Nearly one year after its original date of publication, my video, Hedge funds and the global economic meltdown has finally received its first bit of serious criticism, and I can’t express how pleased I am about it.
So far, at least as far as bloggers and YouTube commenters are concerned, response to the video has come in five flavors:
What’s been missing is educated criticism based on the hard facts presented in the video. And believe it or not, this has bothered me, because it suggests that not enough smart people are paying attention.
As I mentioned, that changed this week when Mike “Mish” Shedlock of SitkaPacific Capital Management analyzed the video on his blog and managed to make a compelling contrary case. Though compelling, Mike misses the mark on a few key points and his analysis requires a rebuttal, which I’ve decided to offer here as it would probably be of interest to DeepCapture.com readers. I’ve also invited Mike to respond, and will print whatever he offers at the end of this post.
(If you’ve not seen the video yet, I encourage you to watch at least the first five minutes now, otherwise nothing that follows will make much sense.)
Shedlock frames his criticism of the video in terms of what he identifies as three assumptions (printed verbatim in black, with my response in blue italics).
1. That whoever bought way out of the money Bear Stearns PUTs “knew” something and illegally acted on it. I agree with this.
2. The same institution that bought the PUTs was illegally shorting shares. I think this is a safe assumption.
3. There is a conspiracy to protect those evil doers. I do not agree that there is a conspiracy to protect the short sellers who attacked Bear Stearns any more than there was a conspiracy to protect Bernard Madoff before his scheme blew up. What “protects” them is Wall Street culture, and it’s no conspiracy…it’s common knowledge.
Shedlock then attempts to explain how the market really works via four statements of fact which he expects will undo my arguments, but which in reality only support them.
Here again, I present Shedlock’s facts verbatim, followed by the information he apparently did not have when he originally wrote them, in blue italics.
Fact #1: When someone buys PUTs the market maker or counterparty who sold them is short those PUTs. This is a mathematical statement of fact. This is 100% truth.
Fact #2: The market maker who sold the PUTs, shorts stocks as a hedge against those short PUTs.
This is also 100% truth, and an indispensible component of illegal naked short selling, which requires the options market maker to sell the stock naked short to the fund buying the puts. This is part of the married put strategy we’ve claimed from early on facilitates illegal short selling. As far back as 2003, the SEC expressed concern about married put strategies as a means of circumventing multiple market regulations. In this 2007 paper, an economist explains how a combined strategy of married puts and reverse conversions provided the engine that powered the naked shorting epidemic that grew unabated until changes were finally made in the wake of Lehman’s demise.
Fact #3: The lower the share price, the more shares the market maker has to short to stay delta neutral. Also true.
Fact #4: Market Makers are not governed by naked shorting rules. Again, Shedlock steals my line. Prior to the repeal of the options market maker (OMM) exception of Regulation SHO, OMMs were not bound by the locate and delivery requirements of that rule. So, it’s entirely predictable that options trading would play a key role in any effort to circumvent Reg SHO.
The existence – and illegality – of these kinds of tactics are documented in this November 2009 administrative action brought by the SEC against Rhino Trading and Fat Squirrel Trading (one of only two enforcement actions specifically alleging naked short selling filed in the Commission’s history). In it, you’ll learn how reverse conversions and “resets” (the call-based alternative to the married put) were used to illegally manipulate other stocks down.
At this point, Shedlock has spelled out the entire philosophical foundation for his disagreement with me, and yet we’re apparently in the awkward position of not disagreeing about any of the parts that really matter. The actual disagreement seems to be based on our interpretations of the implications of these facts, in my case informed by a slightly more detailed (though not very broadly-applicable) knowledge of the tactics used by illegal stock manipulators. That Shedlock is not familiar with these tactics speaks very well of him as an investment manager, in my opinion.
So, while Shedlock claims, “the [options] market makers shorting Bear Stearns did so for purely mathematical reasons, to remain delta neutral” I assert that this necessity, combined with their exemption from Regulation SHO’s locate and delivery requirements in place at the time, made them the perfect counterparty to a short-selling hedge fund seeking to warp the market for Bear Stearns stock through the generation of artificial supply.
Shedlock further asserts that Bear’s demise was the inevitable product of its own greed and toxic balance sheet. I respond by agreeing that Bear probably was destined to go under, and in capitalism, that’s ok. However I further point out that Bear had $18-billion in cash on hand when the assault began, and so the process should not have taken just one week. In a civilized world, even when someone is on their deathbed, it’s not ok to hasten death through forceful application of the pillow; and particularly not when the incentive for doing so is pecuniary.
As promised, the space to follow is reserved for Mr. Shedlock to offer his rebuttal.
Although much attention has been directed at the contribution made by credit default swaps to the financial crisis, most discussion has focused on the companies, such as American International Group, that posted big losses because they sold these instruments without sufficient due diligence.
Another line of inquiry has not been pursued, however, though it is of equal, and perhaps greater, significance. That line of inquiry concerns the way in which the prices of credit default swaps effect the perceived value of all forms of debt — corporate bonds, commercial mortgages, home mortgages, and collateralized debt obligations — and as a result, the ability of hedge funds manipulators to use credit default swaps to enhance their bear raids on public companies.
If short sellers can manipulate the price of credit default swaps, they can disrupt those companies whose debt is insured by the credit default swaps whose prices are manipulated. The game plan runs as follows: find a company that relies on a layer of debt that is both permanent, and which rolls over frequently (most financial firms fit this description). Short sell that company’s stock. Then manipulate the price of the CDS upwards, preferably into a spike, as you spread the news of the skyrocketing CDS price (perhaps with the cooperation of compliant journalists at, say, CNBC).
Because the CDS is, in essence, an insurance policy on the debt of the company, the spiking CDS pricing will cause the company’s lenders to panic and cut off access to credit. As this happens, the company’s stock will nosedive, thereby cutting off access to equity capital. Thus suddenly deprived of credit and equity, the firm collapses, and the hedge fund collects on its short bets.
Moreover, credit default swap prices are the primary inputs for important indices (such as the CMBX and the ABX) measuring the movement of the overall market for commercial and home mortgages. In the months leading up to the financial crisis of 2008, short sellers pointed to these indices in order to argue that investment banks – most notably Bear Stearns and Lehman Brothers – had overvalued the mortgage debt and property on their books. Meanwhile, several hedge funds made billions in profits betting that those indexes would drop.
It should therefore be a matter of some concern that credit default swap “prices” and the indexes derived from them are determined almost entirely by a little company with zero transparency and, it appears probable, a high exposure to influence from market manipulators. The company is called Markit Group, and there is every reason to believe that its CDS-driven indices (the CMBX, the ABX, and several others) are inaccurate, while the credit default swap “prices” that they publish and which rock the market are in fact nowhere close to the prices at which credit default swaps actually trade.
Last year, the media reported that New York Attorney General Andrew Cuomo had sent subpoenas to Markit Group as part of an investigation into possible manipulation of credit default swap prices by short sellers. This investigation, like Mr. Cuomo’s other investigations into market manipulation, have yielded no prosecutions.
The Department of Justice is reportedly investigating Markit Group for anti-trust violations. This investigation (which is reportedly focused on how Markit Group packages and sells its information) seems to acknowledge that Market Group has near-monopolistic control of information about credit default swap prices. However, if the press reports are correct, the DOJ has not considered the possible appeal of this monopolistic control to market manipulators.
Meanwhile, Henry Hu, the director of the Securities and Exchange Commission’s division of risk, has said that it has been nearly impossible for the SEC to conduct investigations into any matter concerning credit default swaps because the commission does not have access to any data on the trading of CDSs. In itself, this is a shocking admission. It is all the more shocking when one considers that the necessary data exists and might be in the hands of the Markit Group – a black box company based in London.
A thorough investigation of Markit Group is urgently required.
Here is what we know so far:
Conclusion: Ten years ago, there was no such thing as a credit default swap. Six years ago, a very small number of investors traded credit default swaps as hedges against the long-shot possibility of corporate defaults. Nobody looked to credit default swaps as reliable indicators of corporate well-being.
Then, suddenly, there were over $60 trillion in credit default swaps outstanding. That is, over the course of a few years, somebody had made over $60 trillion (many times the gross domestic product) in long shot bets that borrowers would default on their debt. As this derivative risk marbled through the system, the trading in credit default swaps was completely opaque. Nobody knew who bought them, who sold them, or at what price.
But starting in 2001, we knew the “prices” of CDSs. We knew the “prices” because two Canadians, a developer of Bulgarian real estate, and four mysterious hedge funds had founded a small, black-box company in London. That company, the Markit Group, achieved near-monopolistic power to publicize the “prices” through its magic process of aggregating quotation information provided by 22 hedge funds and broker-dealers who could well have been betting on the downstream effects of sudden price changes.
These “prices” were not prices in any meaningful sense of the term. But, suddenly, these “prices” became perhaps the single most important indicator of corporate well-being. Assuming that those four hedge funds and the 22 “contributors” (or hedge funds affiliated with them) bet against public companies, it seems more than possible that short-sellers got to run the craps table, call the dice, and place bets, all at the same time.
So perhaps it is not surprising that a lot of long-shot rolls paid off quite nicely.
“Telling the truth is only possible by accident through a special sort of boastfulness…”
- Fyodor Dostoevsky, “The Idiot”
Regular readers of Deep Capture are aware that we have sought to expose certain journalists who seem to serve the interests of a network of market miscreants, many of whom are tied to the famous criminal Michael Milken or his close associates.
One of these journalists is Roddy Boyd, who worked at the New York Post before moving to Fortune magazine. It has come to our attention that Roddy has left Fortune. The magazine did not return a phone call seeking comments on the circumstances behind his departure, but whatever those circumstances might be, it seems fit to honor his departure by publishing an excerpt from a book called “House of Cards.”
In this book, which is written by a Wall Street insider named William Cohan, Roddy is quoted at length, and one particular passage stands out for being quintessentially Roddy. While you are reading the passage, keep in mind that I spent a number of hours talking to Roddy some years ago, and can report that he has a manner of speaking that is similar to what Dostoevsky called “a special sort of boastfulness” –which is to say that Roddy likes to stroke his own back, and in so doing, he often rambles in such a way as to unintentionally admit to his own buffoonery, or to some form of miscreancy on the part of his favorite Wall Street sources.
In this passage, Roddy tells the story of certain communications he had with Tom Marano, Bear Stearns’s (NYSE:BSC) top mortgage trader, on March 6, 2008 – a few days before false rumors began swirling about Bear Stearns’s access to credit. The following week, the false rumors were rampant, and those rumors, along with naked short selling, quickly brought Bear to its knees.
A couple of weeks after the collapse of Bear Stearns, Marano found a new job – with Cerberus Capital Management. As I have detailed elsewhere, Cerberus is run by Steve Feinberg, who was once one of Michael Milken’s top traders at Drexel Burnham. After working for Milken, Feinberg moved to Gruntal & Co., a criminal-infested brokerage, where he worked closely with Steve Cohen, who was once investigated by the SEC for trading on inside information fed to him by Michael Milken’s staff at Drexel. Cohen now runs SAC Capital, believed to be one of the biggest short sellers of Bear Stearns’s stock.
I am not yet going to state what I think is important about the passage quoted below. But I have other reasons to believe that the facts that Roddy drops in the course of his braggadocio are key to understanding what happened to Bear Stearns. Read the passage yourself, focusing on the facts, not on Roddy’s version of the facts. Consider that Roddy’s conversation with Marano took place on March 6, when there were not yet any rumors in the market, and Bear’s stock was trading above $60. Then, let me know if you spot what’s important.
Here’s the passage:
“…at eleven in the morning on March 6 Marano placed a phone call to Roddy Boyd, then a writer at Fortune. Marano had been a source of Boyd’s for years, when the journalist was covering Wall Street at the New York Post, and had freely offered commentary about his competitors and the markets generally. Boyd had been a trader for eight years before switching careers to journalism, and the two men spoke the same language. ‘I know the mortgage product dead cold,’ Boyd said. Their relationship was a well-defined pas de deux. ‘It was unusually well defined,’ [Boyd] explained. ‘We knew exactly what we were saying. I could have a very long conversation in two minutes. I protected him always. I never BS’d with him. I never got him in hot water. The corollary was he never BS’d with me, and he would give me good stuff.’
“This time, Marano called Boyd to talk about Bear Stearns, and specifically about his concern that the firms he had traded with for years were suddenly asking him whether Bear had enough cash on hand to execute his trades. ‘He called me at 11:00 A.M. that day and we talked about one or two things,’ Boyd continued. ‘It was weird. He knew it was weird. We did small talk in under ten seconds. I said to him, ‘What’s up?’ He said, ‘What are you hearing about Bear?’ I said, ‘You know what I’m hearing and you know what I’m seeing. He said, ‘I know what you’re hearing and you’re seeing. It’s just baffling.’ Now here I’m playing him a little because I’m hearing things and I’m seeing some things, but he’s not saying much more than I am, so I let him walk and talk. He said to me, ‘Roddy, our guys, our senior guys here, are hearing a really strange thing from custies.’ That’s customers. He said, ‘We were not prepared to hear stuff like this. This is baffling. People are quite literally questioning our solvency, questioning our ability to go on. The shorts are having a lot of fun with us today.’…
“‘He’s thinking two things,’ Boyd continued. ‘One, he’s got to stop this whole line of inquiry right here, right now, because if you have to ask the question, oh my God. Second, he’s thinking about the trajectory of rumor and supposition, and that thesis of smoke versus fire….With a question of their ability to act as a counterparty on the table, that’s unimaginable. I mean, this is Bear Stearns….Now they’re being questioned from the standpoint of fundamental liquidity. He [Marano] said that he believed that these short sellers had been speculating in the credit default swap market and telling counterparties at other firms that they had concerns about Bear Stearns’s liquidity and solvency, and that was driving the cost of spreads wider. What that was doing was making their overnight funding more expensive. That was cutting into their profit margin, and in turn was also starting a sort of cottage industry of rumors about Bear Stearns.’
Roddy continued: “‘There’s no need to explain anything between us,’ he [Marano] said. I said, ‘Are you sure you’re seeing this?’ He said, ‘Look at [the credit default] swaps.’ So I looked them up and then I see the hockey sticks’ – a sharp spike up in their cost… ‘He said, ‘It’s unbelievable. It all bullshit.’ At that point—he’s very much a corporate guy—but he had left me [with a clear message]. I’m not stupid. Hedge funds and prime brokerage accounts are unusually skittish about questions of financial health, financial solvency, and he said, ‘I’m hearing there’s questions about our financial health.’ At that point, Marano is telling me he knew he was done, because once that question of credibility goes out there, and serious people say it to you enough, you’re done. It’s all that there is to it. It’s all that there is to it. Where do you go to get your reputation back.’ …
“Boyd worked hard [the following night] and over the weekend trying to figure out which bank—said to be European—had decided it would no longer be a counterparty to Bear Stearns in the overnight financing markets. Obviously, this would be a huge negative development for the firm…‘At that point, I’m pulling my fucking hair out—pardon my language—calling everybody,’ [Boyd] said. ‘I’m calling Deutsche Bank, I’m calling UBS, and I’m very aggressive. Get your senior guys on the phone. Get your financing desk on the phone. I don’t want to talk to some stupid flack. I spent eight years on a desk. I’m smarter than all those flacks. They’re all Kool-Aid drinkers. They don’t honestly know a derivative from a bond from a stock. None of them are going to be able to ask their financing desk. They don’t even know enough to call the repo guys on the financing desk. I told them, Get your financing guys or get your credit guys on the phone with me, or you’re going in Fortune. Here’s the New York Post coming out of me. I said, There’s two ways this is going to work: bad or good. This hand is good; this hand is bad. I shake your hand or I punch you. Let me know…I’m talking to the guys in New York, and they’re saying, We swear to Christ we are not the ones to have done that [cut financing]. If Deutsche Bank had done it, I’m thinking, ‘Okay, that’s the story right there.’ The minute a repo line gets pulled, you die, okay? They die a terrible death.’…
Roddy continued that, after the March 6 call with Marano, ‘“I was thinking, I’m going to poke around in this more…but then I was thinking, This is strange. This is like a situation where you can abuse your position as a reporter. When you’re at Fortune, you have to do stuff right. When you’re at the New York Post, you have to be there first and fastest. At Fortune, you write the first draft of history, and you have to get it right and you have to be consistently right. I’m thinking, I don’t really want to screw with this company – I don’t want to spread rumors. I don’t want to become part of the story. I don’t want to hurt people unnecessarily. I’m an aggressive guy and I’ll pick fights with anyone or anything, but there’s a right way of doing my job and there’s a wrong way. I weighed my duty as an employee here versus the right thing to do.”
Do you see what happened here? Feel free to post your opinion in the comments section. Or contact me privately by email at firstname.lastname@example.org.
Matt Taibbi has published a story in Rolling Stone magazine that nobody should miss. It’s not yet available on-line, so you’ll have to pick it up at the newsstands, but here’s a quick summary.
“On Tuesday, March 11th, 2008, somebody – nobody knows who – made one of the craziest bets Wall Street has ever seen. The mystery figure spent $1.7 million on a series of options, gambling that shares in the venerable investment bank Bear Stearns would lose more than half of their value in nine days or less. It was madness – “like buying 1.7 million lottery tickets,” according to one financial analyst.”
Bear’s stock would have to drop by more than half in a matter of days for the mystery figure to make a profit. And that is what happened.
As Taibbi explains, “the very next day, March 12, Bear went into a free fall…Whoever bought those options on March 11th woke up on the morning of March 17th having made 159 times his money, or roughly $270 million. This trader was either the luckiest guy in the world, the smartest son of a bitch ever or…Or what?”
Taibbi speculates (as has Deep Capture) that these options might have been purchased by somebody who was abusing the options market maker exemption to engage in illegal naked short selling. And Taibbi goes beyond speculation to state, as an obvious fact, that illegal naked short selling helped bring Bear Stearns to its knees.
Presumably operating under that assumption, the SEC issued more than 50 subpoenas to Wall Street firms in the wake of Bear’s collapse, but “it has yet to indentify the mysterious trader who somehow seemed to know in advance that one of the five largest investment banks in America was going to completely tank in matter of days.”
Taibbi continues: “The SEC’s halfhearted oversight didn’t go unnoticed by the market. Six months after Bear was eaten by predators, virtually the same scenario repeated itself in the case of Lehman Brothers – another top-five investment bank that in September 2008 was vaporized in an obvious case of [naked short sellers engaging in] market manipulation. From there, the financial crisis was on, and the global economy went into full-blow crater mode.”
Taibbi notes that there were many other factors that made the economy weak. But he says that naked short selling is what pushed Bear and Lehman over the edge. If it weren’t for naked short selling – a massive “counterfeiting scheme,” in Taibbi’s words — those banks would likely have survived, and we might have avoided an all-out financial catastrophe.
This cannot be stressed enough. Criminals deliberately destroyed two of America’s biggest investment banks, precipitating the greatest financial cataclysm since the Great Depression. And the government has done absolutely nothing to bring those criminals to justice. In fact, as Taibbi makes clear in his story and on his blog, the most likely culprits are feted by top government officials in closed door meetings.
I’d call this the biggest financial and political scandal in the history of this country.
Certainly, it is, as Taibbi writes, “one of the most blatant cases of stock manipulation in Wall Street history.” Certainly, it is, as Taibbi writes, “the two biggest murders in Wall Street history.” And, certainly, it is odd that this very big story has appeared in Rolling Stone, but has yet to be covered by a single mainstream news publication.
The Wall Street Journal, The New York Times, Fortune, BusinessWeek – they have all known about naked short selling since Deep Capture reporter Patrick Byrne began hollering about it in 2005. But none of them write about it. Instead, we find a competent financial journalist, and the only major story about one the greatest financial crimes of all time, published in a slightly alternative magazine about music.
I worry for the Republic.
* * * * * * * *
I originally published this video on the first anniversary of the destruction of Bear Stearns, though its lessons seem even more timely today, the first anniversary of the destruction of Lehman Brothers.
And so, as you bump into some of the many discussions currently underway touching upon the cause of Lehman’s demise and the global financial meltdown that followed, kindly refer folks to this video. When the shorts protest that it’s a “conspiracy theory,” you might agree that it is indeed a conspiracy, but a conspiracy fact, not theory.
When they continue to protest, ask them to get specific.
And then sit back and enjoy the silence.
(As I mentioned in an earlier post, I’m looking for extra feedback on the ideas presented here, as they are currently under development and able to benefit greatly from your insights.)
I think we can all agree that the middle of last September was as strange a time as our financial markets have ever experienced.
In case you’ve forgotten, let me remind you with a simple timeline. As you read it, keep in mind that following the demise of Bear Stearns, the strictest interpretation of the so-called investment bank “Bulge Bracket” included just four entities: Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley.
As I see it, the most interesting event to come of that most eventful period was the SEC’s September 19 ban on legitimate short selling. What makes it so enigmatic is the fact that not even the most vocal opponents of illegal naked short selling have ever even hinted at the need to restrict legitimate shorting. In fact, Patrick Byrne himself compared the ban to limiting motorists to making only right-hand turns.
However, I have a theory that might explain what was going on.
An examination of the volume of both naked and legitimate shorting of Goldman Sachs in September of 2008 reveals something very interesting: while there was an enormous amount of short selling taking place, there was essentially no naked shorting of Goldman shares. Indeed, short selling accounted for a third of total volume on September 15 and 16, while failed trades accounted for less than 0.07%, suggesting shortable Goldman shares were in abundant supply.
This conclusion is supported by an analysis of the stock loan rebate rate that prevailed for Goldman shares during the period in question: a very reliable indicator of the scarcity of shares available for short sellers to borrow, where a lower rebate rate indicates a more limited supply.
In the case of Goldman, from May through August 29 of 2008, the rebate rate averaged 1.80%. And, between September 1st and the September 19th short selling ban, Goldman’s average rebate rate remained exactly the same: 1.80%.
By way of comparison, the average rebate rates for Lehman Brothers shares over the same periods were 1.18% and 0.16% (bottoming out at -0.25% during Lehman’s last week), respectively.
By contrast, Goldman shares appear to have been easy to borrow right up to and in the midst of its stock price free-fall.
This scenario is consistent with the levels of naked short selling of Lehman and Goldman during the same period: extremely high in the case of Lehman, and almost non-existent in the case of Goldman; furthermore, this suggests that, given abusive naked shorting does not tend to occur until after short sellers have exhausted the supply of borrowable shares, it was legitimate shorting that pushed Goldman’s share price over the edge.
With that in mind, let’s revisit the above timeline, focusing on Goldman, with my interpretation appended.
Might the SEC have been acting in the best interest of the market when it issued both emergency orders? I suppose that’s possible. But given the utter disinterest – even contempt – that organization has demonstrated toward investors and small public companies that have complained about the issue, I find it very difficult to believe.
Meanwhile, the SEC stood by and watched as naked short selling destroyed Bear Stearns and Lehman Brothers. Merrill Lynch then took itself out of the game, leaving a Bulge Bracket consisting of only Goldman Sachs and Morgan Stanley.
Of those two, which has uncommon influence over the federal government?
Goldman Sachs, of course.
And if this is true, does it leave any doubt as to the lengths the SEC might have gone to preserve a corrupt system when it benefited the company?
“Accountability – Integrity – Reliability”
That’s the motto of the Government Accountability Office, and it almost makes you believe that there really is a functioning watchdog – somebody, aside from us Internet loons, to investigate and report on the incompetence and malfeasance that pervade our public institutions.
Certainly, there were high hopes when the GAO began investigating the Securities and Exchange Commission’s oversight of the Depository Trust and Clearing Corporation (DTCC), a black box Wall Street outfit that is at the center of one of the great financial scandals of our era.
Alas, the GAO has completed its “investigation” and issued a report on its findings. After reading this report, and considering once again that the GAO (“Accountability – Integrity – Reliability”) is the last line of defense against government miscreancy, I have concluded, and am obliged to inform you, that we are, without a shadow of a doubt, totally screwed.
The report begins with an explanation: “An effective clearance and settlement process is vital to the functioning of equities markets. When investors agree to trade an equity security, the purchaser promises to deliver cash to the seller and the seller promises to deliver the security to the purchaser. The process by which the seller receives payment and the buyer, the securities, is known as clearance and settlement.”
In other words, people who sell stock need to deliver real stock. That’s kind of important to the“functioning of equities markets.” If you think it is strange that the GAO ( “Accountability – Integrity – Reliability”) needs to clarify this point, you can begin to understand the scope of a scandal that has helped bring us to the brink of a second Great Depression.
The problem is that many hedge funds and brokers engage in illegal naked short selling – selling stock and other securities that they have not yet borrowed or purchased, and failing to deliver stock within the allotted 3 days. They do this to drive down stock prices and destroy public companies for profit.
Emmy Award-winning journalist Gary Matsumoto reported on the Bloomberg newswire last week that naked short selling is one of Wall Street’s “darkest arts” and contributed to the demise of both Lehman Brothers and Bear Stearns. SEC data shows that an astounding 32.8 million shares of Lehman were sold and not delivered to buyers as of last September 11, days before the company declared bankruptcy.
The collapse of Lehman, of course, triggered the near-total implosion of our financial system.
How could this have been allowed to happen?
One answer lies within that black box – the Depository Trust and Clearing Corporation. The DTCC is a quasi-private, Wall Street owned and operated organization that is charged by Congress and the SEC with ensuring that securities trades are cleared and settled. As is evident from the cases of Lehman, Bear, and hundreds of other companies, however, the DTCC often fails to do its job.
In fact, it enables naked short selling to go unpunished. Rather than track individual trades to ensure that delivery occurs, the DTCC merely calculates a net total of sales and purchases at the end of each day. So we know how many shares of a given company fail to deliver each day, but the DTCC won’t tell us which hedge funds or brokers are responsible.
Meanwhile, the DTCC maintains something called the “Stock Borrow Program,” whereby it purportedly borrows a bundle of shares from cooperating brokers and uses the shares to settle failed trades. These shares are not on deposit with the DTCC, and the DTCC records a trade as “settled” with a mere electronic entry — i.e. by pushing a button on a computer rather than exchanging an actual certificate. So it is unclear that the Stock Borrow Program is actually delivering stock. Moreover, trade volume data suggests that the Stock Borrow Program might be using its bundle over and over again, settling multiple trades with the same “shares,” and generating what is, in effect, massive amounts of counterfeit, or “phantom” stock.
While enabling hedge funds and brokers to engage in their dark art, the DTCC also goes to lengths to deny that illegal naked short selling occurs and to smear the reputations of people who say otherwise. It has orchestrated this vicious public relations campaign in cahoots with a crooked Portfolio magazine reporter named Gary Weiss, who has worked closely with a motley cast of Mafia-connected hedge fund managers and convicted criminals.
There is indisputable evidence showing that Weiss, while posing as a journalist, not only worked inside the DTCC’s offices, but also went so far as to seize total control of the Wikipedia entries on “naked short selling” and “Depository Trust and Clearing Corporation.” Yet, to this day, Weiss flat-out denies that he has ever worked with the DTCC and insists that he has never edited any Wikipedia page, much less the fabulously distorted entries dealing with naked short selling.
That the DTCC facilitates and seeks to cover up naked short selling is not surprising given that it is owned by the very brokerages who profit from catering to hedge funds who commit the crime. The DTCC’s board of directors has included several market makers – including Peter Madoff, brother of Bernard Madoff, the $50 billion Ponzi schemer with ties to the Mafia — who made a tidy profit from naked short selling.
At any rate, the SEC is responsible for overseeing the DTCC and ensuring that it is doing all it can to enforce delivery of shares and other securities. But the SEC conducts examinations of the DTCC only once every two years, and former SEC officials have admitted to Deep Capture that these visits entail nothing more than “investigators” asking a few courteous questions. Indeed, a number of former SEC officials have told us that the nation’s securities regulator doesn’t even understand what the DTCC does.
Enter the GAO (“Accountability – Integrity – Reliability”). Ostensibly, the GAO was going to determine whether the SEC was properly monitoring the DTCC. However, the GAO’s “investigation” entailed nothing more than visiting the SEC and asking a few courteous questions. In response, the SEC told the GAO that there is nothing to worry about, and the GAO duly issued a report that concluded that the SEC had told the GAO there is nothing to worry about.
Really, that, in essence, is what the report says.
It notes, for example, that the SEC examines the DTCC only once every two years, but offers no opinion as to whether this is sufficient oversight of an organization that processes securities transactions worth $1.4 quadrillion – or 30 times the gross product of the entire planet – every year.
And here’s what the report has to say about the DTCC’s Stock Borrow Program:
“…in response to media criticism and allegations made by certain issuers and shareholders that NSCC and DTC [units of the DTCC] were facilitating naked short selling through the operation of the Stock Borrow Program, OCIE [a unit of the SEC] also incorporated a review of this program into the scope of its 2005 examination. These critics argued that the Stock Borrow Program exacerbated naked short selling by creating and lending shares that are not actually deposited at the DTC, thereby, flooding the market with shares that do not exist. As part of their review, OCIE examiners tested transactions in securities that were the subject of the above referenced allegations or had high levels of prolonged FTD. The examination did not find any instances where critics’ claims were validated. However, we did not validate OCIE’s findings.” [Emphasis mine]
In other words, the SEC claims to have examined the Stock Borrow Program once – in 2005 — but the GAO (“Accountability – Integrity – Reliability”) has no idea what that examination entailed. The SEC claims to have “tested transactions” in securities that had “high levels of prolonged” failures to deliver, but offered the GAO no credible explanation as to why so many companies have seen millions of their shares go undelivered nearly every day since 2005.
The SEC says it looked into the “critics’ claims” and found them to be without merit. The GAO duly notes this as if what the SEC has to say were the final say in the matter. As to whether the SEC’s own claims might have been without merit, the GAO says only that it “did not validate” the SEC’s findings.
Isn’t the job of the GAO (“Accountability – Integrity – Reliability”) to “validate” – or, as it were, invalidate – the SEC’s findings? It is not exactly an “investigation” to merely ask the SEC what it has to say and then publish a report confirming that that is, in fact, what the SEC had to say.
Last year, more than 70% of all failures to deliver were concentrated on a select 100 companies that short sellers had also targeted in other ways (planting false media stories, issuing false financial research, filing bogus class action lawsuits, harassing and threatening executives, engaging in corporate espionage, circulating false rumors, pulling strings to get dead-end federal investigations launched, etc.), but the SEC told the GAO that the failures to deliver could be mostly the result of “processing delays” or “mechanical errors.”
Billions of undelivered shares – most of them concentrated on 100 known targets of specific short sellers. Many of those shares left undelivered for months at a time. The SEC tells the GAO that this might be due to “mechanical errors.” And what does the GAO (“Accountability – Integrity – Reliability”) do? It transcribes the SEC’s claims, offers no opinion as to whether the SEC might be full of it, and then acknowledges that it is in no position to have such opinions because it “did not validate” anything.
In a written response to the GAO, the SEC noted happily that the GAO (“Accountability – Integrity – Reliability”) “made no recommendations” in its report.
“We appreciate the courtesy you and your staff extended to us during this review,” the SEC told the GAO.
* * * * * * * *
Far better is a report issued last week by the Office of the Inspector General at the Securities and Exchange Commission. Inspector General David Kotz, charged with conducting independent oversight of the SEC, is a heroic figure – an honest man in government. He has consistently lambasted the SEC for corruption and incompetence, and now he has investigated the SEC’s regulation of naked short selling. He found the regulation to be fairly abysmal and offered concrete recommendations for how the commission could reform itself.
The report concludes:
“The OIG received numerous complaints alleging that [SEC] Enforcement failed to take sufficient action regarding naked short selling. Many of these complaints asserted that investors and companies lost billions of dollars because Enforcement has not taken sufficient action against naked short selling practices.”
“Our audit disclosed that despite the tremendous amount of attention the practice of naked short selling has generated in recent years, Enforcement has brought very few enforcement actions based on conduct involving abusive or manipulative naked short selling…during the period of our review we found that few naked short selling complaints were forwarded to Headquarters or Regional Office Enforcement staff for further investigation…”
“Given the heightened public and Commission focus on naked short selling and guidance provided to the public leading them to believe these complaints will be taken seriously and appropriately evaluated, we believe the ECC’s current policies and procedures should be improved to ensure that naked short selling complaints are addressed appropriately.”
As for the SEC’s claims that naked short selling isn’t really a problem, or that failures to deliver could be the result of “mechanical error,” the OIG nicely contrasts this blather with the SEC’s own decision last fall to take “emergency” action against naked short selling (because naked short sellers were contributing to the toppling of the American financial system) and the SEC’s statement that “we have been concerned about ‘naked’ short selling and, in particular, abusive ‘naked’ short selling, for some time.”
In response to the OIG’s rightfully scathing report, the SEC wrote a letter in which it flatly refused to abide by most of the OIG’s recommendations.
The SEC did not thank the OIG for its “courtesy.”
* * * * * * * * *
Meanwhile, that other watchdog – the media – continues to ignore the problem of naked short selling. After Gary Matsumoto’s rather earth-rattling Bloomberg report that naked short selling destroyed Bear Stearns and Lehman Brothers – and, by extension, destabilized the entire financial system – there were a total of two mainstream media stories on the subject.
The first was in Portfolio magazine. Actually, this wasn’t really a story. It was one of those question and answer things. And the Q&A was not with some credible expert. Instead, a Portfolio magazine reporter interviewed another Portfolio magazine reporter about the Bloomberg reporter’s story. Even more shocking to those who believe there is hope for balanced media coverage of this issue, the interviewee was none other than… Gary Weiss, the crooked reporter who sidelines as a flak for the DTCC.
Weiss, of course, smeared the messenger, suggesting that Matsumoto was a “conspiracy theorist.” He cited no data or evidence, but repeated the SEC and DTCC nonsense that failures to deliver might be caused by mechanical errors (which just happen to show up overwhelmingly concentrated in those firms targeted by the hedge funds who serve as Gary Weiss’s sources). And he asserted that naked short selling isn’t a problem because the SEC says that naked short selling isn’t a problem (except when the SEC says that naked short selling is an “emergency”).
Read the full interview here. You’ll get a sense of the way Weiss deliberately employs straw man arguments to distort the truth, though as an example of Weiss’s dishonesty, this is rather mild.
* * * * * * * *
The other magazine to report on the Bloomberg bombshell was the Columbia Journalism Review, which is the most prominent watchdog of the watchdogs – an outlet for serious media criticism. As Deep Capture‘s regular readers know, I used to work as an editor for the Columbia Journalism Review. I spent ten months preparing a story for that publication about dishonest journalists (including Gary Weiss) who were deliberately covering up the naked short selling scandal.
In the course of working on this story, I was threatened and, on one occasion, punched in the face. Then, in November 2006, shortly before the story was to be published, a short selling hedge fund that I was investigating announced that it would henceforth be providing the Columbia Journalism Review with the funding that would be used specifically to pay my salary.
The hedge fund that bribed the Columbia Journalism Review is called Kingsford Capital. It has worked closely with criminals, including a thug named Spyro Contogouris. In November 2006, a couple weeks after Kingsford bribed the Columbia Journalism Review, an FBI agent arrested Spyro. This was the same FBI agent who was investigating a cabal of short sellers – SAC Capital, Kynikos Associates, the former Rocker Partners, Third Point Capital, Exis Capital — who were then working with Spyro to attack a company called Fairfax Financial.
Spyro had harassed and threatened Fairfax executives, so he was going to feature prominently in my story. The centerpiece of my story, however, was to be that cabal of short sellers, not only because the Fairfax case was quite shocking, but also because these short sellers and a few others were the primary sources to dishonest journalists (especially MarketWatch reporter Herb Greenberg and CNBC personality Jim Cramer) who were then whitewashing the naked short selling scandal. Moreover, nearly every company known to have been targeted by these short sellers had been victimized by naked short selling, with millions of shares going undelivered, often for months at a time.
Emails in my possession show that Kingsford Capital is closely connected to that cabal of short sellers. Moreover, one of Kingsford’s managers at the time, Cory Johnson, was, along with Herb Greenberg and Jim Cramer (the journalists who were going to feature most prominently in my story) a founding editor of TheStreet.com. (Johnson removed Kingsford from his online resume after I revealed the relationship in “The Story of Deep Capture.”).
For a number of years, Kingsford Capital was partnered with Manuel Asensio, who was one of the most notorious naked short sellers on the Street. Prior to his work with Kingsford, Asensio worked for First Hanover, a Mafia-affiliated brokerage whose owner later became a homeless crack addict.
I was investigating Kingsford and Asensio primarily because they appeared to be among the favorite sources of Gary Weiss, the crooked journalist who was then secretly doubling as a flak for the black box DTCC. Asensio, for example, helped Weiss write “The Mob on Wall Street,” a 1995 BusinessWeek story that was all about the Mafia’s infiltration of Wall Street stock brokerages, but which deliberately omitted reference to Mafia-connected naked short sellers, even though the brokerage that featured most prominently in the story, Hanover Sterling, was at the center of one of the biggest naked short selling fiascos in Wall Street history.
According to someone who knows Weiss well, Asensio was also a source for a Weiss story about the gangland-style murder of two stock brokers, Al Chalem and Meier Lehmann. Chalem was tied to the Mafia and specialized in naked short selling. Multiple sources say that Russian mobsters killed Chalem in a dispute over the naked short selling of stocks that were manipulated by brokerages connected to the Russians and the Genovese organized crime family.
One of these sources – a man who worked closely with Chalem – says that he tried to tell Weiss the true story, but Weiss refused to listen to anybody who would pin the murders on the Russian Mob or accuse Chalem of naked short selling. Instead, Weiss wrote a false story describing Chalem as a “stock promoter” and suggesting that he had been killed by people tied to the Gambino crime family, which was then a fierce rival of the Genovese and the Russians.
On another occasion, the current principals of Kingsford Capital sent Weiss a fax containing false negative information about a company called Hemispherx Biopharma. Another source, who was sitting in Weiss’s office at the time, says that he tried to tell the reporter that Kingsford was working with Asensio, that Asensio might have ties to the Mob, and that Asensio was naked short selling Hemispherx stock. Weiss ignored this information and wrote a negative story about Hemispherx. Hemispherx’s stock promptly plummeted by more than 50%.
Remember, Gary Weiss is the Portfolio magazine reporter who just who just told Portfolio magazine that only “conspiracy theorists” believe that abusive short selling is a problem.
* * * * * * * *
It is too much for me to believe that Kingsford Capital’s managers (along with Gary Weiss and Asensio?) could be influencing the Columbia Journalism Review’s stories, but I do know that the magazine is now an ardent defender of short sellers and has written favorably about several of the dishonest journalists – including Gary Weiss –who were to appear in my story.
And, in its recent piece about Matsumoto’s Bloomberg bombshell, the Columbia Journalism Review cast doubt on the theory that naked short selling wiped out Lehman – never mind those 30 million shares that didn’t get delivered.
The Columbia Journalism Review reporter, who receives a salary thanks to the beneficence of Kingsford Capital, wrote this:
“Now, I don’t have a dog in the naked-shorts fight. I can’t tell you if this is being done illegally on a large-scale and having a real impact on companies. I just don’t know.”
“But one of the first things that comes to mind here is—wouldn’t you expect fails-to-deliver to soar for a company teetering on the brink of bankruptcy under an avalanche of bad news? I’d expect there would be a rush to short a stock like Lehman, which was about to collapse anyway. So, people who usually could expect to borrow shares to short might have found that they couldn’t because everybody else was doing the same thing.”
In other words, people who “could expect to borrow shares,” but “found that they couldn’t” went ahead anyway and sold 30 million shares that did not exist. This was a gross violation of securities regulations that require traders to have “affirmative determination” that a stock can, in fact, be borrowed. Assuming the intent was to manipulate the stock, it is a jailable offense.
It is true that by mid-September of last year, Lehman was on the brink of bankruptcy. Partners backed out of deals and there was a run on the bank. But people got nervous and pulled their money only because hedge funds bombarded Lehman with rumors (which are currently the subjects of a federal investigation) while simultaneously naked shorting the stock to single digits.
In July of 2008, the SEC issued an emergency order designed to prevent just this eventuality. For a few weeks, the order stopped naked short selling of Lehman Brothers and 18 other big financial companies. At this time, Lehman was not on the brink of bankruptcy.
But in early August, the SEC lifted its order and Lehman immediately came under a massive naked short selling attack. On the day the SEC lifted the order, Lehman’s stock was trading at around $20. A few weeks later, the stock was worth around $3 – a fall of 85%.
Only after this precipitous fall did Lehman’s partners begin pulling their money, making bankruptcy inevitable.
But, apparently the Columbia Journalism Review believes that it is perfectly natural for a stock to fall 85%, even though no new information (aside from unsubstantiated rumors) had entered the marketplace. According to the Columbia Journalism Review (which has, no doubt, plowed Kingsford Capital’s money into a thorough investigation of this issue), it is perfectly natural that people who “found they couldn’t” borrow stock nonetheless proceeded to flood the market with 30 million phantom shares.
The truth is, that 30 million share “mechanical error” helped bring this nation to its knees.
That’s one reason why I do have a dog in this fight.
* * * * * * * *
This is the first anniversary of the destruction of Bear Stearns.
For a while there, just after it happened, everybody was talking about the role of short selling, both legal and illegal, in Bear’s rather violent passing.
Since then, the big question has gone from “who the hell set this fire?” to “how did this place devolve into such a firetrap, anyway?” and “how the hell do we get out of this burning building?”
Finding answers to all three questions is vitally important. Yet, I’m a little bothered by the fact that these days, so little attention is being focused on the first.
And so, exactly one year after criminal arsonists set a match to the over-leveraged heap of oily rags that was Bear Stearns, I offer up this video examination of that event, and those that would follow.
While I hope you will all enjoy and help circulate it, I should point out that this video was not primarily made for the frequent readers of DeepCapture.com (as everything in it has already been examined in these pages). Instead, it’s for those who’ve yet to understand why they should be outraged at what’s going on.
In other words, it’s primarily for future readers of DeepCapture.com.
Yet, I need you regulars to take a look, and then help get this out there. Plus, the music is pretty cool, so it’ll be worth your time to watch anyway.
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.
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.
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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.