A reader asked for my take on the naked short selling issue that is explored in a video that you can watch here, its a long one, I watched the whole thing.
I go months at a time without thinking about this. This means very little to the vast majority of stocks. Most of the stocks mentioned in the video (like Krispy Kreme and Martha Stewart) are all very hot potatoes facing big problems, real or perceived.
There are some very strange things with the video that need to be mentioned. Early on in the video an expert from a company called Buyins.net gives his take from what looks like the Buyins.net offices. During the video there two one-commercial breaks. Whose commercials? Ahem, Buyins.net. I find that strange. Am I the only one?
There are also a couple of mechanical issues with regard to selling short that literally are not mentioned one time in the video that need to be explored and explained to get some sense of how important or not naked short selling is and to be clear I don't know the answer.
First, there was no mention of the uptick rule. Stocks (as opposed to ETFs) can only be sold short on an uptick but it is more complicated than that. For NYSE stocks not only does the last trade have to be an uptick but also a given short sale cannot itself create a down tick. Think about that for a moment; getting a fill can be difficult, even market orders to sell short can go unexecuted.
To sell short a Nasdaq stock the bid has to be on an uptick. I have never been too clear, given these mechanical issues how a stock can be pushed down in the manner described. I am not saying it does not or cannot happen, I am saying I am not sure how.
One way it could be done would be if these orders are entered as straight sales as opposed to short sales. When you place an order online you choose from buy, sell or sell short. So if they mean that orders are being entered as sales, OK, but the video never said this. In fact toward the end one person named Breen specifically refers to short sale orders, implying they are entered as short sales.
Now after all that there are 1000 stocks that are uptick exempt. I did some digging and it looks like the 1000 stocks come from the Russell 3000 but anyone feel free to correct me. I checked most of the stocks in video (the ones I could remember, I did not want to watch again) and they were not in the Russell 3000.
Correction as of 8:26 PM Friday night. Several of the stocks in the video are in the Russell 3000 index. I did not realize the Yahoo Finance components page did not include the Russell indices. Stocks that I found in the Russell 3000 from the video were TRMP, KKD and MSO. I did not find OSTK or ADBL. There was a penny stock or two mentioned that are not in the Russell 3000. I scanned the iShares.com Russell 3000 page to find these names. If I missed OSTK or ADBL please leave a comment. Since all all the stocks in question are below $1 billion in market cap I doubt they are uptick exempt but anyone who knows should also feel free to comment.
A lot was made in the video of phantom shares. One thing never mentioned is that legitimate short sales create phantom shares, but maybe the meaning is different? Again I don't know because the video did not say. Here is how this works. Joe owns 100 shares of IBM in his margin account and he has a margin debit in the account, meaning his shares can by hypothecated for a short sale. Bill wants to sell short 100 IBM and borrows Joe's shares. All the uptick business sorts itself out and Bill executes his order to sell short. Well, someone took the other side of Bill's short sale and now he owns 100 shares too. The company did not create more stock yet where there was 100 shares long in one account now there are two accounts that each have 100 shares.
I do not doubt there is an issue with naked short selling but it effects very few stocks, very few. As I said have throughout this post I do not have many answers but I know what questions to ask. The Bloomberg video comes up way short of asking the right questions and why on earth did they place ads from someone who is a part of the story?
One last thing; in the video Jim Chanos said that if there is an issue it is with the prime brokers. This was not really explored. Clearly some portion would have to rest with the prime brokers. I don't know how much is their fault, 5%, 95% who knows because the video did not explore this either.
A thorough dissection of the mechanics has to accompany this in order to sort it out.
I started out saying I go months without thinking about this and after watching the video that is unlikely to change.
This could whip up a lot of comments and some good discussion.
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16 comments:
A risky game to play for non-24/7 investors.
Naked shorts? Danny DeVito sans clothes.
A well-researched and chosen stock portfolio? The Sports Illustrated Swimsuit edition.
My comparison does not include the cost of maintenance.
As I've heard it, the accusation is that some big brokers are allowing some big customers to sell short without the borrow the stock element, creating more stock float than has been issued. This is against SEC rules but they don't have time for little details. Presumably, this would also skirt the uptick rule.
Love your blog.
I didn't watch the video, but I the much maligned CEO of Overstocks, P. Byrne, did a presentation (an excellent one in my view, but it may be technically compromised; I wouldn't know). BTW, there was absolutely no bully pulpit use of that presentation with respect to Overstock.
I looked and could not find it, but it was a wonderful tutorial. Perhaps other readers remember it or have a link.
Charlie at the Lake, thanks for the kind word. Borrowing or not borrowing does not involve the people who execute short sale orders on the floor or Nasdaq. Borrowing is done through the stock loan department of the broker. If an order is entered as a short sale it has to be executed in accordance with the uptick rules except for the 1000 exempt stocks.
A specialist or market maker would have no idea if the stock has been borrowed properly or not. I don't think this is a way to skirt the uptick.
Only marking the order as a straight sale instead of a short sale would do it.
i did not watch this video either, but this subject has been floating the around the net for at least a year. The OSTK CEO talks about it a lot. The claim behind the law suits and the accusations is that brokers are are executing short sales without borrowing the stocks.. hence the term "naked shorts".
The accusations are that hedge fund managers and brokers are beating down stocks by flooding the market with sell orders over a long time period. We are not talking about selling a 100 shares here and there. But a systematic sell of millions of shares over months to crush the stock.
i do not know if any of it is real and frankly i do not care. but it wouldn't surprise me.
Byrne is a pretty sharp guy and gets an absolute horrible reputation. He does have his theatrical moments, conference calls of OSTK have great comic value, check out his star wars theory. But back to the subject, his father is in charge of WTM (white mountains) whom Buffett owns 17% of, Jack (the father) ran Geico for a while and helped turn it around.
I looked in my archives of articles that I thought were great to read, and I quote, "When Patrick Byrne first came to his father to suggest spending $1.5 million to buy a company that sold liquidated bulk products on the Internet, he suggested that instead he pile the money "up in Dartmouth Square here at the college and light it. let the freshman dance around it and have some fun. That's the worst idea I ever heard."
But Dad not only came on board, he eventually became chairman of the board. Patrick, like his father, is not a reticent man, and he was soon in a major battle with analysts and short-sellers and the Securities and Exchange Commission, which he maintained were trying to destroy his company.
Jacks reputation still stands, its his son thats a little crazy (on the surface). His father is a billionaire, Im just not sure that OSTK is a sound business.
A very long time ago, in the 1950's - I was a Margin Clerk for a regional Brokerage firm. No computers then, if the market dropped big time, you worked all night getting out Margin Calls and balancing out the long and short positions in all the margin accounts.
Accordingly, I think I have some crediblity on the subject, although many things are handled differently today, I doubt that the essential rules have changed.
You are right that Joe must have a debit balance in his account to borrow (we called it floating) his shares, but his debit balance must be at least large enough to equal the 100 share IBM market value, otherwise you could only float up to the debit balance and go look to other accounts for more shares to float.
Since I worked for a partnership - all the partnership shares as well as the partner's personal account's shares were allowed to be perpetually floated, regardless of debit or credit balances.
These accounts were the only exceptions. Every customer's margin account could only float shares equal to the debit balance.
i think Charlie at the lake's info may have come from a misunderstanding of the fact that a brokerage house's shares are always made available for floating.
But short sales must always be covered, always - even if they have to borrow from another broker, or from the issuing corporation's treasury shares. (The NYSE required a listing company to make a certain number of these available for short covering))
I don't know about the SEC not checking, but I remember sitting with NYSE auditors while they picked through my accounts looking for errors and violations. (Since this could result in having the firm's trading privileges suspended or revoked - it was not without a bit of tension)
Each account contained four columns. Debit$, Credit$, Shares Long, and Shares (Short).
A Margin Clerk would look at the example of phantom stock as follows:
There are two accounts that are long a total of 200 shares and one account (short) 100 shares, net position equals 100 shares long. Stock positions were accounted for the same way as dollars.
The uptick rules were handled by the floor brokers, but you are right that a short sale must always be identified, if not, payment in cash on settlement day.
If an adjustment was needed to change a trade from regular sale to short sale, a partner had to sign off on it.
OG
So OG are you saying the second 100 shares are or are not phantom shares?
My experience is from 1984 working at Schwab in their stock record department.
The ledger then, in the computer, had a balance or offset. For every long there was a corresponding short on the screen. Not someone who had sold short necessarily but an offset.
If there were 1000 shares long in ten different accounts (10,000 total) and 1000 sold short, the online ledger would show all ten accounts long, the one account that had short and the other 9000 shares would be offset by something like a DTC position of 9000 "short" but not sold short.
NCANS (National Coalition Against Naked Short Selling) describes the current incarnation of naked short selling here: http://tinyurl.com/7znyg
The key appears to be in how failure to deliver (FTD) is handled by DTCC; i.e., a chronic, large scale de facto phantom float of book entries/IOU's
Roger
The second 100 shares are not phantom - BUT - only if a Failure to Deliver has not taken place -
I was somewhat naive discussing short sales from my past simple legal point of view. FTD's are a recent problem, and a big one.
Reading the NCANS description, if the FTD shares are not phantom, they are certainly counterfeit.
The risk is in the entire market, not just short sales. Wow, I'm beginning to think Dave B is an optimist!
OG
DaveB as optimist, zoiks (hey DaveB just a good natured heckle).
I will be dumbfounded is this turns out to be a big deal. This strikes me as the same type of thing as CEOs certifying earnings and options expensing.
These things mattered very rarely here and there if naked short selling is any different...well egg on my face for sure.
Roger, really nice review. I'm impressed greatly at your willingness to dig into a topic. On the surface I'm luke warm open to the criminal implications. First, the video was posted at a creditable site. Secondly, I've been involved with a speculative tech stock for the past ten years. Fellow holders of this stock, whom I've seen show their own creditability over time, have some conviction that naked shorting has kept the price down. They've dug into the numbers, and it seems to relate to specific purposes. For years it allowed shares to be bought cheap when the company needed to raise money through private sources. Now, it's being done to take the company private. Third, hedge funds are running out of angles. You don't live on the street without being coverted to sociopathy. It's kind of like global warming. It does exist, but the consequences and severity of the issue are unclear. And, yes, those adds were annoying. Made me wonder about Bloomberg. Was this video ever apart of regular broadcast and then made into an infomercial, or is it just the latter?
fascinating angle on this topic, thank you for posting it.
The Bloomberg publication was short expose on a very long and complicated subject matter. I think it meant the intent of raising awareness that forces individuals like those that posted here to ask more questions.
a Couple of comments:
1. Uptick rules only work when the trade is properly marked. Every month a firm is being fined for improperly marking short sales and...just recently Goldman Sachs was fined $2 Million for allowing mismarked short sales that were naked short sales executed by hedge funds.
2. Patrick Byrne. While the financial media has crucified Byrne for his comments, Jim cramer came out with a December 2006 interview (recently exposed in NY Post) in which all or most of Byrne's allegations were confirmed as reality. Including the excercise of using teh financial press to disseminae lies that are intended to manipulate markets.
Naked Short selling is very real - as stated by Chairman cox. the magnitude of the abuse however is not and it is not because at the present time Congress and the Regulators are allowing such collateral abuse to exist to maintain liquidity and profitability at the hedge fund and Wall Street institutional levels. It is the general public that needs to force the transition into full transparency.
I'm totally hypothesizing (never worked in a securities clearing office) but...
so how about this:
adam is long 100 shares IBM...
Bill Borrows 100 shares to short..
before the sale clears (its like 3 days or something right?) Adam, panicked by the falling price sells his 100 Shares.
when it comes time to clear Bill's trade, the shares borrowed from adam are already marked for sale and undeliverable, Bills broker finds it cheaper to fail to deliver the trade than to borrow the shares on the open market...
great question, like a lot of things there was no mention of it.
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