The Shocking Truth About Naked Shorting

While shooting the breeze the other day with Professor Pat, I asked him if he knew anything about naked short selling. He said no and I said great! Why don’t you write an article about it? And so he did and here it is. It’s a good read and trust me, you’re not going to like the practice of naked shorting. The SEC should be ashamed of itself at allowing this clearly unfair–if not downright fraudulent–practice to occur and the brokerage firms should be shamed as well for engaging in it. I’m glad this practice is being exposed because last week’s panic in the banking and mortgage-backed securities sector forced the SEC to ban naked short selling on 17 brokerage stocks along with Fannie Mae and Freddie Mac for 30 days.* (BTW, if you hold stock in either of those companies, get out now as their balance sheets are only going to get worse.) Former SEC Chairman Harvey Pitt was recently quoted as saying that he hopes the SEC will extend the ban to include all publicly traded stocks forever. Finally, a breath of sanity!

Anyway, enough from moi. Here’s Professor Pat’s explanation and take on the shocking practice of naked short selling.

Shenanigans Beyond Belief!
While watching CNBC the other day one of the commentators happened to mention the practice of naked short selling and how that might be affecting the downward trend of recent markets. I had heard the term before and never thought much about it but this time I wondered what exactly is the mechanism that is followed for such transactions.

Normal short selling is simple: The short seller borrows stock from someone who has agreed to loan them their stock. Since stock is being loaned, the seller agrees to pay interest on the value borrowed for the duration of the loan. The short seller then sells the shares on the open market and pockets the cash. Assuming the value of the shares have decreased at a later point in time, the seller buys back the shares on the open market. The stock is then returned to the lender and the interest on the borrowed amount is paid. The balance remaining is the profit from the short sale. This is all perfectly legitimate as everyone knows what is happening and they have agreed to it, or at least they should. If you have a brokerage account and you keep your shares there in what is called “street name,” you have agreed to let the brokerage firm loan your shares to short sellers at their discretion. This is legitimate as you have been informed of and have consented to this practice as part of the account terms and agreement.

However, when someone or some institution practices naked short selling they are skipping the part where they first borrow the shares to sell. They are, in fact, selling something they don’t have. Three days later at settlement time they have no stock to deliver unless they have borrowed the shares in the meantime. This is much like the kiting of checks where you rely on the clearing delays to create cash you don’t actually have in your account. According to the SEC, naked shorting is perfectly legal unless the selling itself is done for the purpose of causing the price of a stock to drop rather than benefiting from a drop due to other reasons. Wikipedia quotes an “official with the SEC” saying that 1% of all dollar denominated trades (amounting to $1 billion every day) experience a settlement incident requiring additional time to complete, perhaps necessary for the stock to decline further for the short sale to become profitable at the expense of the buyer. This practice is even excused under the guise that it adds to market liquidity.

Now, let’s say that I advertise to sell a used car and I find an out-of-town buyer who buys the car on the phone and sends me the cash for the car to reserve it. “I’ll be by in three days to pick it up” he says. If I were to enter into such a transaction without ever actually having a car to sell I would be guilty of fraud and would go to jail. Selling something you don’t own is usually a criminal act whether it be a used car or the Brooklyn Bridge. But when it comes to selling stock it’s surprisingly not! Brokers do this kind of thing all the time and they don’t have to go to jail.

There is no question that naked short selling is contributing to the current decline of the financial markets and therefore all our investment portfolios and 401K’s. The brokerage houses are complicit in aiding and abetting this shady and dubious activity. Why do they do it you ask? Well, because they make money doing it that’s why. They make money on every sell transaction and they make money on every buy transaction. For them, volume is what generates revenue. So, if a valued large client says they want to short naked they will likely go along for as long as the naked shorter is able to eventually deliver the promised sold stock and pay their brokerage commissions. The brokerage houses may even stand behind the short sale themselves making good on the transaction in the event of a default by the short seller. The brokerages can even keep this up, presumably within regulatory limits, as long as the eventual buyers of the stock do not demand to take physical delivery of their shares. Maybe we should all do that.

So, why sell naked instead of correctly borrowing the shares first? Well, maybe there are insufficient shares available to be borrowed. Or maybe a big advantage to the naked short sellers is the presumed absence of the interest charge that would normally be paid on the borrowed amount. Nothing borrowed, no interest cost.

In 1985 the SEC enacted Regulation SHO to combat abusive naked short selling. It has so many loopholes however that it may as well not exist. Market makers and brokerage houses are exempt from the rule. Brokerages also have immunity if the naked short selling client is “deemed” to own the stock they are selling. Yeah, right! While this nonsense is permitted here in the US one can only imagine the unbridled chicanery that goes on in relatively unregulated foreign markets.

So, what do we do about this? For now what I want is for all of you to get up out of your chairs and go to the window, open it and stick your head out and yell “I’m as mad as hell and I’m not going to take this anymore.” … with apologies to Peter Finch.**

-Written by SMCB Guest Contributor, Professor Pat

*What is so ironic is that the stock of the major brokerages are now exempt from naked shorting but the brokerage firms themselves are not exempt from doing it! To view the current SEC ruling regarding naked short selling and a list of those exempt from it, click on the following link:

**If you’d like to do more than shout out the window, send a brief online note to the Senate Banking Committee. If you live in a state represented by a Banking Committee member, you can also contact that person. Here’s the link to the Senate Banking Committee website (don’t worry–it’s easy to use and sending a note will only take a minute):

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