Naked Shorting Comes Full Circle

During last week’s testimony to the Senate Banking Committee from Bear Stearns (BSC) and JP Morgan (JPM), the world's leading bankers from Humungous Bank & Broker seemed to be in tears over the naked shorting, organized and otherwise, that had gone on in the BSC stock, going so far even as to infer that that problem, not the illiquid assets of Bear unwanted by other bankers, was the real issue.

Surprise, surprise; only when their houses are affected by vermin do these people speak up and admit that just maybe Patrick Byrne of Overstock.com (OSTK), whom the same illegal short selling syndicates have tried to destroy, slander and humiliate, may have been right after all.

(From the Overstock.com website) "Patrick Byrne is waging a fight with Wall Street over naked short selling. He believes that, through the practice of naked shorting, Wall Street is cheating Main Street America and destroying small companies for a profit. Byrne feels that the SEC is failing to protect retail investors and small companies because it has been captured by Wall Street, and that the New York financial press is similarly co-opted. Byrne believes that the SEC's efforts to eliminate this abusive practice are falling short, not simply for Overstock (which has itself been on the Regulation SHO Threshold list for over two years), but in a way that creates the possibility of systemic risk for our financial world."

Of course Patrick Byrne was right. He was up against the most powerful network in the world, HB&B, and Patrick is just a guy like you and me, trying to make a living doing the right thing, while the last thing the leaders of HB&B want is social equity. They want to control us, plain and simple. Now that naked shorting is threatening their control of the capital markets, they speak up.

That is the entire point to my blog, which is to say that the owners of capital have been made subservient to those who run the credit-based financial services industry in the world, which has been headed by Mr. Moral Hazard himself, Henry Paulson.

Who were the people who permitted naked short selling in the past? Why, it’s HB&B. If these investment bankers had refused to allow unsupported short sale trading, this issue would be a non-starter. But they liked the extra commissions and knew that the practice was being done by their best clients and friends, so they allowed it.

We have discussed this issue at length here, in full support of our friend Dave Patch who has taken this fight to the SEC.

Finally some positive response from the SEC. Well done Patchie.

From: OIG [mailto:[e-mail]] Sent: Friday, April 04, 2008 1:14 PM To: Patch, David (GE Infra, Aviation, Non-GE, US) Subject: Proposed Response on Naked Short Selling Dear Mr. Patch, We are planning on sending an update regarding the naked short selling issue to the investors who have previously expressed their concerns on this subject to us. Specifically, we plan to send out an email that mentions our meeting with you. We wanted to show you our proposed email (which we've copied below) before we send it to the investors who have corresponded with us. Please let us know if you have any thoughts on our proposed email. “ *** You previously contacted the Office of Inspector General on the subject of naked short selling. We would like to provide you with an update on our progress regarding this issue. We have conducted a thorough review of all the correspondence provided to us about naked short selling. We also met with Mr. David Patch on Wednesday, March 26, 2008, at which time he gave us an extensive briefing on this topic. We understand the seriousness of the concerns about naked short selling and have begun looking into potential audit issues related to this matter. Thank you again for providing us with information about naked short selling and we will keep you advised of further developments on this topic. *** “ Thank you, Mary Beth Sullivan Counsel to the Inspector General Office of Inspector General U.S. Securities & Exchange Commission

What we need to do is to send letters of support (e-mail) to Dave Patch ([e-mail]), particularly if you are concerned about specific cases where you believe the illegal naked shorting to be happening. Let Patchie deliver them to the SEC, where they will be heard.

By the way, I once did a blog headed "Short selling is not un-American". I couldn't find the article, but this reference was to another one that was kind of fun doing.

Mr. Sell-Side: Stop this nonsense. You'll never get rid of me! You short-seller, you.
I ought to call the SEC. Maybe even the President, because you're Un-American.

Wizard: Thankfully it's not un-American to be a short-seller. On the other hand, Mr. Sell-Side; in the USA alone, the Government's SEC sees fit to permit Buy-Side to pay its mutual fund managers directly for advisory fees the shocking total of $80 billion dollars annually -- over 1.1% of over $7 trillion -- which is a travesty when, as Mr. Morningstar tells us...

So, the short selling is ok; it's the problem called "naked shorting".

I wrote another one in 2006 called “A Failure to Deliver” in which Kaimu pointed directly to the main offending culprit. Guess who? It was Jamie Dimon, the JP Morgan CEO who was the man giving testimony to the Senate Banking Committee. Kaimu also outlined, as he has on many occasions, the dire straits facing Patrick Byrne in his fight against Wall Street. This is all coming full circle.

We are here to learn the truth, right? Re-read the “Failure to Deliver” article until you come to the point of it all – the problem at the DTCC that needs to be fixed.

The current rules don't require the brokers to fix the trades by buying shares to cover their short positions after 13 days, they merely say that if the trades aren't fixed, the broker can't do any more short-sales in that security without borrowing or arranging to borrow the stock.

The Depository Trust & Clearing Corp., the New York clearing house that is owned by the big brokerage houses and whose mission is to settle and clear the lion's share of the daily stock transactions that occur in the markets, says it has no power to force brokers to fix the trades either, a fact that also frustrates critics of the current system.

"We don't have any power or legal authority to regulate or stop short-selling, naked or otherwise," the DTCC says on its Web site. "We also have no power to force member firms to close out or resolve fails to deliver."

About ten years ago, I gave a formal presentation in a major hearing conducted by the Canadian Securities Administrators, chaired by the heads of the nine major Provincial Securities Commissions. This hearing on the future of electronic markets heard presentations from every axe-grinder in banking and capital markets in the world, from the Investment Dealers Association, all the stock exchanges and ETN’s, all the major info services, Bloomberg, Instinet, and so on.

The acting-Executive Director of the Ontario Securities Commission had asked me to present material that would serve the public interest. He gave me almost 30 minutes. So I gave my usual song-and-dance about the need to break up the broker-agent from the dealer-principal; separate the credit-based financial system from the capital market; and, along with flow diagrams even, I even showed how control of the Depository Trust & Clearing organization had to be taken away from HB&B, and put under the control of private banks that serve only the client.

The people in that room either didn’t understand the magnitude of what I was saying or they scoffed that I could break their control of the system. My associates have always said I am 15 years early.

I do agree that I am always thinking ahead, analyzing the problems, and formulating solutions. It helps me see the enemy. Patrick Byrne is not the enemy. Those Senators were staring for the afternoon at two of them, calling them wonderfully successful people and all. Yes, but for what reasons and at whose expense?

We will never have social equity unless and until the capital markets are freed of the iron fist of Humungous Bank & Broker.

I am taking time to teach you that what transpired in Congress this week, at least the pieces we were able to see on TV, was presented as a clown show, but in fact was a start to getting to the truth. All of you need to seize the moment. You have to understand that these people who run HB&B are an organized gang, hiding behind one another’s skirts, with no intention of giving up control over you. But you now see who they are. They put their pants on same as you and me. In fact, I’ll go so far to say they couldn’t carry the lunch pail of the average steelworker or auto assembly line worker who still have jobs that these people haven’t helped shipped off to countries that are cheaper but have bad labor practices, leaving 25% of Americans in debt to them with underwater mortgages and credit card debts they cannot escape.

Yes, finally, Mom & Pop got to see their masters, the people they have become slaves to. Recognizing the enemy is the start. Yes, these are Henry’s friends, and sad to say, unless Congress and the SEC do an about face here, the new system will be called Henry’s Rules.

To be crystal clear, I am not saying one bad thing about these firms; just about the control they have in the present structure and the executive managers who will do pretty much anything to keep in control. In fact, I said already my heart goes out to the Bear Stearns employees, who, like you, get paid to do a job and don’t expect to have their life-built pensions wiped out in a couple hours. I am happy to see them suing their bosses. What goes around comes around.

I was criticized, as I had expected, for saying two weeks ago that lawyers were changing the fundamental rules of capital markets, which is that a trade is a trade; not a maybe trade. The lawyers here were saying to me that they just carry the water for these investment bankers, and that’s where I disagree. A desperate banker doesn’t know the law, but will ask the lawyers what might be possible to help solve their dilemma. Lawyers seeking fees will not care a whit about the public interest, and that’s the problem. As soon as the JP Morgan-Bear-Fed deal was consummated at $2/share and reported, and then subsequently changed, the SEC (and Congress) had an obligation to the People to step in and stop the change. A deal was a deal. The bullet was out of the gun. Hundreds of millions of dollars, if not much more, was subsequently transacted on the basis that Bear had sold out for $2.

Congress also should be totally embarrassed that once Wall Street figured out the impact of the $29 billion guarantee, the Bear shares were worth more. By changing the deal, the JP Morgan shareholders got screwed because after the merger, there is greater dilution. And the public got screwed because if Bear shares were actually worth $10, then a full $29 billion guarantee from the Fed was not needed.

Now, it goes without saying that the new unwritten rule on Wall Street is that no investment bank of any large size is going to be allowed to fail; that the People’s money, not the shareholders capital, will stand behind the company debts and the mistakes of executive management. That offends me because I stand up for social equity, not socialism.

This latest situation in Washington is simply mind-boggling to the owners of capital in America who once had a measure of faith in their capital market. Now it is apparent that the market will be played by Henry’s Rules, and Mr. Moral Hazard had the arrogance to not even show his face at these crucial hearings. That’s not right.

A final note regarding the Treasury Secretary; I ask, is it possible under the freedom of information act to see Paulson’s income tax returns and his so-called blind trust? I think America had better awaken to what’s happening here before the upcoming change in the Administration, during which time certain people will be trying to accomplish whatever they can for themselves, Friends & Family.

This week the markets were in a state of confusion because of all the happenings in Washington. Traders are uncertain regarding the new power of HB&B, so far giving them the benefit of the doubt.

Comments

[lenofus]

Thanks, Bill, for supporting my friends Dave, Patrick,........ That being said, how sad is it that there are so few like you, I singled you out for praise?

When it looked like we had no one, you piped up, and I'm grateful. We'll win!!!! No Doubt.

[bankerjim]

I agree completely. Naked short selling is destroying our capitalist underpinnings. Small cap companies can be targeted and overwhelmed with such short selling of shares that don't even exist, destroying the value of the targeted enterprise. I refuse to buy small cap stocks for this very reason. Is this good for America? No!!!

[luminor]

Thanks for a great article and stand, we need more people in america like yourself and Patrick Byrne to fight for our rights and freedom....this is the real freedom, this war is as important as our basic rights that we fought for. God be with you and The Great Patrick Byrne......and protect him....

[helplessobserver]

All the SEC has to do is impose a penalty of $100.00 per share for every share sold illegally.

[datalink1995]

Why not ban the "no up tick" rule as well? That coupled with the naked short will kill the market (like 1929 all over again...it CAN happen).

[Gumwars]

Naked short selling is yet another weapon in the toolbox of the corrupt financial elite that is destroying our country. I've come to the conclusion that the banking sector, in particular the central banks, are the main offenders in nearly every problem that our nation now faces. From the war in Iraq to the collapse of the dollar the central banks are the responsible party to these crimes.

While the email from the SEC is encouraging, I will not hold my breath. Honestly, it seems to be more a holding pattern which could be indefinite. The promise that resolution is merely a few weeks away, which turn to months, then years; all the while corruption continues and government turns a blind eye to the destruction our financial sector has brought on us.

By now, nearly all of you must agree that our government is controlled by these institutions. Simply put, if you control the money, you control the government. The FED is filled with the minions of Wall Street and was established by names like JP Morgan, Rothschild, Goldman Sachs, and many other A list players.

The only question in my mind is, when will Main Street storm Wall Street and forcibly demand change.

[john haskell]

thanks for giving Bear Stearns management more cover. Yes, it was the naked shorts. Management did nothing wrong. BSC going bankrupt was just like Hurricane Katrina, totally unforeseeable, the victims innocent of responsibility in this natural disaster.

[jimmy46]

shorting stocks is a moderating factor and something long term investors should approve.
They keep momentum players pushing stocks up higher than they would've, and when stocks are low, shorts cover and keep stocks from going as low as they otherwise would.

EVERY SHORT ENDS UP WITH A BUY

People using MARGIN should especially like this,
because they won't be so likely to be sold out at a bottom.

Anyway, if shorting has such power,
WHY DON'T YOU JOIN THE GAME?

DO YOU like seeing other people make money
when you're not?
You can't have it both ways.

[Gumwars]

To jimmy46:

"WHY DON'T YOU JOIN THE GAME?" Probably because naked shorting is illegal. And I'd check the SEC filings before firing off, because not all shorts end up with a buy.

[Gates]

"Why not ban the "no up tick" rule as well? That coupled with the naked short will kill the market (like 1929 all over again...it CAN happen)."

As long as naked shorters are allowed to play by a different set of rules we might as well shut the markets down. You sure can't invest with any confidence.

[oldgoldbug]

Evidently shorts are occurring without the initial act of borrowing the shares. What happens on settlement date? Does the shorting broker get to keep the profit that may have been made or pay the loss if on the wrong side? If so, the $100 per share fine seems like a good way to go but who would have the manpower to enforce it? Bill, thanks for all your thoughtful articles and thanks to the comment writers who always add an interesting perspective.

[Patchie]

Bill, thanks for the plug.

As for those wondering about Bear Stearns. The collapse of Bear Stearns rests solely on the SEC. If you look closely at the trade data, the initial collapse took place while heavy puts were taking place in the market. Because the SEC has failed for 2 years to remove the OMM exemtion, the heavy put volume created massive naked shorts into the equity market (OMM hedge).

The short sellers were well aware of the liability their trading would have on the OMM and forced a heavy equity selloff to hedge the puts they sold. Add in the rumors and the sell off based on these naked put sales and the fear in the market was created. This data is 100% supported by the timeline to when BSC hit the SHO list.

[jcrash]

You should've put it in terms they might understand. Say, "See, naked shorting is like giving the janitor the keys to the money printing press."

Maybe then they would've understood.

[AustrianEconomist]

Patchie, you're wrong. Without the OMM exemption liquidity would dry up in the options markets as market makers would not be able to hedge their open positions option positions in the equity markets, causing spreads to widen significantly. I can't see the reasoning behind making other markets (apart from everything asset backed or high yielding) such as option markets more illiquid at this time...

[Patchie]

AustrianEconomist, I believe you are misguided.

1. An options trader has no right to directly impact the equity market through the sale of unlimited options contracts. Such activity is being used as a form of manipulation as short sellers have simply moved their naked shorting into that environment.

2. The volume of options trading these past years has experienced 20 - 30% growth year over year. The OMM exemption represents an extremely small subset of that total volume according to a study by Vodia Group and the use of the exemption is primarily in localized issues.

3. Citadel, the largest Options Trader drafted a repsonse to the SEC in the 2006 proposed rule stating that they do not use nor do they need the OMM exemption to run their business.

Liquidity can never be an excuse for fraud. In this case, with such a small percentage of investors trading the options market, it is foolish to give these investors such significance in the market pricing of an equity to which so many do invest. Options traders simply want to stock without paying the premium, such freedom will come at a price and that would be liquidity controls. If you hadn't noticed, insider trading fraud (all recent cases) and now most likely short sale fraud has originated from the Options market.

[Patchie]

For reference on the issue of liquidity at all cost;

Dow Jones 2004;

"Whatever the proper oversight scope applied to these agile pools of private capital, Donaldson in a Sept. 20, 2004 interview in The Financial Times injected a strange rationale into the contentious debate: 'How much fraud are you willing to tolerate for liquidity? I think the answer is zero.'"

Clearly not all believed that just adding liquidity into the market was a safe approach. Not every investor has a right to purchase or sell at a convienient fixed price, such must be balanced on proper supply and demand of shares issued not IOU's and entitlements to future shares.

[jjason]

I have proposed that short selling be made illegal. I especially abhor those involved in naked short selling. Thank you Bill Cara for this article.

[OscarBullFrog]

hmmmm, what about a *new* sec rule (gag) that says something along the lines of: short selling available IFF co has $2b market cap or greater AND stock price must be greater than $20.00. if either limit is reached short selling MUST be halted. [[lock limit down variant?]]

[TiredOfNakedShorting]

Because of naked shorting NTRI ... and losing a lot of money, I no longer invest in the stock market. Now, if EVERYONE starts to feel this way, can you imagine what that would do to America ??

[JohnOlagues]

I read Bill Cara's article and some of the comments and thought I would enter the discussion a bit.

I was a market maker on the CBOE for 5 years from 1980 to 1985 and a short stint in 1989. I also was a market maker on the PSE options exchange from 1976 to 1980. These were the early days when most market makers were sole proprietors and small groups. Money could be made by hard working tough minded traders would took risks, understood theoretical pricing models and used strategies consistent with buying what they thought were under-priced options and selling what they thought were over priced options.

I probably traded and held the largest positions that the rules allowed at that time in several widely traded stocks

In the early 80's there were cases of insider trading using the options markets. The victims of these insiders were generally the options market makers. The SEC prosecuted such notables as Michael Milken, Ivan Boesky and Michael Levine and that put a damper on the more obvious form of illegal insider trading.

However that just meant that the illegal insider traders were required to be more subtle about their theft. Rather that buy 2000 out of the money call contracts just prior to the announced take-over, the illegal traders would then (and still do) buy a bullish vertical call spread or a straddle or some combination of trades that would profit handsomely while having a built in explanation for their lucky situation just prior to the announcement.

Now matters have changed. Options position limits are 100 times as large and the Wallmarts have run the corner stores out of business. For example the Designated Primary Market Maker in Bear Stearns options at the CBOE is Citigroup. There are no sole props. operating as OMMs.

So these Options trading firms are capitalized with billions of dollars and do have the ability to force both the options and the stocks to positions to their liking.

These firms also have the ability to get and use illegal inside information against the public and opposing professional traders. And yes, they use the advance information. Please do not believe the idea that because a trader works for Citigroup or Goldman or Morgan that he must be a great trader. Most success that these traders have be they market makers or hedge fund managers is because they cheat. And the forms of cheating become more subtle every day.

Selling calls or buying puts have similarities with the short sale of stock. And the person selling puts to or buying calls from these illegal insiders do try to hedge those long positions by shorting stock or buying other puts or selling other calls. But often the good faith sellers of puts are not able to hedge and are left holding the "Bag".
But it is not the case that all sales of puts are completely hedged because that is impossible.

In the case of the Bear Stearns/J.P. Morgan Bail out, I do not believe that naked short selling is what collapsed the company. The short selling and put buying was done by insiders who knew the stock was going to collapse because of collusion between J.P. Morgan the FED and the inside traders, who planned the collapse in advance.

John