Rolling Stone's Taibbi on Naked Short Sales: Close but No Cigar

Matt Taibbi once again writes in Rolling Stone, this time on naked short sales, and while he gets a good part of the issue right, he (and many others who have opined on this situation over the years) misses the forest for the trees.

Matt writes:

But the most damning thing the attack on Bear had in common with these earlier manipulations was the employment of a type of counterfeiting scheme called naked short-selling. From the moment the confidential meeting at the Fed ended on March 11th, Bear became the target of this ostensibly illegal practice — and the companies widely rumored to be behind the assault were in that room. Given that the SEC has failed to identify who was behind the raid, Wall Street insiders were left with nothing to trade but gossip. According to the former head of Bear's mortgage business, Tom Marano, the rumors within Bear itself that week centered around Citadel and Goldman (GS). Both firms were later subpoenaed by the SEC as part of its investigation into market manipulation — and the CEOs of both Bear and Lehman were so suspicious that they reportedly contacted Blankfein to ask whether his firm was involved in the scam. (A Goldman spokesman denied any wrongdoing, telling reporters it was "rigorous about conducting business as usual.")

Matt gets so close, but fails in the closing.

See, there are two areas of naked shorting that nobody wants to really deal with, yet both have to be if we are ever to make a difference. Let's deal with them in turn.

The first, the writing of "naked" swaps, is one that I've written about before. The essence of a "credit default swap" is a contract whereby the buyer of protection insures against the default of a credit instrument (usually a bond of some sort.) If the bond issuer doesn't pay principal and/or interest, the buyer collects the face value of the bond from the seller of protection - but in turn must tender the defaulted bond to the seller.

This "tender requirement" is due to the fact the most of the time a default bond is not worth zero - even in a bankruptcy most companies have some value, and the bondholders are entitled to that recovery.

This is pretty much like homeowners insurance if you think about it. Your house might have a fire, but odds are it won't be worthless if there is. Same with auto insurance - you buy insurance against a wreck, but if you have one, the insurance company can pay you the market value of the car prior to the crash and in turn they get to keep the (wrecked) car.

Now envision that we allow any number of people to buy fire insurance against your house. There's only one house, but ten fire insurance policies. Only one of those people (you) owns the house and only one of them (you) lives there, but ten people stand to collect whatever the damage amount is if there's a fire.

How likely would it be that someone would be sneaking around with a gas can at 3:00 AM were this to be allowed?

Now let's add another wrinkle to the mix - to collect on any of the insurance policies you must have possession of the house!

Tonight, you have a real fire and the house burns to the ground. The recovery value is zero; indeed, it might be negative (since you have to hire a bulldozer and cleanup crew to clear away the mess before you can rebuild.)

But if there are ten insurance policies, suddenly that burned out smoking hulk has value that doesn't really exist, and a bidding frenzy is likely to develop for the (one) house. See, without the (burned out) house to tender those insurance policies are worthless.

We don't allow this sort of thing in the insurance business because it both distorts the market and creates a reason for people to intentionally start fires.

Why do we allow it in the "credit default swap" business?

Did a few people intentionally start some (financial) fires?

The same thing applies, ironically, when it comes to options. See, if I buy a PUT option the market maker who sells it to me immediately hedges his exposure. If the market maker does not hedge and the price collapses, I will put the shares upon him at vastly more than their value and he will suffer a huge loss. He has no reason to take that risk; his money is made on the bid/ask spread, and he has no reason to take a directional bet on the stock's price (he may, for that matter, agree with me on which way he believes the prices will move!)

Market makers are exempt from the prohibition on naked short sales. They should not be. To allow them to be is to remove one of the actual risks in an option transaction - execution risk. That is, it is entirely possible to have more PUTs (or CALLs) outstanding than there is public float of the underlying issue! It is also possible for those to go out in the money and be exercised, and if that happens then you have created exactly the same sort of counterfeiting fraud that exists with a raw naked short.

The same problem exists on the long side. When a naked short has to be bought back, there are insufficient shares available to do so. This creates a dislocation in price to the upside. While everyone talks about "bear raids" nobody talks about synthetic and fraudulently-generated short squeezes - yet they are just as pervasive in impact as naked shorting, but in the opposite direction.

How many of the so-called "vertical" moves we have so often seen in stocks since last fall, in both directions, can be attributed to this?

The answer? Most of them.

The only check and balance on this is to not exempt market makers from the constraints that everyone else must follow - that is, you can't short shares you cannot actually borrow, and you can't buy something that nobody is willing to sell at the desired price. Put more simply, the quantity of a given stock in "float" is in fact fixed, determination of the float is made by the corporation when they decide how many shares to issue, and nobody can be allowed to count a given share twice, no matter how that double-counting would otherwise occur.

Removing this pervasive fraud from the markets would cause option premium to rise a lot when the open interest began to approach a meaningful fraction of the float, and it would bar the writing of credit default swaps in amounts that exceed, in total value, the underlying reference. That's how it should be, and it would have made the sort of bets placed last year uneconomic, as execution risk, which in fact exists, would have to be computed into the option's (or CDS') value. Today, it is not.

Matt gets so close, but then fails in the end.

The reality is that this sort of "counterfeiting" is in fact part and parcel of both the option and credit-default-swap markets, and in each and every case, including old-fashioned naked short sales, it is in fact an act of fraud.

We don't need new laws - we simply need the existing laws that deal with forgery and counterfeiting enforced across all investment products, and the "special exceptions" that legalize certain sorts of fraud must be removed.

Comments

[Tony Petroski:]

Mr. Denninger. You're on the mark.

Buy insurance on the house down the street and then pay an arsonist to set it on fire.

Except you're the arsonist. And you naked-short the house into a fire. That way you'll profit on both ends.

Am I the only one who has figured this out?

Oct 22 01:57 PM

[58robbo:]

i still don't believe this should be regulated or outlawed. we're supposed to be living in a free country. if all parties are happy with the risk that their partners are selling naked shorts then so be it. they just shouldn't come running for bailout money.

in gambling terms, if someone walks into a casino and wants to place bets with money they don't have it's up to the casino to decide whether they're happy to take those bets. as an investor in said casino, i understand what the casino's credit policy is and if i'm not happy with that risk i shouldn't invest. likewise if i'm a punter i should question the casino's ability to pay out. if i'm not happy with that risk i shouldn't gamble there.

the big problem with our system is that we seem to outsource some of our most important life decisions without fully researching the risk. we then sit back and pray that bureaucrats have done their jobs.

Oct 22 02:42 PM

[Michael Clark:]

The problem is: they do go running to the government for the bailout. That is: the casino runs to the government for a bailout. But is the government supposed to protect Las Vegas from the gamblers in Las Vegas (when things go wrong)?

Laws exist to protect the lambs from the lions. Lambs get taken in quite often by the lions on Wall Street. If we have enough laws now to protect the lambs, then so be it. If not, then we need the laws to be updated. In fact, one definition of 'civilization' is the updating of 'civil laws' over time.

If we have a government that is owned by the lions and is, thus, kept from enforcing the laws on the books, then we have a whole different problem on our hands. The lions have too much money and power and need to be liberated from their excessive influence.


On Oct 22 02:42 PM 58robbo wrote:

> i still don't believe this should be regulated or outlawed. we're
> supposed to be living in a free country. if all parties are happy
> with the risk that their partners are selling naked shorts then so
> be it. they just shouldn't come running for bailout money.
>
> in gambling terms, if someone walks into a casino and wants to place
> bets with money they don't have it's up to the casino to decide whether
> they're happy to take those bets. as an investor in said casino,
> i understand what the casino's credit policy is and if i'm not happy
> with that risk i shouldn't invest. likewise if i'm a punter i should
> question the casino's ability to pay out. if i'm not happy with
> that risk i shouldn't gamble there.
>
> the big problem with our system is that we seem to outsource some
> of our most important life decisions without fully researching the
> risk. we then sit back and pray that bureaucrats have done their
> jobs.

Oct 22 02:52 PM

[Andrew Butter:]

Very good anlaysis

Oct 22 04:32 PM

[Dialectical...:]

I can't agree. I can't sell you the Brooklyn Bridge, even if you're willing to accept the risk that you can find another sucker to buy it from you. It is simply fraud to sell something you don't own regardless of whether the buyer is willing to play along or not. Why? Well for one thing, ownership is partially defined by who can and can not sell an asset. So when a company is having shares of its stock sold when they don't even exist (aka naked short selling), it is having something it has a right to stolen from it. And stealing is one of the few things even libertarians agree has to be a no-no. Without laws against stealing, the concept of private property doesn't work. This kind of counterfeiting and fraud is simply stealing.

On Oct 22 02:42 PM 58robbo wrote:

> i still don't believe this should be regulated or outlawed. we're
> supposed to be living in a free country. if all parties are happy
> with the risk that their partners are selling naked shorts then so
> be it. they just shouldn't come running for bailout money.

Oct 22 11:04 PM

[John O:]

I was an options market maker on the PSE for 5 years and the CBOE for 5 years and traded options and stocks short and long in about every conceivable situation. I am intimately familiar with the Bear Stearns take down.
I will say that the author here and Taibbi and others who believe that naked short sellers caused the Bear Stearns crash do not have a clue to what has happened or they are deliberately misdirecting the blame away from people like Dimon, Bernanke, Cox, Cramer, and many others who stole billions from illegal insider trading.

Just ask Cui Bono? and the answer becomes the illegal inside traders and J.P. Morgan.

See the real explanation of Bear Stearns below:

www.optionsforemployee...

Oct 22 11:42 PM

[58robbo:]

if you have lied and told parties to the deal that you own the brooklyn bridge, that is fraud. if all the parties are aware that you don't own it and they're willing to take that risk that is their problem.

i really don't see any difference between naked shorting and spread betting for instance. it's all gambling in my opinion, everyone knows it and if you're willing to step up to the table and accept massive gains you have to be able to accept the potential losses. you also have to understand counterparty risk.

caveat emptor


On Oct 22 11:04 PM Dialectical Materialist wrote:

> I can't agree. I can't sell you the Brooklyn Bridge, even if you're
> willing to accept the risk that you can find another sucker to buy
> it from you. It is simply fraud to sell something you don't own regardless
> of whether the buyer is willing to play along or not. Why? Well for
> one thing, ownership is partially defined by who can and can not
> sell an asset. So when a company is having shares of its stock sold
> when they don't even exist (aka naked short selling), it is having
> something it has a right to stolen from it. And stealing is one of
> the few things even libertarians agree has to be a no-no. Without
> laws against stealing, the concept of private property doesn't work.
> This kind of counterfeiting and fraud is simply stealing.
>
> On Oct 22 02:42 PM 58robbo wrote:

Oct 23 09:44 AM

[RiskAverseA...:]

Very cogent expose` revealing how power to game the system and effectively elevate volatility of select securities likewise elevates such systemic risk as could collapse whole markets. Such, too, is the work of financial industry "talent?" Hmmm.

Oct 23 11:00 AM

[Dialectical...:]

I agree that you have to be able to accept the losses and "caveat emptor". The problem with naked short selling in particular is that others outside of the transaction are affected. You could own all 10000 shares of a company valued at $8 a share. I could sell 10000 shares of that company by shorting them even though I don't own them (naked short selling) and this would drive the price down. But there is no reason for the value of your stock to drop when you own all the shares and you aren't even selling. The fraud I am committing (even if I have willing participants on the other end of my transaction) is negatively affecting you, the ONLY rightful owner of the shares. If the real owner of the Brooklyn Bridge, for example, could not find a buyer because several fake Brooklyn Bridges had already been sold (likely at ever decreasing prices) then we have a problem. That is the nature of what's wrong with naked short selling. It's not that your chickens come home to roost. It's that they're not your chickens.


On Oct 23 09:44 AM 58robbo wrote:

> if you have lied and told parties to the deal that you own the brooklyn
> bridge, that is fraud. if all the parties are aware that you don't
> own it and they're willing to take that risk that is their problem.
>
>
> i really don't see any difference between naked shorting and spread
> betting for instance. it's all gambling in my opinion, everyone
> knows it and if you're willing to step up to the table and accept
> massive gains you have to be able to accept the potential losses.
> you also have to understand counterparty risk.
>
> caveat emptor

Oct 23 11:21 AM

[Gaucho:]

Fraud is breaking the law unless the very powerful on Wall Street do it. Then they just call their bought congressman and get the SEC neutered. I have see stock programs manipulate companies caring or forcing investors to dump their shares. This is basic thug tactics dressed up in a 4 K suit. We need the Middle East laws to be imposed that way the vast majority of crooks could be spotted since they will have no hands.
So with this article you have in my book identified yourself as a tool for the hedge funds or a fool.

Oct 23 03:06 PM

[58robbo:]

do you think that because someone shorts a stock the price automatically goes down? have you considered that if you short something, you have to first find someone who thinks that the price will go up to sell to. ie when you sell short all you are doing is effectively betting the stock will go down. obviously then the person who you are betting against believes the stock will go up. where i come from that's called a zero sum game.
generally, people only short when they believe something to be overvalued and people go long when they believe something to be undervalued. if the stock in your portfolio is neither, you have nothing to worry about. bears can short your stock all day but fundamentals will eventually prevail.


On Oct 23 11:21 AM Dialectical Materialist wrote:

> I agree that you have to be able to accept the losses and "caveat
> emptor". The problem with naked short selling in particular is that
> others outside of the transaction are affected. You could own all
> 10000 shares of a company valued at $8 a share. I could sell 10000
> shares of that company by shorting them even though I don't own them
> (naked short selling) and this would drive the price down. But there
> is no reason for the value of your stock to drop when you own all
> the shares and you aren't even selling. The fraud I am committing
> (even if I have willing participants on the other end of my transaction)
> is negatively affecting you, the ONLY rightful owner of the shares.
> If the real owner of the Brooklyn Bridge, for example, could not
> find a buyer because several fake Brooklyn Bridges had already been
> sold (likely at ever decreasing prices) then we have a problem. That
> is the nature of what's wrong with naked short selling. It's not
> that your chickens come home to roost. It's that they're not your
> chickens.

Oct 24 05:19 PM

[Dialectical...:]

I am not against shorting stocks. I am against naked shorting.

NAKED short selling is when the shares which are being shorted are not borrowed and in some cases DON'T EVEN EXIST. This is a critical distinction that it seems you're not getting. If you disagree with me, fine, but my argument is not against selling something short. It is about selling something that isn't there... and that is what is at the root of Karl's article.


On Oct 24 05:19 PM 58robbo wrote:

> do you think that because someone shorts a stock the price automatically
> goes down? have you considered that if you short something, you have
> to first find someone who thinks that the price will go up to sell
> to. ie when you sell short all you are doing is effectively betting
> the stock will go down. obviously then the person who you are betting
> against believes the stock will go up. where i come from that's called
> a zero sum game.
> generally, people only short when they believe something to be overvalued
> and people go long when they believe something to be undervalued.
> if the stock in your portfolio is neither, you have nothing to worry
> about. bears can short your stock all day but fundamentals will eventually
> prevail.

Oct 24 05:49 PM

[58robbo:]

i'm well aware what NAKED shorting is Dialectical. the point i'm trying to make is this: the only person who has anything to fear from a naked short seller is the counterparty ie the person to whom you sell the stocks you don't own. As long as they are aware you don't own the stock ie you haven't missrepresented your position (this would constitute fraud) and they are happy that you will be in a position to fulfill your obligations should the stock price rise, i don't see why this needs to be regulated.

this belief that naked shortsellers adversely affect stock prices is also way over stated.

the bottom line is that i don't believe the state should be there to protect people from their own stupidity. i understand that my view is no longer popular in america today or the world for that matter. this worries me because behind every stupid thing people do (smoking, drinking, j-walking, unprotected ---, going into personal debt, driving too fast, eating fast food..... i really could go on all year....) there is a bureaucrat/politician who wants to 'help you' by regulating 'your' behaviour!

unfortunately for me george orwell had a profound effect on my psyche!


On Oct 24 05:49 PM Dialectical Materialist wrote:

> I am not against shorting stocks. I am against naked shorting. <br/>
>
> NAKED short selling is when the shares which are being shorted are
> not borrowed and in some cases DON'T EVEN EXIST. This is a critical
> distinction that it seems you're not getting. If you disagree with
> me, fine, but my argument is not against selling something short.
> It is about selling something that isn't there... and that is what
> is at the root of Karl's article.

Oct 25 05:48 PM

[58robbo:]

i think i answered this post in my reply to dialectical above!


On Oct 22 02:52 PM Michael Clark wrote:

> The problem is: they do go running to the government for the bailout.
> That is: the casino runs to the government for a bailout. But is
> the government supposed to protect Las Vegas from the gamblers in
> Las Vegas (when things go wrong)?
>
> Laws exist to protect the lambs from the lions. Lambs get taken in
> quite often by the lions on Wall Street. If we have enough laws now
> to protect the lambs, then so be it. If not, then we need the laws
> to be updated. In fact, one definition of 'civilization' is the updating
> of 'civil laws' over time.
>
> If we have a government that is owned by the lions and is, thus,
> kept from enforcing the laws on the books, then we have a whole different
> problem on our hands. The lions have too much money and power and
> need to be liberated from their excessive influence.

Oct 25 05:50 PM

[drbob66:]

Interesting link...


On Oct 22 11:42 PM John O wrote:

> I was an options market maker on the PSE for 5 years and the CBOE
> for 5 years and traded options and stocks short and long in about
> every conceivable situation. I am intimately familiar with the Bear
> Stearns take down.
> I will say that the author here and Taibbi and others who believe
> that naked short sellers caused the Bear Stearns crash do not have
> a clue to what has happened or they are deliberately misdirecting
> the blame away from people like Dimon, Bernanke, Cox, Cramer, and
> many others who stole billions from illegal insider trading.
>
> Just ask Cui Bono? and the answer becomes the illegal inside traders
> and J.P. Morgan.
>
> See the real explanation of Bear Stearns below:
>
> www.optionsforemployee...

Oct 28 01:52 AM

[John O:]

I am trying to find someone who will take a pot at explaining how so called "naked short sales", 90% of which occurred after the collapse of Bear Stearns and after the collapse of Lehman, caused the collapse of those two towers, faster than Larry Silverstein can say "pull it."

Oct 29 05:12 PM