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I suppose I should write something brimming with wit and brio about the chart above, but since 500 people lost their jobs today as VeraSun declared bankrupcy, I think I’ll skip that and just state the point like the crescendo of a dry old economics class:

A price is a combination of of information about value and scarcity, and because some folks likely manipulated the scarcity in VeraSun, they likely manipulated the price. Thus VeraSun was likely deprived the ability to access the capital markets at the true market-clearing price for any securities offering for at least the last year, and maybe for longer. Say what some will about its business model, its adventures in corn futures, the virtues of corn-derived ethanol (not a big fan myself), etc., the point is that those capital allocation decisions are something the market should figure out, not “something the market should figure out but one side gets to sell and fail to deliver over and over and over.”

Interestingly, we don’t even know what happened with the fails during the third quarter because, as the SEC explains right now, tonight, on their website, in this choice little nugget:

“V.1.11. Can I obtain fails information?

“Currently, threshold lists include the name and ticker symbol of securities that meet the threshold level on a particular settlement date. Some investors have requested that the SROs provide more detailed information for each threshold security, including the total number of fails, the total short interest position, the name of the broker-dealer firm responsible for the fails, and the names of the customers of responsible brokers and dealers responsible for the short sales. The fails statistics of individual firms and customers is proprietary information and may reflect firms’ trading strategies. The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to “squeeze” the firms improperly. “

In mid-2004 the Securities & Exchange Commission (itself a kind of a joint venture of the US federal government and Wall Street) adopted Regulation SHO. Among other things, “Reg SHO” insisted that exchanges publish the names of firms being victimized by naked short selling. They left plenty of loopholes (grandfathering, offshore failures, option market making abuse) and used lots of weasel-words to say it, and courteously stipulated no penalties for failing to follow the rules, and gave everybody until January 2005 to figure out new ways around them, but tepid though these measures were, curtailing naked short selling was their basic thrust.

This graph registers the daily total of companies appearing on the Reg SHO list.

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I have maintained all along that naked short selling was not a hard problem to solve: it was just a hard problem to solve without seeing about 20 rich guys get their asses handed to them. And because they were rich and well-connected, efforts to persuade the federal government to enforce the law were stopped dead in their tracks.

Somewhere in the middle of 2008, after the horses bolted from the barn, the barn collapsed, the barn burned, and the barn’s ashes scattered to the four winds, the federal government decided to close the barn door. They enacted a subset of the reforms which Deep Capture and a handful of other activists had been suggesting for a few years. The data suggests those reforms are working. I would not stake money on the likelihood that this means much, but hope springs eternal….

There is a problem with the voting mechanism, which we are currently working to repair.

Because we don’t know exactly how long this glitch has been in place, much less know how long it will take to resolve, we’ve decided to extend entry and voting deadlines to midnight (Utah time) November 15, 2008.

Good luck to all!

A couple of days before Lehman fell and all hell broke loose on Wall Street, Floyd Norris, the chief business correspondent of The New York Times, published a blog (headline: “Short Sale Conspiracies”) wherein he implied that I was mentally insane for suggesting that Deutsche Bank Securities had been caught selling “massive amounts of phantom stock.”

I promise to take this up with my psychiatrist, but first let me tell you a bit more about the peculiar case that led the New York Stock Exchange to hand Deutsche Bank Securities the largest fine in history for violations of SEC rules designed to prevent the creation of what the chairman of the SEC has called “phantom stock.”

The NYSE’s disciplinary order states that Deutsche Bank’s traders “effected an unquantified but significant number of short sales…without having borrowed the securities.” Indeed, the traders sold the shares “without having any reasonable grounds to believe that the securities could be borrowed for delivery when due…”

This is a clear-cut case of abusive naked short selling – traders selling stock without bothering to even check whether the stock could be obtained. In other words, Deutsche Bank’s traders were selling phantom stock, and it appears that they were doing this systematically over the course of the 22 month time period (ending in October 2006) that the NYSE investigated.

I asked NYSE spokesman Scott Peterson how much stock Deutsche Bank sold without knowing that the stock could be borrowed. He said, “We’re not saying how much, but let me put it this way: It was A LOT.” (The emphasis was his.)

Interestingly, however, the NYSE pointedly did not include the words “naked short selling” anywhere in its written disciplinary action. And the Big Board’s spokesman went to great lengths to suggest that Deutsche Bank was not engaged in naked short selling. “This is a case of failure to locate stock,” the spokesman said. “We’re being careful not to call it ‘failure to deliver’ stock.”

Mr. Peterson referred me to a section of the NYSE’s disciplinary order where it says that “according to [Deutsche Bank’s] delivery records,” there were “only two failures to deliver.”

So Deutsche Bank systematically failed to even locate the stock that it sold, but the NYSE isn’t calling it “naked short selling,” and Deutsche Bank managed to deliver the stock in a timely fashion in all but two instances.

Does this seem strange to you? It should.

SEC rules give short sellers three trading days to borrow and deliver real shares. If the stock is not produced within three days, it is called a “failure to deliver.” If a company’s shares “fail to deliver” in excessive quantities, the SEC puts the company on the so-called “threshold” list of publicly listed firms that are likely victims of improper naked short selling.

When I pressed Mr. Peterson, the NYSE spokesman, he conceded that there were not “only two cases of failure to deliver.” In fact, Deutsche Bank routinely failed to deliver specific securities–all of which appeared on the SEC’s threshold list. When I asked how much stock Deutsche Bank failed to deliver, Mr. Peterson said, again, “a LOT.”

So what was this “only two cases of failure to deliver”? It turns out that there were only two instances (among the sample of questionable trades for which it was charged) where Deutsche Bank still had not delivered the stock after thirteen days. Surely the NYSE must have known that failures to deliver of three to thirteen days are considered by the SEC to be improper naked short sales. At the time of the Deutsche case (the rules have since been changed slightly) day thirteen was the point at which the SEC would hand the delinquent naked short sellers a pathetically light penalty, forcing them to forfeit their short positions by buying back (rather than borrowing) shares.

In practice, this 13-day rule only encouraged stock manipulation. Some traders, correctly reckoning that the SEC would do nothing, simply left stock undelivered for weeks or months at a time. But a great deal of abusive naked short selling involved traders who sold phantom stock and (obviously) failed to deliver it on day three, and then absorbed the “penalty” on day 13 – purchasing (rather than borrowing) the stock and delivering it.

As soon as they closed out their “short” positions (which were fake positions since they never intended to borrow the stock), the traders would immediately sell another batch of phantom stock and leave that undelivered until day 13. By the end of each of these 13 day periods, the phantom shares had, of course, diluted supply and watered down the price (at which point it was hardly a “penalty” to have to buy back the stock).

A great number of the companies that appear on the SEC’s “threshold” list have been subjected to precisely this pattern of abuse. And if I understand the NYSE spokesman correctly, this is what Deutsche Bank was up to – short selling phantom stock with no intention of borrowing shares, waiting to buy (rather than borrow) the cheaper shares at day thirteen, and then selling more phantom stock, targeting the same threshold-listed company, the very next day.

Deutsche Bank did this week after week for at least two years.

Predictably, the SEC has not gone after anyone in the Deutsche Bank case. Instead, it leaves the NYSE to render its “largest ever” fine – a mere $500,000, which is many millions, if not billions, of dollars less than what the bank earned from its illegal activity.

And the question remains: Why is the NYSE failing to call this illegal activity by its proper name: “naked short selling”?

When the NYSE levied its fine at the end of August, the scandal of naked short selling was beginning to receive nationwide attention. Indeed, the SEC had just lifted a temporary emergency order designed to prevent the crime – three weeks after stating that abusive naked short selling had the potential to topple the American financial system.

Moreover, Deutsche Bank had recently become embroiled in a multi-billion dollar lawsuit filed by shareholders alleging that Deutsche and several other banks were involved in a “conspiracy to engage in illegal naked short selling of Taser International Inc. and to create, loan and sell counterfeit shares of Taser stock.”

Clearly, Deutsche Bank had reason to keep its involvement in naked short selling under wraps. I asked Mr. Peterson whether the NYSE had cut a deal with Deutsche Bank, whereby Deutsche agreed to pay the fine, and the NYSE agreed to portray its case as something other than a clear-cut instance of abusive naked short selling.

Mr. Peterson told me to put my question in writing. I did this, and waited for several weeks for a response. No response was forthcoming.

Another interesting question is whether Deutsche Bank’s prime brokerage (which services hedge fund clients) was involved in the naked short selling. If it was, this would suggest that the bank was helping its hedge fund clients manipulate stocks, including, perhaps, Taser International, whose shareholders had filed that multi-billion dollar lawsuit.

The NYSE disciplinary actions makes it seem like only Deutsche Bank’s proprietary traders (who trade for the bank, not for any hedge fund clients) had broken the rules. When I asked Mr. Peterson about this, he said, yes, the prime brokerage was not involved.

However, the NYSE’s disciplinary action said, in legalese, with no explanation, that at least two of the five Deutsche Bank proprietary trading desks investigated by the NYSE “failed to adhere to the independent trading unit aggregation requirements.” This was a reference to SEC “unit aggregation” rules, outlined in Regulation SHO, which prohibit prime brokerage units and proprietary trading units from coordinating their short-selling activities.

In other words, it seems possible that Deutsche Bank’s proprietary trading unit was washing naked short positions for its prime brokerage, which had placed phantom stock sales on behalf of market manipulating hedge fund clients.

I asked Mr. Peterson if this was the case. He said to put the question in writing. I did this, and waited a few weeks for a response. No response was forthcoming.

Apparently, Mr. Norris, the chief financial correspondent of the New York Times, spoke to the NYSE, because he regurgitates its party line, almost verbatim. He says the case against Deutsche Bank is “largely about the failure to locate shares before they were sold short…But there do not seem to be many cases of sustained failures to deliver.”

He goes on to improperly define “failures to deliver” as occurring on day 13. He buys into the suspect claim that Deutsche Bank’s prime brokerage wasn’t involved. And he implies that the case could be a matter of “record keeping violations,” apparently unaware that these “record keeping violations” were in fact brazen failures to deliver of unborrowable stock – typically lasting right up to day 13, when the traders “penalized” themselves by buying back the shares, no doubt at a steep discount to the price at which they had sold them.

Mr. Norris concludes, “I don’t know if Mr. Mitchell’s suggestion [that Deutsche Bank sold massive amounts of phantom stock] is nutty or prescient, but I do not see how it is supported by what the Big Board says it found.”

Of course, what the Big Board says it found might be quite different from what the Big Board did find. That a prescient nut case has to point this out to the presumably sane chief financial correspondent of the New York Times speaks volumes about the media’s coverage of the naked short selling scandal and the state of America’s public discourse.

* * * * * * * *

“Morgan Stanley shares have been under extraordinary pressure as of late, for no apparent fundamental reason, as we estimate liquidity, the balance sheet, and long-term earnings, prospects are sound.”

- Fox-Pitt analyst David Trone in a research note, today

Here we go again. A giant bank has some weaknesses, but it is, in all respects, a going concern — except that short sellers are peddling rumors and phantom stock, so the share price is plummeting. With the share price in peril, the rating agencies (perhaps over vigilant after taking so much criticism from short sellers and the media) put the bank’s debt ratings on review for a downgrade.

Meanwhile, short sellers corner the market for the bank’s credit default swaps, and point to the value of the CDS as evidence that the bank is doomed. They feed the media with analyses and bogus indexes that mark the bank’s assets to nothing. They spread the news that the bank’s counterparties and trading partners could bail.

The clients and partners stay with the bank. Up until now they have no reason not to.

But then, there’s more naked short selling, the hedge funds flooding the market with stock they do not possess – phantom stock. Maybe the hedge funds send a fax to CNBC with one last rumor. Over the course of a day or two, the stock price is slashed in half.

Then, suddenly, the stock is in the single digits.

As a result of the low stock price – not as result of the balance sheet – the bank’s partners and clients freak out. This time, they really do pull their money.

End of bank.

And if there are one or two more like this — end of story. The financial system will be fried.

We’ve seen precisely the same scenario with Bear Stearns, Lehman, Merrill Lynch, Washington Mutual, and IndyMac. A variant of this scenario took down AIG, Fannie Mae, Freddie Mac, and perhaps 200 other companies before them.

Morgan Stanley could be gone by next week.

We have new data for September that shows that there was plenty of short selling of Morgan Stanley (and other companies) even during the SEC’s ban on short selling, which ended Wednesday at midnight. Some hedge funds ignored the ban, and the SEC did nothing.

Worse, in place of the ban, the SEC has offered only tepid new rules (cheered by the short seller lobby) that do little to prevent the sale of phantom stock. Under these rules, short sellers do not have to borrow real stock before they sell it. They merely have to “locate” the stock. The SEC doesn’t say how it’s supposed to know whether a short seller has actually located real stock as opposed to telling his broker, “yeah, I located it, it’s in your mother’s wig” (which is pretty much how these conversations go).

Furthermore, the SEC gives hedge funds three days to deliver the stock they sell. This would be fine if they were required to possess real stock before selling. But since they are not, a hedge fund can offload a large block of phantom stock and let it eat away at the financial system for at least three days.

Sometimes, the hedge funds settle the trade with another block of phantom stock, transferred to them by a friendly broker. But even if they fail to deliver the stock, the SEC stipulates no serious penalties. Meanwhile, it shows no inclination to actually prosecute anyone for the jailable crime of short-side market manipulation.

I’m willing to bet anybody a sizeable amount of money that when the SEC releases its “failures to deliver” numbers for October, they will suggest unbridled illegal naked short selling of Morgan Stanley during this past week, even on days when the ban on all short selling was in place. The data will show that naked short selling rose to unprecedented levels just before somebody floated Wednesday’s false rumor that Morgan Stanley was going to lose its $9 billion deal with Mitsubishi.

And the data will show that after the ban was lifted, the law-breaking shorts went nuclear – with failures to deliver of well over a million shares every day. Ultimately, many millions of Morgan Stanley’s shares will be sold and never delivered, just as hedge funds have yet to deliver more than 10 million shares of Bear Stearns that they sold during that bank’s final days last March.

As I write this, Morgan’s stock price is in the single digits, trading around 7 bucks, down an astounding 70% in the 36 hours since the short selling ban was lifted. A death spiral like that does not happen naturally. Because of the short-battered stock price – and only the stock price (again, this has nothing to do with the balance sheet) — Moody’s today put Morgan’s long-term debt ratings on review for a downgrade.

I suspect another 15% off the stock price, and one more well-placed rumor, will do the trick. There will be a run on the bank. Morgan will be gone. And the global financial fire will blaze still hotter.

It is beyond surreal that our most prestigious financial media continue to allow this to happen. It is beyond comprehension that journalists – in possession of the evidence, and presumably in possession of their faculties – continue to spout the line, originally formulated by short-sellers and now woven into conventional wisdom – that this crisis is only about bad mortgages and bad managers and bad balance sheets.

One can argue that, in the long run, the world is better off without half of Wall Street – without its ponzi schemes and paper profits, the sickening salaries and arrogance. Certainly, anyone with a Shakespearean state of mind will appreciate the fates of Morgan Stanley, Lehman, and Bear – all of which eagerly pimped their dodgy prime brokerage services to the very short sellers who destroyed them.

But it does not require Shakespearean nuance to see that this crisis is not just about scandalous banks. It is about criminals destroying banks that are tawdry, yes, but possessing of some virtue, and capable, if left unmolested, of carrying on and contributing to society – perhaps even staving off a global calamity.

Moreover, these same criminals are destroying many other companies, most of which are run by honest people who labor far from the insalubrious alleyways of southern Manhattan. The SEC maintains a list of companies whose stock has failed to deliver in excessive quantities. As I explained in an earlier dispatch, many victims of naked short selling (including some of the big banks) do not appear on that list. But surely it is a scandal that more than 300 companies, many of them financial firms that have nothing to do with Wall Street, do appear on the list.

Surely, it is an even bigger scandal that around 100 of those companies have appeared on the list chronically, day after day, for months on end, and though the sheriff posts the names of these rape victims on its wall, it has yet to prosecute a single rapist. The SEC tells us that a billion shares remain undelivered on any given day — and yet it doesn’t bother to find out which hedge funds sold the phantom stock.

It might be too late, but if Washington and the financial media really want to save the world, they ought to start by demanding that hedge funds borrow real stock before they sell it. And what the heck: Maybe some newspaper could offer the radical suggestion that the SEC should tell hedge funds that they can either go to jail or close out all unsettled trades – today.

If one hedge fund manager were to get cuffed, all the others with outstanding “failures to deliver” might scramble to buy real stock so they can settle. The markets might soar. The innocent victims might get some relief. And the delinquents on Wall Street would get some time to clean up their acts.

Meanwhile, would anyone care to guess which company the naked short sellers will take down after Morgan Stanley?

And would anyone like to share a bunker with canned goods and weapons?

* * * * * * * *

If you’d like to place that bet on the Morgan Stanley data (I’ll give 2:1 odds that it will show short sellers offloading massive amounts of phantom stock , with more than a million “failures to deliver” every day) feel free to contact me. Mitch0033@gmail.com.

* * * * * * * *

In the adult novelty & video arcade shop that is our New York financial establishment, one of the mop-and-spooge-bucket boys is Roddy Boyd, formerly of the New York Post (for folks who move their lips when they read Entertainment Weekly), and currently, of Fortune Magazine (also known as “People Magazine for Capitalists”). I have met Roddy on occasion, and a more seedy and furtive character would be difficult to name. Many years ago I knew a one-eyed Chinese guy named “Chaney” who ran a Bangkok pawn shop/mail-drop who was (it was rumored) working for Taiwanese, Chinese, and Soviet intelligence, simultaneously, but by appearances anyway, Chaney was a model of probity and fair-dealing when compared to Mr. Boyd.

Admittance into Roddy’s New York financial journalism spooge-bucket-brigade is conditional upon acceptance of The Fundamental Principle and First Corollary of that august fraternity:

The Fundamental Principle - Hedge funds can do no wrong, particularly if they belong to a small constellation whose brightest lights are Stevie Cohen, Dan Loeb, David Einhorn, Jim Chanos, David Rocker & Marc Cohodes.

The First Corollary -  If any corporation or individual appears to have been wronged by activities of any of these hedge funds, using methods up to and including stock counterfeiting and manipulation, blackmail, harassment, and intimidation, use of private eyes and internal moles, inciting endless and expensive investigations that go nowhere, and so on and so forth, it must only be because they deserved it (for proof, see The Fundamental Principle).

Today Fortune Magazine’s Roddy Boyd gives fine illustration of these rules in an article on  Copper River Partners (née Rocker Partners). This is the same Copper River/Rocker Partners whose exploits are chronicled throughout DeepCapture, and who have been frequent beneficiaries of reportorial lotion-jobs from Roddy, Karen Richardson (WSJ), Herb Greenberg (CBSMarketWatch), Joe Nocera (New York Times), and Jim Cramer (CNBC & TheStreet.com), and have been long-time recipients of  Bethany McLean’s highly-regarded regulars-only service. (Full disclosure: Copper River is also on the business end of a Marin County lawsuit filed by Overstock.com, in which I played modest role.)

In today’s think-piece, Roddy treats us to such insights as:

• “But for noted short-sellers Copper River Management, a $1 billion hedge fund based in Larkspur, Cal., the month turned into a perfect storm. A devastating combination of counter-party failure, sudden regulatory edicts and margin calls conspired to turn the fund’s performance on its ear, leading to a 55% loss in just two weeks.” Translation: In the last two weeks Copper River lost over half of its billion dollars, not through any decisions made there. Instead, counter-party failure, regulators, and those pesky margin calls “conspired” to create “a perfect storm” that lost the half-billion dollars.

• In case the point was lost that none of this had to do with the quality of Copper River’s investments, Roddy Boyd writes it out. He really does, in those words: “What’s worse for Copper River is that the battering had nothing to do with the quality of its investments.”

• We are treated to a bit of financial arcana: “On top of that, as Lehman unwound its own internal hedges to the Copper River trades, its trading desks bought shares of these companies, driving up their prices and leading to losses for Copper River.” Translation: Lehman sold puts to Copper River that Lehman then hedged by shorting stock (most likely in more abuse of the option market-maker exception), and when Lehman covered its shorts it hurt Copper River, whose investment strategy assumed an environment where shorts rarely need cover (and understandably so). As far as Roddy Boyd is concerned, the possibility that a short might “cover” (that is, “at some point obtain and deliver that which they have sold”) and thereby cause loss to a favored hedge fund has “nothing to do with the quality of its investments.”

• As though that litany of impositions were not harrowing enough, Roddy chronicles further injustices suffered by Copper River: “That was bad enough, but on September 19, the bottom fell out for the fund. That was when the Securities and Exchange Commission ordered unprecedented restrictions in short sales” (as our nation’s financial system was imploding). And further, “As prices in those stocks shot upwards, Copper River was forced to cover - or buy back - some of its positions at steep losses. “ This is intolerable: how could a hedge fund such as Copper River make money if it has to deliver what it sells? And lastly this chestnut: “The rising stock prices also led to a series of margin calls (demands for additional cash collateral to be deposited in a margin account) from Goldman Sachs, Copper River’s prime broker.” I’m with Roddy on this one: it’s damn inconsiderate of Goldman Sachs to insist that Copper River have funds to back its play.

Perhaps I am too hard on Roddy.  “Out of the crooked timber of humanity no straight thing will ever be made”, said Kant. A gal moves to the big city, gets behind, does things of which she is not proud. Molded are we all of imperfect clay.

But normally, she doesn’t write home about it.

It’s just Roddy’s ill fortune to have to perform these acts in national print.

So the SEC today lifted its ban on short-selling, and all but declared open season for law-breaking naked short sellers to start destroying companies again – and who does CNBC have on for two hours as its honored “guest host”?

None other than Jim Chanos, the salamander-slick director of the short-seller lobby.

Asked about naked short selling, Chanos said, with a straight face: “Anytime a hedge fund or short seller shorts a stock, it is a legitimate short. We have to get a locate or pre-borrow from the broker….”

Chanos continued: “The one thing I have in common with Patrick Byrne, chairman of Overstock.com [and Deep Capture reporter], is that we are calling for strict, strict delivery…in terms of delivering shares…that is how to end this naked short selling…”

CNBC, which serves as a sort of seedy massage parlor to the short selling community, gave Chanos the usual treatment – lubrications and sweet nothings. No tough questions. No retorts to his outlandish assertions. No wondering aloud as to his absurd and self-serving logic.

Let’s get this straight.

Not long ago, Chanos insisted that naked short selling did not occur.

Now, he says naked short selling occurs. But it’s not short sellers who are naked short selling. Short sellers make sure their brokers borrow real stock before they sell it.

In any case, Chanos acknowledges that short sellers’ brokers are not borrowing real stock before they sell it. That is why they are not delivering the stock. And that is why he claims to agree with Patrick Byrne that there needs to be “strict, strict delivery.”

But Chanos is against a ban on naked short selling (which would force short sellers to borrow real stock, thus ensuring delivery). Chanos says that a ban on naked short selling would destroy “market efficiency.”

So, to summarize the Chanos position: Naked short selling didn’t occur, but now it occurs, except short sellers don’t do it, and the SEC shouldn’t ban it because the market would cease to function properly if short sellers were forced to stop doing what they don’t do.

And given that so many shares are failing to deliver (after being sold naked by short sellers who never sell naked), Chanos is calling for “strict, strict delivery” of stock (while praising the SEC for its “strict” new rules which stipulate that nothing happens to short sellers who fail to deliver stock).

CNBC treated us this morning to two hours of Chanos nonsense. At one point this charlatan even insisted that short sellers aren’t short selling financial stocks at all. Really, he said short sellers aren’t short selling. Period. Take his word for it. CNBC did.

That was around 7:30 AM, right after CNBC’s Becky Quick referred to Chanos as “the legendary short seller….er, investor.”

At 9:30 AM, the markets opened and the criminal naked short sellers…er, investors…went back to work, unfettered by the SEC’s “strict” new rules.

Within an hour, Morgan Stanley was down 25%.

* * * * * * * * *

In a few hours, the SEC will lift its ban on short-selling of 900 stocks. That is well and good, except that it appears that hedge funds will also be permitted to resume abusive naked short selling – offloading stock that they do not possess in order to dilute supply and drive down prices.

Given that naked short selling precipitated the collapse of Lehman Brothers, which triggered global panic, it seems fair to say that the resumption of naked short selling could precipitate the collapse of another big bank, which will fuel still more panic, and then we will really be screwed.

Say what you will about Lehman’s balance sheet, that company was not going out of business until its stock price hit rock bottom, making it impossible to raise capital, and triggering a run on the bank. The stock price hit rock bottom because it was bombarded by naked short selling and false rumors.

Some financial media have been cheering the imminent lifting of the short-selling ban. According to these journalists, the ban did not prevent the stock market turmoil of the last couple weeks. Therefore, lifting the ban should not make things worse and short-selling is good for the markets and blah blah blah.

The media never cease to astound on this issue. The fact that markets have been bad does not mean they wouldn’t have been a whole lot worse without the ban. And if short-selling is good for markets, this is fully besides the point. The point is that naked short selling is most definitely not good for the markets, and, as of tomorrow, that very not-good-for-the-markets activity is going to be allowed to resume with the full acquiescence of the SEC and the financial media.

Look, on September 16, Morgan Stanley was trading around $26. On September 17, it hit a low of $11. The stock was slashed in half in less than a day. That tends to happen when a company is under a full-scale attack by naked short sellers.

On the day after Morgan Stanley was slashed in half, the SEC banned short selling. It is fair to say that if the SEC had not acted, Morgan Stanley would not be with us today.

After the SEC banned short selling, hedge funds stopped circulating false rumors about the companies they had been attacking. Today, in anticipation of the short selling ban coming to an end, hedge funds began circulating false rumors about Morgan Stanley – the most damaging being that Mitsubishi had pulled out of an agreement to inject $9 billion of capital into the bank.

What happens tomorrow when those rumor-mongering hedge funds resume naked short selling?

As one prominent economist said, forebodingly, “We will see.”

In testimony before Congress yesterday, Richard Fuld, the former CEO of Lehman Brothers, said that (criminal) naked short selling precipitated the demise of Bear Stearns and Lehman, and nearly toppled Goldman Sachs and Morgan Stanley.

Given that not only Fuld, but also the CEOs of Goldman Sachs, Morgan Stanley, JP Morgan and a good number of traders on Wall Street – along with John McCain, Hillary Clinton, the Chairman of the SEC, the Secretary of the Treasury, and countless others in Washington — have all now implicated naked short selling in the hobbling of the American financial system, you would think that the mainstream media could produce just one investigative report – just one story taking a serious look at this criminal activity and its recent effect on our markets.

Instead, we get the usual platitudes from the likes of Joe Nocera at The New York Times. He writes:

“Mr. Fuld, in typical C.E.O. fashion, claimed to take ‘full responsibility’ for his actions — but spent the entire time blaming others for Lehman’s downfall. Early in his testimony, he even blamed [emphasis mine] ‘naked short-sellers’ who passed along “false rumors” that started a run on his bank.”

By Nocera’s standards of anti-investigative journalism, a serious issue is settled not with data or evidence, but with one word – “even.” Could naked short selling have triggered the bank run that has Chernobyled our financial system? Can’t be, writes Nocera, because Lehman’s CEO “even” said it can be.

Nocera continues: “As both The New York Times and The Wall Street Journal pointed out in lengthy stories on Monday, Mr. Fuld had assets on his books that were wildly overvalued.”

So, apparently, Lehman could not have been a victim.

A woman who once shoplifted is raped in an alley. Was she raped? No, because she was a shoplifter and she “even blamed” the rapist.

Keep in mind that Nocera once encouraged an assembly of his media colleagues not to investigate naked short selling. “Life’s too short,” he told a panel audience at the annual conference of the Society of American Business Editors and Writers. “I don’t want to do it.”

Well, somebody should do it – and fast – because the SEC is going to lift its ban on short selling tomorrow, and there are no signs that it’s going to force hedge funds to borrow real shares before selling them.

So it will once again be open season for naked short selling – and market destruction. Countless more companies will fall prey to an easily preventable crime. And more CEOs will “even” point fingers at the criminals while Joe Nocera and the Media Mob stand idly by.

* * * * * * * *

If any journalists are interested, here is Fuld’s testimony:

“The second issue I want to discuss is naked short selling, which I believe contributed to both the collapse of Bear Stearns and Lehman Brothers. Short selling by itself can be employed as a legitimate hedge against risk. Naked short selling, on the other hand, is an invitation to market manipulation. Naked short selling is the practice of selling shares short without first borrowing or arranging to borrow those shares in time to make delivery to the buyer within the settlement period – in essence, selling something you do not own and might not ultimately deliver to the buyer.

Naked short selling, followed by false rumors, dealt a critical, if not fatal blow to Bear Stearns. Many knowledgeable participants in our financial markets are convinced that naked short sellers spread rumors and false information regarding the liquidity of Bear Stearns, and simultaneously pulled business or encouraged others to pull business from Bear Stearns, creating an atmosphere of fear which then led to a self-fulfilling prophecy of a run on the bank. The naked shorts and rumor mongers succeeded in bringing down Bear Stearns. And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers. In our case, false rumors were so rampant for so long that major institutions issued public statements denying the rumors.

Following the Bear Stearns run on the bank, we and many others called on regulators to immediately clamp down on naked short selling. The SEC issued a temporary order that went into effect on July 21 prohibiting “naked” short selling of certain financial firms, including Lehman, Merrill Lynch, Fannie Mae and Freddie Mac. This measure stabilized the share prices of Lehman Brothers and the other firms. However, this restriction was temporary, and on August 13 it expired after 17 trading days. History has already shown how wrong and ill-advised it is to allow naked short selling.

Many of the firms that have recently collapsed or have been forced into emergency mergers, takeovers, or government bailouts – Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, AIG – did so during the gaps of time in which there was no meaningful regulation of naked short selling. On September 15, when the market opened after the collapse of Lehman, naked shorts appeared to turn their attention to Morgan Stanley and Goldman Sachs. In the three days between the announcement of Lehman Brothers’ bankruptcy and the SEC instituting an emergency ban on short selling,

Goldman Sachs’ and Morgan Stanley’s share prices fell 30% and 39% respectively.

None of this was a coincidence.

After seeing this stock price reaction in the week following Lehman Brothers’ bankruptcy, the SEC, like the Federal Reserve, took immediate action to stabilize the system. On September 18, following the decision of the Financial Services Authority in the United Kingdom a day earlier, the SEC instituted an emergency ban and other restrictions on short selling financial institutions. In taking these steps, Chairman Cox explained: “Given the importance of confidence in our financial markets as a whole, we have become concerned about the sudden and unexplained declines in the prices of securities. Such price declines can give rise to questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence without a fundamental underlying basis. The crisis of confidence can impair the liquidity and ultimate viability of an issuer, with potentially broad market consequences.” These new restrictions are set to expire no later than October 17. Permanent regulation of naked short selling is needed to prevent a similar demise for the firms that survived with the government’s help.”

The Wall Street Journal stated in a lead editorial last week that the SEC was “reasonable” to “clamp down” on naked short selling. Well, that was progress of sorts, though one wonders how it could have taken all these years for the nation’s most important newspaper to suggest that it might be “reasonable” to put an end to criminal activity that has eviscerated hundreds of companies and destroyed countless lives.

And now that this criminal activity has been implicated in the Humpty Dumptying of our financial system, one grows wistful for the golden age of journalism when editorialists (people working for famous newspapers, not just cyber weirdos) would express a little outrage, demand that heads roll – muster something better than “reasonable” to describe the limpid “clamp down” of an SEC that bows in oily servitude to the very short-sellers who manhandled our markets.

Alas, The Wall Street Journal is not angry about the scandal of naked short selling. To the contrary, it devotes most of its editorial to tut-tutting the SEC for taking the mild step of requiring hedge funds to disclose their short positions. This, the Journal laments, means the government wants to “slap a scarlet letter on short sellers.” And (shed a tear) hedge funds will now have to “worry that their strategies will be put on display for the world to see.”

Might the world like to see which hedge funds are employing the strategy of illegal naked short selling – offloading huge chunks of stock that they do not possess – phantom stock – in order to drive down prices? No, nothing to see there, says the Journal. Having thoroughly investigated the matter, the editorialist reports that there is “no evidence of widespread naked shorting of financial stocks in this panic.” Indeed, the Journal assures us that there is no evidence that short sellers have engaged in any market manipulation whatsoever.

That is a mighty bold claim. As the Wall Street Journal itself reported, the SEC has ordered two dozen hedge funds to turn over trading records as part of its investigation into possible short-seller manipulation of six big financial institutions — American International Group, Goldman Sachs, Lehman Brothers, Morgan Stanley, Washington Mutual, and Merrill Lynch.

The SEC has never in history prosecuted a major case against a short seller, and there is no reason to believe that it is actually going to nail someone now. But it is not difficult to see why the SEC feels that is has no choice but to investigate.

It must investigate, or at least appear to investigate, because the data scream, “Investigate!”

Take the case of Washington Mutual, which met its demise on the same day that the Journal published its editorial. While the SEC has not yet released data covering the last couple weeks of turmoil, the data through June show that at one point that month “failures to deliver” of Washington Mutual’s stock reached an astounding 9 million shares. From June 5 to June 19 there were, on any given day, at least 1 million WaMu shares that had “failed to deliver.”

In other words, hedge funds and brokers sold as many as 9 million shares that they did not possess (which is why they “failed to deliver” them), and they kept the market saturated with at least 1 million phantom shares for more than two weeks. WaMu’s stock price dropped by more than 30% during this period. Similar attacks, with similar effects, occurred one after another in the months leading up to June.

That is very good evidence of illegal market manipulation.

Aside from Washington Mutual, Bank of America, Fannie Mae, MBIA, Ambac, and close to 50 smaller financial firms – not to mention a couple hundred non-financial companies – have appeared on the SEC-mandated “threshold” list of companies whose stock has “failed to deliver” in excessive quantities.

That, too, is very good evidence of illegal market manipulation.

A number of the big banks never appeared on the SEC’s “threshold” list. Perhaps that explains the Journal’s claim that there is “no evidence” that naked short selling contributed to our financial crisis. If so, the Journal does not understand the methods that naked short sellers use to manipulate the markets. The Journal also does not understand how powerful financial elites manipulate the government (and the media).

Peter Chepucavage, the former SEC official who authored Regulation SHO (the rules that governed short sales from 2005 until the SEC temporarily banned short-selling of financial stock last week) has told us that the rules were watered down under fierce pressure from the hedge fund lobby.

One result is that Regulation SHO did not force short sellers to borrow real shares before they sold them. They were given three days to produce stock before it was declared a “failure to deliver.” If they missed the three-day deadline, they were given another ten days, after which they were supposed to buy (not borrow) real shares and deliver them, or face penalties.

In practice, many hedge funds and brokers ignored the deadlines without repercussions. But even traders who met the deadlines were able to churn the markets. Since they were not required to possess real shares before they hit the sell button, they could offload a large block of phantom stock and let it dilute supply for three to 13 days. When the deadline arrived, they might borrow real shares and deliver them, and then sell another block of phantom stock, which would hammer prices for another three to thirteen days.

Or, rather than borrow real shares, the hedge fund might buy stock (the price having been knocked down during 13 days of diluted supply) from a friendly broker. Often, the brokers did not have any stock to sell the hedge fund, but they pushed the sale button anyway. The hedge funds then used the broker’s phantom stock to settle its initial sale of phantom stock, and when the broker’s deadline came, he bought an equal quantity of phantom stock from another broker, and so on.

A lot of journalists have portrayed this naked short selling as “legal.” In fact, it is grossly illegal assuming the goal is to manipulate markets. But the SEC until recently shied away from making that assumption. So long as the hedge funds met the delivery deadlines, they could distort and destroy at will.

Another result of the short-seller lobby’s intervention is that a company does not appear on the SEC’s “threshold” list unless there are failures to deliver of more than 10,000 of the company’s shares (and at least 0.5% of its total shares outstanding) for five consecutive days. So long as there are no failures on day six, there are no flashing red lights at the SEC. That is, threshold (excessive) levels of phantom shares can float around the system for a total of eight days (three days before they are registered as “failures to deliver,” plus five more) without a company being designated a victim of naked short selling.

An eight-day blast (or even just a one day blast) of, say, a couple-hundred thousand phantom shares can knock down a stock’s price very nicely. Blasts of a million-plus shares, which are common, can do even more damage.

If a company has weaknesses that can be blown out of proportion with help from the media, and if hedge funds blast the company with phantom stock, then pause, then blast again, then pause, then blast again — over and over — for a couple of months, then the company’s share price can soon be in the single digits. – without ever having appeared on the SEC’s threshold list.

Unsurprisingly, the data through June shows this blast-pause-blast pattern in the stocks of nearly ever major financial institution that has been wiped off the map, and quite a few that were in death spirals before the SEC temporarily banned short-selling. Very often, huge failures to deliver have occurred in stretches of precisely five days – just long enough to keep a stock off the threshold list.

The attack on Bear Stearns, for example, began on January 9, when hedge funds naked shorted more than 1.1 million shares. The shares “failed to deliver” at the end of Friday, January 11 (the three-day deadline). For the next four days, beginning Monday, January 14, there were massive failures to deliver, peaking at 1 million shares on January 17. That is, the attack lasted a total of eight days, with failures to deliver lasting precisely five days. On day six, there were few failures to deliver, so Bear did not appear on the threshold list.

Over the next few weeks, there were several more blasts – with failures to deliver ranging from 200,000 to 500,000 shares. Those were threshold levels, but the failures lasted less than five consecutive days, so no flashing red light at the SEC.

On February 28, 800,000 shares of Bear Stearns failed to deliver. For the next five business days, anywhere from 100,000 to 350,000 shares failed to deliver. On day six, there was a pause — few failures to deliver. So no threshold list – no flashing red light at the SEC.

A week later, just before CNBC’s David Faber reported the false information (given to him by a hedge fund “friend” whom he had “known for twenty years”) that Goldman Sachs had cut off Bear’s credit, somebody naked shorted more than a million shares of Bear’s stock.. Over the course of the next couple of weeks, there was a sustained effort to drive the stock to zero, with massive failures to deliver every day — peaking at 13 million shares.

This attack lasted long enough to put Bear Stearns on the threshold list, but by then, it was too late. The bank’s mangled remains had been swallowed by JP Morgan. Ultimately, at least 11 million shares of Bear Stearns were sold and never delivered.

Meanwhile, the naked short sellers began their attack on Lehman Brothers. On March 18, Lehman’s stock had begun to increase sharply, so somebody unleashed more than 1.5 million phantom shares. Those failed to deliver on March 20. For the next three days, there were failures to deliver of between 400.000 and 800.000 shares — far exceeding the daily “threshold.” That helped the share price to fall sharply, but on day five, there were no failures, so Lehman didn’t appear on the threshold list of companies victimized by naked short selling.

On April 1, another round of naked short selling commenced, coinciding with a wave of false rumors about Lehman’s liquidity. That continued until April 3, when SEC Chairman Christopher Cox, for the first time, told a Senate committee hearing that naked short selling was a big problem. Using the words “phantom stock,” he said many companies had been affected and vowed to crack down.

For a few weeks after that, there was not much new naked short selling.

Then, on May 21, short-seller David Einhorn gave his famous speech accusing Lehman’s executives of cooking their books. Though Lehman, like most banks, was guilty of participating in the dodgy business of securitized debt, it was not cooking its books. It had, however, failed to mark some of its assets down to levels prescribed by Einhorn, who waved the CMBX index as the proper barometer of commercial mortgages.

The CMBX comes from a company called Markit Group, which is owned by four hedge funds, the names of which the Markit Group will not disclose. I don’t know if the managers of those hedge funds are friends of David Einhorn, but the Wall Street Journal’s Lingling Wei published a story in February noting that the CMBX “doesn’t make sense.” It grossly undervalues commercial property, implying default rates, for example, that are four-times higher than they are in reality.

Nonetheless, the media, including the Wall Street Journal, trumpeted Einhorn’s analysis, which was distorted in many other ways – but that is a tale for a future blog.

For now, it is enough to know that coinciding with Einhorn’s speech, somebody naked shorted more than 200,000 shares (the settlement date for that sale was May 27, three business days after the speech, owing to a holiday weekend). Thus began a five day stretch of failures to deliver (ranging from 120,000 to 450,000 shares). On day six, as usual, there were few failures to deliver, so Lehman did not appear on the threshold list.

After a pause of a few days, somebody circulated the falsehood that Lehman had gone to the Fed for a handout. Coinciding with that rumor, hedge funds naked shorted close to 1.5 million shares. Those shares failed to deliver three days later, on June 9. The next day, there were 650,000 failures. The day after that, 263,000 failures. On day four, there were 510,000 failures. On day five, there were 623,000 failures. Time for Lehman to appear on the threshold list. But, on day six, of course, the failures to deliver stopped. No list – no flashing red light at the SEC.

Throughout this time, Einhorn continued to appear on CNBC and in the major newspapers, doing his best to make Lehman’s problems (which were real, but probably, at this stage, manageable) appear to be both catastrophic and criminal. From May 21, the day of Einhorn’s speech, to June 15, the stock lost almost half its value.

For reasons that I cannot fathom, Lehman then opted for a strategy of appeasement. Rather than challenge Einhorn’s assumptions, Lehman aimed to silence him and his media yahoos by doing what they asked. It “reduced its exposure” to mortgages, primarily by marking them down to levels dictated by Einhorn’s bogus index – the CMBX. This is the main reason why it booked a 2.8 billion loss in the second quarter.

When Lehman announced its quarterly results, on June 16, there was another blast of naked short selling, with failures to deliver at threshold levels from June 19 to June 24. Exactly five days. Then the failures stopped. No threshold list. No flashing red light.

I look forward to the day (in a few months) when the SEC will release data covering July to September. But I can tell you right now what happened next.

On June 30, somebody floated the false rumor that Barclays was going to buy Lehman at 15 dollars a share (it was then trading at 20). Simultaneously, hedge funds no doubt naked shorted large blocks of shares. It’s a safe bet that the data will show failures to deliver lasting precisely five days.

On July 10, somebody (SAC Capital?) circulated the false rumor that SAC Capital was pulling its money out of Lehman. Hours later, there was another false rumor — that PIMCO was pulling out its money. Quite certainly, these rumors were accompanied by naked short selling, with failures to deliver beginning three days later, and probably continuing at threshold levels for precisely five days. Lehman’s stock lost almost 50% of its value in the four weeks leading to July 15..

At this point, the SEC finally came to realize what was happening to Lehman. It realized that similar madness had destroyed Bear Stearns. It realized that AIG, Citigroup, Fannie Mae, Freddie Mac, Bank of America and fifty other financial companies were getting clobbered in exactly the same fashion.

Clearly, naked short selling posed a real threat to the stability of the financial system. So the SEC issued an emergency order forcing hedge funds to borrow real stock before they sold it. No more saying “Yeah, my cousin Louie has the stock in a drawer somewhere.” No more naked short selling.

This order protected only 19 big financial institutions – which is as far as the SEC thought it could go and still retain friendly relations with its short-selling paramours – but it was something. During the three weeks that the emergency order was enforced, Lehman’s stock price increased by around 50 percent. The other companies that had been under attack enjoyed similar rebounds.

The short-sellers, of course, fumed. Some of those fumes wafted to The Wall Street Journal and other prestigious publications, which lambasted the SEC for issuing the emergency order. They published all manner of mumbo-jumbo about the emergency order wrecking “market efficiency” – though the only evidence of this was an utterly dubious report circulated by the short seller lobby (see here for the details), and it was hard to comprehend what could possibly have been “efficient” about a market getting smothered with false information and fake supply.

Of course, the SEC, captured by the short-sellers, and ever mindful of the media, decided to let its emergency order expire, and announced no new initiatives to stop naked short selling..

The day after the emergency order expired, Lehman’s stock nosedived. So did a lot of other stocks that had enjoyed a temporary reprieve.

Mark my words, the data for August and September will show that soon after the order was lifted, rampant naked short selling began anew.

It will show a sustained attack on Fannie Mae and Freddie Mac, with failures to deliver exceeding one million shares, until the day the two companies were nationalized. It will show Lehman getting hammered (blast-pause-blast) until its stock was so low that there was no way it could raise capital. And it will show that in Lehman’s final days, hedge funds sold unprecedented amounts of phantom stock, knowing that the stock would never, ever have to be delivered.

Two days after Lehman was vaporized, AIG watched its stock fall to as low as one dollar. The data through June shows that AIG was repeatedly blasted with phantom stock, often in stretches of eight days (three + five), with peak failures to deliver reaching 2 million shares. It’s a safe bet that the data will show that these attacks continued, and grew in magnitude, until a price of one buck per share resulted in paralysis, and AIG had to be nationalized. But the company never appeared on the SEC’s threshold list.

After AIG, the rumor was that Citigroup would go down next. The data through June shows that Citigroup was bombarded – blast, pause, blast – with massive amounts of phantom stock. Failures to deliver peaked at 8 million shares. No doubt, the blasts continued and grew in magnitude in the days leading up to September 16, when Citigroup’s stock went into a death spiral.

On September 17, the SEC rushed out new rules governing naked short selling. The new rules seemed a lot like the old rules. Hedge funds would not have to actually possess stock before selling it. Instead, they would merely have to “locate” the stock. The SEC would have no way of knowing whether hedge funds had “located” stock, but if they lied and told their broker, “Yeah, I located the stock, I got it somewhere, push the sell button,” then that would be “fraud.” Presumably, the brokers, who depend on the hedge funds for most of their income, and are complicit in their naked short selling, would line up to inform the SEC that their clients were telling them lies.

Meanwhile, the hedge funds would still have three days to deliver stock, with no strong penalties for failing to do so, and no mechanism for determining whether a hedge fund had delivered real stock, as opposed to new phantom stock that it had received from a friendly broker. As for the “threshold” of five consecutive days before a company could get on the list that sets off the flashing red lights that the SEC ignores – that would remain the same.

When these rules were announced, the short-seller lobby cheered loudly. The media transcribed the lobby’s cheerful press releases, and then the naked short sellers eliminated Merrill Lynch. After that, they turned on Goldman Sachs and Morgan Stanley, at which point both stocks went into death spirals and the companies’ CEOs treated us to the spectacle of calling the SEC to complain that Morgan and Goldman (ie., the companies that housed the brokerages that invented and profited the most from naked short selling) were now getting mauled by their own monstrous creations.

A week later, the Wall Street Journal stated in an editorial that there was “no evidence” of naked short selling or market manipulation during this financial crisis.

* * * * * * * *

P.S. I am a former employee of The Wall Street Journal editorial page. I think it is the finest editorial page in the world. I enjoyed my time at the Journal. They let me live in Europe. I got to write mean things about socialists.

But with genuine respect, I say to my former colleagues –you are like the boy in the bubble. You live and breath the “free markets” paradigm. This is healthy, but it is limiting. It is not the real world..

Please, get out of that bubble. Get dirty with the data. Behold the slop in our clearing and settlement system. Consider how this slop is affecting our market, and tell me what is free or efficient about it.

Please, do it quickly.

If you do not, this nation is screwed.

Mark Mitchell

Mitch0033@gmail.com

For anybody familiar with this site, the following, published today in The Register, will be a reprise of a well-worn tale. But believe me…it’s still well worth the read…

Two and a half years ago, Overstock.com CEO Patrick Byrne penned an editorial for The Wall Street Journal, warning that widespread stock manipulation schemes - including abusive naked short selling - were threatening the health of America’s financial markets. But it wasn’t published.

“An editor at The Journal asked me to write it, and I told him he wouldn’t be allowed to publish it,” Byrne says. “He insisted that only he controlled what was printed on the editorial page, so I wrote it. Then, after a few days, he got back to me and said ‘It appears I can’t run this or anything else you write.’”

The Journal never changed its stance. But last week, the editorial finally saw the light of day at Forbes - after Byrne added a few paragraphs explaining that naked shorting had hastened what could turn out to be the biggest financial crisis since The Great Depression. (get the rest here)