Category | The Crime: “Naked Shorts” & Other Insincere IOUs

A Financial Crime Explained, With Two Hurdles & Two Promises

I will explain to you a financial crime that is occurring on Wall Street. It will not be difficult to understand. In fact, the crime’s simplicity will probably amaze you.

From three years of experience explaining this crime to many people, however, I know that there are two hurdles people face in understanding it. The first seems big but is, in fact, easy to surmount. The second is small, but is the one that trips people up. I have an easy way to get you over both hurdles, but to do so, I will ask you, esteemed reader, to make two promises to me. If you keep these promises you will overcome both hurdles.

Hurdle #1: Because it is a financial crime, people who are not too conversant with financial issues may shrink from technical-sounding jargon.  The way over that hurdle is this:

1) I will start by giving a super-simplified explanation that any high school kid could follow. It will be accurate, but only metaphorically accurate.

2) Then I will give an explanation that is literally accurate, but is still somewhat simplified, and uses just a little jargon.

3) Next I will give an explanation that is literally accurate, and includes technical jargon.

4) Last, I will provide links to numerous articles, news reports, interviews, and explanations that have appeared in academic papers and the financial media, for those who want to bury themselves in the technical details. 

In sum, I will start with simplified explanation, then move through the explanation again and again, getting more accurate with each pass, but also, more technical.    

Promise #1: Please make the first promise to yourself that you will not plough through this material until it defeats you. Instead, start by reading the first, metaphorical explanation and, if you understand to your own satisfaction, stop. If you are not sure you understand or remain unconvinced, read through the second, literal-but-simple explanation. If you get it then, stop. If you still are not sure you get it or remain unconvinced, read on through the fuller literal explanation, etc. etc. That is, promise that you will not wade through this material until it leaves you defeated and unconvinced. Instead, just read as far as you need to before you feel you get it, then feel free to bail out.

Hurdle #2: I have discovered that, given the right explanation, anyone can understand this crime. The second hurdle, however, is that when people start to understand it, their minds react as follows: “No way. No way. There’s no way that could be happening in our country. No way.”

Promise #2: Please make a second promise to yourself. That is, when you reach the point where your mind is reacting this way, you’ll go back and read Promise #1.    

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A Financial Crime Explained, With Two Hurdles & Two Promises

I will explain to you a financial crime that is occurring on Wall Street. It will not be difficult to understand. In fact, the crime’s simplicity will probably amaze you.

From three years of experience explaining this crime to many people, however, I know that there are two hurdles people face in understanding it. The first seems big but is, in fact, easy to surmount. The second is small, but is the one that trips people up. I have an easy way to get you over both hurdles, but to do so, I will ask you, esteemed reader, to make two promises to me. If you keep these promises you will overcome both hurdles.

Hurdle #1: Because it is a financial crime, people who are not too conversant with financial issues may shrink from technical-sounding jargon.  The way over that hurdle is this:

1) I will start by giving a super-simplified explanation that any high school kid could follow. It will be accurate, but only metaphorically accurate.

2) Then I will give an explanation that is literally accurate, but is still somewhat simplified, and uses just a little jargon.

3) Next I will give an explanation that is literally accurate, and includes technical jargon.

4) Last, I will provide links to numerous articles, news reports, interviews, and explanations that have appeared in academic papers and the financial media, for those who want to bury themselves in the technical details. 

In sum, I will start with simplified explanation, then move through the explanation again and again, getting more accurate with each pass, but also, more technical.    

Promise #1: Please make the first promise to yourself that you will not plough through this material until it defeats you. Instead, start by reading the first, metaphorical explanation and, if you understand to your own satisfaction, stop. If you are not sure you understand or remain unconvinced, read through the second, literal-but-simple explanation. If you get it then, stop. If you still are not sure you get it or remain unconvinced, read on through the fuller literal explanation, etc. etc. That is, promise that you will not wade through this material until it leaves you defeated and unconvinced. Instead, just read as far as you need to before you feel you get it, then feel free to bail out.

Hurdle #2: I have discovered that, given the right explanation, anyone can understand this crime. The second hurdle, however, is that when people start to understand it, their minds react as follows: “No way. No way. There’s no way that could be happening in our country. No way.”

Promise #2: Please make a second promise to yourself. That is, when you reach the point where your mind is reacting this way, you’ll go back and read Promise #1.    

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The Simple, Metaphorical Explanation

When you or I travel to another country, the first thing we do when we land is change some US dollars into the local currency. Perhaps you change enough to get a cab to the hotel, go out and buy a meal, etc. For the duration of your stay you keep changing your dollars into the local currency to get around. Then when you are ready to leave, you take whatever you have left and you convert it back into dollars, or spend it, or give it away, and board the plane back to the United States.

Yet imagine that there are some travelers to whom special privilege is granted. When they go to a foreign country, they are allowed to take a small machine that prints out the local currency. If they are in Paris, it prints out Euros. If they are in London, it spits out British Pounds. When in Mexico City, it prints pesos. And so on and so forth. On every trip, however, this special “currency machine” keeps track of how many Euros, pounds, or pesos it has spit out. When its owner goes to the airport to leave the country, a government official reads the machine’s printout and makes the traveler settle his account. For example, if the traveler visits Paris, then as he stands in the airport ready to depart, the official reads his machine and says, “Monsieur, you printed out €1,000 (one thousand euros) while you were here. At today’s exchange rate that is equal to $1,500 US.” The traveler hands over US $1,500 in cash, then boards his plane for the US.

Why are such boxes allowed? Because the people to whom this privilege is granted are wealthy hedge fund managers and Wall Street brokers. It is more convenient for them to carry these currency machines, and print what is in effect “temporary” local currency, than to do what the rest of us do, changing currency every morning at our hotel’s front desk. Besides, they’re rich. Everyone knows they are good for it: in fact, when one of them arrives in a new country, before he gets to use his curency machine he has to prove that he is wealthy, so that no matter how much local currency he prints and spends, he’ll have the dollars to buy them all back at the end of his trip, at current exchange rates. That way, when he is ready to leave the country and at the airport his machine is read to find out how much of the temporary local currency he printed on his visit, and that number is converted into US dollars, he can simply reach into his valise and pull out the requisite cash, even if it is thousands, or millions, of US dollars.

Imagine now that between the two Caribbean nations of St. Bart’s and St. Maarten’s there is a small island nation, St. Smallcap. It may be poor in comparison with the United States, but it has a working, even vibrant, economy. Its currency trades at parity with the US dollar (that is, one of the first converts to one of the other, and vice-versa). No one knows what the future holds for St. Smallcap. Perhaps it will stay as it is for generations. Perhaps it will develop into a prosperous island nation like Bermuda. Maybe it will become a destitute, impoverished nation like many other small island nations. Perhaps it will become an economic powerhouse, like Hong Kong or Singapore. There is no way to tell.

One day, as if on cue, a dozen hedge fund managers and Wall Street bankers show up in St. Smallcap. No one thinks much of it as these fellows start driving around Smallcap with their special machines. They print off the local currency with great abandon, using that currency to buy drinks and dinners on the town, pay for taxis, and gamble at the casino. In time, they begin buying the island’s houses, cars, yachts, and cargo ships. They even buy Smallcap National Airline’s sole 727 jet. They buy anything that is not nailed down, paying for it all along with the local currency, which they print off their special currency machines as they need it.

After a few weeks something funny begins to happen. There is so much extra currency floating around, it begins to affect the economy. As everyone realizes that there is a lot of extra currency sloshing around the island, prices for goods rise in anticipation that Smallcap’s currency will become less valuable. It may even happen that prices soar, as they did in Weimar Republic Germany after WWI, in a bout of hyper-inflation. Of course, as this happens, the rate at which Smallcap’s currency can be exchanged against other currencies, including the dollar, collapses.

There is an even more insidious effect, however, that one can understand by thinking about the nature of prices. There are many ways to think about prices. Often we see them simply as obstacles preventing us from getting what we want (“Jim wants a new Mercedes but on his teacher’s salary he cannot pay the price.”) Another way to think of prices, however (a way many economists think of them), is to see prices as little bits of information passing back-and-forth around the economy, permitting millions of strangers to coordinate their economic activities. Prices for corn are going up and prices for wheat are dropping? That is a signal to farmers that they should cut back on wheat production and plant corn instead. Rents soar in a city while prices for office space stagnate? That is a signal that someone should convert some office space to apartments and condominiums. A city is washed out because of a hurricane, and prices for flashlights are soaring? That is a signal to surivivors within the city to share the scarce resource of flashlights, and a signal to outsiders to start trucking in flashlights for resale (i.e., “profiteering,” which to economists means, “responding quickly to price signals without regard for ethical concerns such as loyalty”).

Like any other normal economy, in order to function St. Smallcap’s economy relies on prices to pass information around the economy. The hedge fund managers and their special currency machines, however, print out so much of their “temporary” currency that Smallcap’s economy becomes awash in it. Imagine listening to a radio playing across the room while someone plays white noise in speakers set up next to your ears: you would not be able to hear what was being said. Similarly, this flood of “temporary” currency washes out the signals that prices normally carry within St. Smallcap’s economy. No one knows whether to grow wheat or corn, and since seed prices are rising but no one knows what income can be generated from any crop, fewer farmers plant anything. Savings drop: it makes less and less sense to save, because what is the point of delaying consumption today in return for a future benefit that cannot be estimated? Since less money is being saved, banks have less capital to loan to businesses to expand, or even maintain, current production. As a result, manufacturing on the island also collapses.

One can imagine a situation where, if Smallcap’s economy were small enough, and the Wall Street bankers and hedge funds swept down on Smallcap with enough currency-printing machines, that they could flood Smallcap with so much of its own currency that the price signals of the local economy would be mostly lost. The white noise of massive amounts of this “temporary” currency would disrupt real economic activity, like farming and manufacturing, until the economy of Smallcap cracked. Hyper-inflation, starvation, and mass unemployment might set in. People would begin trading anything they have in return for a ticket to flee the island.

Throughout it all, the Wall Street bankers and hedge fund managers continue using their machines to print local currency with which they can buy, buy, buy.

After six months, when nothing of value is left on the island that they do not already own, the bankers and hedge fund managers take everything they bought and load it onto their new cargo ships and yachts. They gather at the airport to board their new jet.

A government official arrives and sets about to find out how much of the local currency they printed while visiting the island. The official reads the print-out from each of their machines, sums it up and exclaims, “100 million!”

One hedge fund managers speaks for the rest: “Yes, but that is not 100 million US dollars. It is 100 million in your local currency. And while we have been visiting your country your local currency seems to have collapsed. That is hardly surprising, given that your farms are vacant and your factories are boarded up. It seems that on the international markets your currency is worth 1/10,000th of what it was worth when we arrived six months ago. Thus, in US currency, we owe you precisely… $10,000.” He flashes his thick wallet and counts out the sum. Laughing, his hedge fund colleagues and banker friends board their jet and take off, banking to watch their new cargo ships sail out of the harbor loaded with the wealth of the country, for which, in the end, they paid $10,000.

Imagine also that surprisingly few reporters seem interested in these events, or notice the pattern of it happening to one small island nation after another. Those who do notice it take it for granted that small island nations are supposed to be the way they are: destitute and impoverished. Only rarely does a reporter challenge the bankers and fund managers on their actions, but the financiers respond in unison so perfect it appears rehearsed, “Are you kidding? Don’t you know what a dump that island is? The last time I saw St. Smallcap its farms were barren, its businesses were boarded up, and everyone was fleeing. I tell you, the place is just a disaster.”

If you can understand the story above, then you can understand the crime that is occurring in our financial markets (the metaphor is a sound one, if I say so myself). The point of subsequent posts in this category will be to convert the story you just read into Wall Street lingo, one step at a time. You will see how the preceding story precisely expresses behavior that is occurring on Wall Street, routinely, today.

In reality, of course, the “special machines” that bankers and hedge fund managers are using are not actual physical machines, and what they are destroying are not “small island nations,” and what they are printing is not “currency.” In reality, the “special machines” are loopholes in our legal system, what the bankers and hedge funds are destroying are small companies, and the “currency” they are printing off to do so are shares of stock in those small companies.

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The Simple, Literal Explanation

The “St. Smallcap” example conveyed the dynamics of the manipulation, but it was only a metaphor. This blog will provide an explanation whose truth is more literal.

You and I enter a stock trade. You buy a share of stock from me.  You hand over your money, and I hand over the share of stock. That is called, “settlement.”

It may surprise you to learn that there are loopholes in our nation’s regulations that permit some people, when it comes time to settle, to hand over nothing but an IOU.  By using one of these loopholes, when the time comes for settlement I can take your money but say, “I’m not delivering you any stock. I’m just giving you an IOU for a share of stock that I will deliver later.”

There are reasons these loopholes came into existence. If someone made a mistake by signing the wrong line on a form, for example, or mistakenly sold more shares than he really had, one would not want the entire system to vapor-lock as the mistake was rectified. So the system has been designed so that the gears do not get hung up on minor mistakes. The general idea is that, if someone sells shares it turns out he cannot deliver, he can create these IOU’s and send them on as though they were real shares, giving himself time to clean up whatever error he is experiencing, and sending the real shares a couple days later.

There is no system in place to alert you to the fact that you sent me your money and received nothing but an IOU. The system treats these IOU’s just as though they were real shares. Your brokerage statement will say that you got shares, even though I never sent anything but an IOU. You can sell them, and that IOU will pass on through the system into someone else’s account.

The problem is, suppose I (having mastered these loopholes) start using the system’s “forgiveness” strategically? Suppose I find a company that is likely to need capital to expand, or simply survive, in the near future? They plan on raising that capital by issuing shares of stock to the public (there is no crime in that: for example, lots of young pharmaceutical companies sip at the capital markets for years as they get going).  Imagine that I target one of them, and deliberately go out selling that company’s shares into the marketplace, yet instead of delivering stock, I deliver nothing but IOU’s. I flood the market with them, always standing ready to sell more than anyone wants to buy. My IOU’s are anything but temporary: they drift around in the market for weeks, months, and eventually years. If anyone gets mad and tells me that I have to deliver real shares against one of the IOU’s I sold, I say, “Sure, I’ll deliver shares against that IOU,” but what I deliver is … just another IOU. Eventually I flood the market with so many IOU’s that people end up reselling them, and they go and on until there are more share-IOU’s bouncing around than there are actual shares.

What will the effect be on the price of those shares? If I have chosen a company like, for example, IBM, the effect will be negligible (just as in the example of the preceding blog, if the hedge funds brought their money machines to Paris and printed off 100 million “temporary” Euros to spend around France and Germany, it would not cause any real harm before they bought them all back as they departed).

But remember how the hedge fund managers destroyed the economy of St. Smallcap, so that the “temporary” currency they had issued could be paid off in the end for next-to-nothing? Similarly, if instead of choosing IBM I choose a tiny company, and I generate more IOU’s than there are shares of stock in the company, then the market in those shares will crack just as surely as $100 million of fake currency would crack the tiny island economy of St. Smallcap. Once cracked, the stock becomes next-to-worthless. And if I manage to issue enough IOU’s in my target company’s stock that it cracks and becomes near-worthless, they become barely an obligation at all. Who cares about millions of IOU’s, if those IOU’s are for something with infinitesimal value?

I walk away with my winnings. The company, however, is in a fix: they planned on issuing stock to raise capital, but now their stock price has been destroyed through my manipulations, and they cannot raise capital. Maybe they run out of funds and disappear, or maybe they go into hibernation mode in order to nurse what capital they have. In either case, society is deprived of the output and the jobs that would have existed were it not for my villainy.

It may be hard to believe, but such loopholes really do exist (I will be explaining several of them in subsequent blogs). In reality, however, neither you (if you are like most Americans) nor I can actually use them.  Only large hedge funds and broker-dealers can access these loopholes to create IOU’s (just as, in the story of St. Smallcap, only hedge funds were allowed to own the currency machines with which to print off that “temporary” currency).  As we will see in more detail, these hedge funds and broker-dealers have learned how to manipulate these loopholes in the stock settlement system so as to flood the market with over a billion IOU’s (maybe many billion) in hundreds of companies. In doing so, they have disrupted the market for shares of companies that are researching cures for cancer and other illnesses, figuring out how to make blood substitutes to treat cases of acute blood loss, and building mine-resistant vehicles for troops in Iraq. Hundreds of such corporate “St. Smallcaps” have been damaged or destroyed. Thus, cancer patients are being deprived of treatments, accident victims are dying of acute blood loss, and soldiers in Iraq are dying from IED’s, so that some hedge fund ass-clowns can drive new Ferraris.

It really is that simple.

I have explained the issue through metaphor (“St. Smallcap”), and now, provided this literal explanation.  I will continue with more detailed explanations and citations for further reading for those who wish to gain a more thorough understanding of the workings of the US stock settlement system and precisely how loopholes permeate it. The general reader, however,  may feel satisfied with the account thus far and, feeling no need to learn intricacies of stock settlement, may wish to move on to subsequent chapters, where I discuss in greater detail the harms being done to society, who is doing it, and who has taken part in the cover-up.

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Prepare to be astounded

Prepare to be astounded

I’ve got everything ready to go for my next post, save one thing: the most current stock delivery failures data, corresponding to the second half of January, which the SEC was supposed to have made available yesterday.

I’m particularly eager to get that batch, because it has the capacity to confirm or rule-out my ability to predict the future.

See, I believe I know, to within a few percentage points, how some of that delivery failures data — up to this point supposedly known only to the DTCC and SEC — will read.

But instead of going mad waiting for it to be posted, I’m going to very publicly make my prediction here and now, and then follow up with the actual numbers once published. I shall then take my clairvoyant victory lap around the tiny office where I sit.

Therefore, I do predict the following:

With a margin of error of +/-2.5%, Shares of Sears Holdings Corporation (NASDAQ:SHLD) will be shown to have experienced CNS delivery failures of the following magnitudes on the indicated dates:

1/29/2010 879,444
1/28/2010 873,222
1/27/2010 870,570
1/26/2010 851,904
1/25/2010 848,742
1/22/2010 865,266
1/21/2010 857,106
1/20/2010 1,535,508
1/19/2010 1,540,914

Please check back often between today and tomorrow (or whenever the SEC gets around to posting the final numbers) to learn how accurate my predictions turned out to be, how I arrived at them, and why this is very bad news for our capital markets.

(note: on 2/22 at 8:27am MST I adjusted my prediction)

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Cataloging Sears stock manipulation

Cataloging Sears stock manipulation

Most of the examinations of stock manipulation published here on deepcapture.com take place after the fact, the damage being done. However, we’ve become aware of instances of apparently illegal, manipulative trading in several companies’ stocks, happening right now, which we have the ability to monitor and report on in nearly real time.

I’ll start with Sears Holdings Corporation (NASDAQ:SHLD).

A few months ago, an unusual trading pattern in shares of Sears emerged, in which large blocks of shares change hands within minutes of deep in-the-money call options equivalent to precisely the same numbers of shares in these blocks. This behavior is consistent with the illegal “reset” transaction described in the enforcement case brought by the SEC against naked short seller Steven M. Hazan:

“…a market participant who has a “fail-to-deliver” position in a threshold security buys shares of that security while simultaneously selling short-term, deep in-the-money call options to – or buying short-term, deep in-the-money put options from – the counterparty to the share purchase. The purchase of shares creates the illusion that the market participant has satisfied the close out obligation of Reg SHO. However, the shares that are apparently purchased in the reset transactions are never actually delivered to the purchaser because on the day after executing the reset, the option is either exercised (if a call) or assigned (if a put), transferring the shares back to the party that apparently sold them the previous day. This paired transaction allows the market participant with the fail-to-deliver position to effectively borrow the stock for a day, in order to appear to have satisfied the close out requirement of Rule 203(b)(3).”

If you want to see each of these reset transactions in detail, you can do so here. But if you’re content with the bottom lines, take a look at the following table, keeping in mind each call option contract gives the buyer the right to purchase 100 shares of the underlying stock (meaning, these trades were undeniably “matched” to one another).

Date Call option contracts Equities block size Date Call option contracts Equities block size
12/3/09 6,166 616,600 1/4/10 10,374 1,037,400
12/4/09 6,194 619,400 1/5/10 10,368 1,036,800
12/7/09 6,369 636,900 1/6/10 10,610 1,061,000
12/8/09 6,668 666,800 1/7/10 10,972 1,097,200
12/9/09 7,287 728,700 1/8/10 16,032 1,603,200
12/10/09 7,749 774,900 1/11/10 15,106 1,510,600
12/11/09 7,958 795,800 1/12/10 15,050 1,505,000
12/14/09 8,376 837,600 1/13/10 15,107 1,510,700
12/15/09 8,387 838,700 1/14/10 15,054 1,505,400
12/16/09 8,876 887,600 1/19/10 8,403 840,300
12/17/09 8,654 865,400 1/20/10 8,483 848,300
12/18/09 4,767 476,700 1/21/10 8,321 832,100
12/21/09 6,598 659,800 1/22/10 8,352 835,200
12/22/09 6,918 691,800 1/25/10 8,535 853,500
12/23/09 7,433 743,300 1/26/10 8,561 856,100
12/24/09 8,444 884,400 1/27/10 8,622 862,200
12/28/09 8,773 877,300 1/28/10 8,490 849,000
12/29/09 9,087 908,700 1/29/10 8,326 832,600
12/30/09 9,459 945,900
12/31/09 9,830 938,000

Take a look at how these blocks trades appear when charted.

SHLD matched block trades: click to enlarge

Looking at the relationship between these matched blocks and the delivery failure data currently available suggests the blocks are a pretty reliable predictor of delivery failures reported two days later.

SHLD matched block trades and delivery failures: click to enlarge

Moving fails back two trading days we see just how reliable a predictor these matched block trades really are.

SHLD matched blocks and failed trades, offest -2 days: click to enlarge.

On average, SHLD fails are roughly 102% of these matched blocks. Given that relationship, I feel quite confident predicting how the as-yet-unreleased SHLD delivery failures will appear (note the dashed line).

SHLD matched block trades and offset delivery failures with prediction: click to enlarge

Now for the good and bad news inherent to this situation.

The good news is: this unusual market activity is fairly easy to spot.

The bad news is: despite being easy to spot, in recent months multiple companies have come under identical attack, suggesting whoever is responsible is not too concerned about the consequences of overtly violating the securities laws…a familiar situation for anybody who’s followed deepcapture.com for any length of time.

I’ll have more on this subject as soon as the SEC fails data are released, so stay tuned.

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