with any stock split. Not a problem? HA!!!

Mar 19 06:10 PM

[THofler:]

I don't know who Gary Weiss is, but he seems to be entirely dishonest in this exchange. Oh, the failed settles are because of computer glitches!

I looked up the SEC regs. in the wake of the ban on shorting financials. I believe that was after the Lehman failure.

"Sniper" is completely correct. In the old regs. if a broker was also an options market maker then the SEC loophole says that a trade may be allowed up to 60 days to settle a short sale; a so called T+60 rule. Now how hard is it to locate all the shares you need in the 60 days after the trade?

Some weeks later the reg. was changed to a hard and fast T+3 days settlement rule. Even then, the penalty for a failed settle was vague. Probably an automatic cover, maybe a small cash fine.

Personally, I think the solution to the problem is a hard and fast T+1 hour rule. All short sales settled within 1 hour. Failed settles should require an immediate cover trade and cash fine on the broker equal to 20% of the trade.

Mar 19 11:07 PM

[john s. gordon:]

all i see here is evidence that naked shorting was concealed so that it couldn't be found.
> jack

Mar 20 08:39 AM

[reluctantQuant:]

Failed trades can acutally be interesting (hmmm), but if folks want to get all "House, M.D." on this naked shorting thing, some very important data is not included in anyone's analysis. Fails as a percent of volume, volatility and relative numbers to other "angels falling at the moment" is only one of many perspectives required for this autopsy. DTC or the Fed should do that study, NOT the SEC, which is not in the securities transfer business. This assumes that the study is worthwhile (so that you can... ?).

The bond market has a simple governor against this -- even if seller fails to deliver, seller is still paying interest accruals to the buyer as of settlement date. At institutional sizes, that gets expensive - paying the buyer's interest until delivery is made. To take down a beast like Lehman, we're certainly talking instituional sizes, right? This didn't happen throuh E-Trade and Schwab. Maybe the economic cost of failing on equity delivery simply needs adjustment, versus hard-to-enforce gating rules on trade execution. If failing to deliver becomes punitively expensive then the "nameless faceless conspiritors" might find another line of work.

This factor of LEH's demise is ony one of a dozen or more diseases that killed the patient. But the official cause of death is that no one believed Dick Fuld anymore.

--rq

Mar 20 08:50 AM

[ubuy2w:]

Mr. Weiss should be ashamed of himself, denying the existance and impacts of naked shorting is like denying the holocaust. Mr Weiss continues to tirelessly repeat the same big lie over and over , there is no naked shorting, and all targets of bear raids are fraudsters who are using the naked short bogeyman to distract from their misdeeds. And WHY are his articles on seeking alpha the only ones that do not allow comment?

Mar 20 10:05 AM

[hurls111:]

What about the simple fact that naked shorting is illegal and should be pursued and penalized. Arguments about impact are like suggesting we shouldn't chase robbers because murderers are worse.

Plus, how about a class action that goes after every entity that lends stock. to shorters. They (generally pension or other funds) are accessories in activity that impairs the original investors value.

Mar 20 12:33 PM

[Sigmax:]

Its plain and simple. When the uptick rule was removed and FAS 157 instituted it created a "low hanging fruit" scenario for the bears -easy to be picked. Buy CDS's, short (legally + illegally) the financial stocks unmercifully, start rumours, basically force the ratings agencies to downgrade - add a little "negative" juice from the media (yes they have some blood on their hands too) and bingo-capitulation-a negative feedback loop that led to the abyss/recession.

It was so obvious. They went from BSC to LEH to FRE & FNM, back to LEH to AIG to WM to Wachovia to MS to GS to C to BAC and to GE (to name the big names). The SEC was clueless/ culpable because they started the cascade the the rule/accting changes mentioned above. Cox is an idiot and they knew that and proceded without fear.

It is no coincidence that when it leaked out that the SEC is looking at reinstituting the Uptick Rule and FAS 157 is being looked at for modification - that the market rallied. Its game over for the "bad guys" - to quote Tony Montana.

The shame of this is that it could have all been prevented. I'm not saying we did not have a problem in the housing market, we did, but it was a "market functionality" problem that was exploited and caused the situation to get out of control. They were pounding stocks so fast-the gov't couldn't keep up. The market was moving 80 mph in the left lane and the gov't was going 40 mph in the right lane. They kept putting their fingers in the dike to stop the leak without fixing the problem. (Maybe that is why they are throwing so much money at it-because they realized they are culpable.)

Maybe we should put a commision together from the general public to investigate.......that would be fun!

Mar 20 03:15 PM

[tc1:]

The folks at web-group BUYINS.NET have the capacity to compile (and present to us) statistical information on the amount of phantom shares --most of it likely naked short selling-- of numerous companies at their website.

I also found the articles by Mark Mitchell (of Columbia University's prestigious journalism dept.) and Patrick Byrne at DeepCapture.com to be VERY PERSUASIVE on the topic of deleterious naked short selling.

In confirmation of the Deep Capture team’s findings, see a valuable report by Leslie Boni, an SEC resident economist, “Strategic Failures to Deliver,” identifying phantom stock as a major problem. Former Undersecretary of Commerce Robert Shapiro, a member of the Obama transition team, did his own study, concluding that naked short sellers vaporized as many as 1,000 companies. See, too, Liz Moyer, of Forbes, one of the rare journalists (outnumbered, it seems, by too many journalists who are friends of short-sellers but who have the gall to write stories on the topic and pose as "objective journalists") who has accurately described the phantom share problem.” (E.g., see Liz Moyer’s article-series in Forbes Magazine in 2006-7 on the dangers of naked-short-selling; and see Forbes’ original 1987 cover-article on damaging short-selling. Finally, one can view journalist the 30-minute report for Bloomberg Television by, yes, Gary Matsumoto. And Weiss should recall SEC Chairman Christopher Cox’s March 4, 2008 announcement that “today’s elaborate system of electronic net settlement [read: DTCC] has enabled a particularly pernicious form of fraud called naked short selling… Illegal naked short selling is an especially serious threat to smaller public companies, whose relatively thin market capitalizations can be more easily manipulated. And in the same way, it threatens the savings and investments of many retail investors in these smaller companies.”

Mar 20 09:38 PM

[tc1:]

Addendum-- here is an excerpt from Mark Mitchell's long investigative piece, "The Story of Deep Capture" (archived at deepcapture.com). And please, Gary Weiss, if you're listening in, i always like to hear both sides of an argument, so i'd appreciate hearing your side of things, but presented with facts, not ad hominems:

[Mark Mitchell writes:]
"Deep Capture has come to possess a great number of emails between various journalists and miscreants. In one, the former BusinessWeek reporter [Weiss] brags to the crooked mortgage broker of influencing the contents of Nocera’s “Campaign of Menace” article in The New York Times. “This is totally my doing,” Gary writes. “Yuk. Yuk. Yuk.”

In another email, Gary recounts his successful campaign to keep a reporter named Liz Moyer from getting a job at BusinessWeek because she has written favorably of companies victimized by short-sellers. Moyer, who is now with Forbes, is one of the few journalists who have accurately described the phantom share problem.

Gary left BusinessWeek in 2004 under circumstances that remain a closely guarded secret. From January 2006 until today, his primary occupation has been to author a blog devoted entirely to badmouthing Patrick Byrne and pooh-poohing the notion that phantom stock is a problem. His arguments are not so much arguments as personal attacks. Anybody who utters the words “phantom stock” is a “crackpot” or a member of the “Baloney Brigade.”

There's much more, but one gets the point.

Mar 20 09:46 PM

[frosty:]

naked shorting is selling stock that you neither own nor borrow. it creates shares that don't already exist for the purpose of a sale (on a gamble that the shares will decrease in value). only a company's board of directors should be allowed to create stock. naked shorting should be criminalized and aggressively invesigated.

wouldn't it be fun if you could sell other assets you don't own. like your neighbor's house for example. they actually catch people doing that from time to time and they end up in prison. so too naked shorters.

Mar 25 09:32 AM

[User 209633:]

Mr. Weiss has been accused, on the basis of what appears to be incontrovertible evidence, of using a dummy account to manipulate and virtually control the Wikipedia entries on naked shorting: www.theregister.co.uk/.../

Sep 25 03:15 PM