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.
Posted in 4) The Crime: "Naked Shorts" & Other Insincere IOUs |
February 11th, 2008 at 7:29 am
i am behind you on your quest to suceed in exposing and punishing all those in the defrauld of the capital markets for personal gain through coruption. This has been demise of may companies and hard working individuals with no legal support from the SEC and Federal regulatory bodys but talk with no action. Keep up your persuit and you will win with the help of the states and congress to force the exposure of all.
February 11th, 2008 at 1:01 pm
Is it really impossible for me to demand that when I buy shares of XYZ through my broker, I can not demand delivery of real shares? If they don’t provide real shares, can I not rescind the transaction and get my purchase money refunded? Isn’t that a fundamental tenet of contracts? After all, I provided my money in good faith, which was delivered to the seller. If I don’t get what was agreed to, I should be able to get my money back.
February 11th, 2008 at 5:06 pm
Fred
We do not know if we have real shares to make that request for money. We, as shareholders, buy company stock with expectations that that stock will rise. So if these crooks can get away with razing a company that you bought nobody would be none the wiser. On the other hand if the company, by some chance, survives would you really want just the initial money you invested repayed? You did take a bigger chance than you thought you were taking. Will you sit back when a broker says to you “oops you really didn’t own this company worth $100 here are your $2 back. What do we do at that point? What rate should you be compensated and who will pay? My guess is taxpayers.
To sum it up:
The community doesn’t get products and services.
The community pays more taxes.
The Shareholder may or may not get compensation.
And the clown-asses are clogging up our highways with Ferraris
Bob
February 11th, 2008 at 6:34 pm
Fred Dashiell
Yes, you can demand your certificates of your broker, and they should deliver them, for a modest fee in 2 - 5 weeks. Your IRA and 401K shares are SUPPOSED to held by your custodial account manager. Finding custodial account managers that will hold the true certificate is very difficult and expensive, most to do want to manage a vault. Most demand $2000+/year for those services.
For your non-retirement accounts brokers will warn you, you could have difficulty getting the certificates back to the your broker after you have sold them, or you could misplace or loose them, causing you to have to get them replaced and probably not within your allowed 3 day settlement delivery requirement. You need a safe place to keep the certificates if you take possession of them. You also need a way others could handle those certificates if the owner becomes incapacitated or deceased.
What the brokerage sold you was a share held in promise to you, but actually listed in the street name CEDE. Until you get the certificates in your name CEDE actually votes those shares, using your votes as the promised owner. If the stock is shorted, or naked shorted beyond the total float, then there will be more shares voted than true shares and all the votes from each brokerage are proportioned across their true holdings.
February 12th, 2008 at 11:36 am
You make it sound like alll we need to do to combat the fail-to-deliver problem is to demand certificates. I don’t think it’s quite that simple.
February 12th, 2008 at 6:49 pm
I had almost all of my IRA money invested in two companies that were both attacked and may yet end up destroyed by naked shorting AND by corruption in the FDA and at the least, favoritism in the DOD. The two companies were Dendrion and Force Protection. I put most of my money into them because they both had extremely promising products, and I totally believed no government agancy could be unfair to either of them and get away with it. I was also completely unaware of how hedge funds could ruin a small company by naked shorting. I’m close to retirement age and my IRA lost 3/4 of it’s value because my elected representatives let these things happen. They who let corruption run rampant in the financial field and even within federal government agencies are just as much to blame as the manipulators and big-spending lobbyists.
I hope any young investors reading this will never make the mistakes I did. Don’t let anyone convince you that the stock market is not manipulated, and don’t ever trust a federal agency to fairly award a contract or decide if a drug is to be approved.
February 13th, 2008 at 7:06 am
P,
What a tragic story. Yes, I am familiar with both of them. I am doing my best. Both of them provide pretty good examples of how this works.
Spread the word about this blog with some links, if you want to help.
Patrick
February 14th, 2008 at 8:35 am
Here’s a great bit from CNBC this morning 2.14.08.
I know how you must adore Mr. Greenberg ~lol~ Watch him squirm in his seat during this interaction……
MBIA vs Shortsellers
Bond insurer MBIA urges lawmakers to curb short-sellers, with Herb Greenberg, MarketWatch senior columnist & CNBC’s Charlie Gasparino
http://www.cnbc.com/id/15840232?video=651897890&play=1
or try this
http://www.cnbc.com/id/15840232?video=651897890
February 18th, 2008 at 9:59 am
Fred, you can no longer get your certificate. How convenient. The link is from the DTCC itself. Notice the big smiles on these basties faces. Traitors!!
http://www.dtcc.com/news/newsletters/dtcc/2006/sep/certificates_get_big_push.php
http://search.dtcc.com/search/?sp_q=certificates&x=0&y=0&sp_a=sp1003a122&sp_p=all&sp_f=ISO-8859-1
You rock Patrick
March 7th, 2008 at 1:49 pm
So a company stock gets artificially devalued, so what? As I understand that, the company has already made its money by putting the stocks in the market. Its operations do not change. Unless it tries to issue treasury stock, the company is not harmed. I can see victims in existing stockholders whose shares lose value. What am I missing?
March 7th, 2008 at 6:11 pm
Dear Help Me,
1) Comapnies don’t “make money” by issuing stock. They raise capital.
2) The shareholders are harmed by having their shares manipulated downwards. Both shareholders and the firms are harmed by being unable to issue stock at the true market price. For example, Force Protection makes MRAPs for soliders and Marines in Iraq. $200 million in revenue, $18 million GAAP net income. They could not keep up with orders, and announced a secondary to raise capital to expand their factory to build more MRAPs. Immediately they went on the Reg SHO list as they were naked shorted from $25 to $5. They cancelled their offering, so they did not raise capital, so they did not expand their factory, so they cannot produce as many vehicles, so some soldiers will die in Iraq this month. Now imagine this happening over and over again at companies that are researching blood replacements, anti-cancer medicines, transdermal delivery systems for long-chain proteins, etc. (That is, imagine a world where diabetics don’t need needles.)
Understand the damage done to firms, shareholders, and society?
Patrick
March 10th, 2008 at 10:46 am
Patrick,
You represent a ray of hope for many of us who are experiencing the effects of naked short selling. I am an investor in BIDZ.com (NASDAQ) which has been reporting good performance, but whose stock has been clobbered by naked shorts.
If there is any way I can help the fight, let me know.
March 19th, 2008 at 1:22 am
Patrick,
I’ve just recently started to try and get a grasp on economics in general, silver in particular. I hope I’m not too late to protect my family from the coming collapse. Do you subscribe to the theory of a coming economic collapse on par with the Great Depression? Sorry I know it may be a bit off topic but I feel the practices of Wall Street and the Fed are leading the common man straight down the toilet. I’m with the guy that said you should post on YouTube because I’ve seen some real quacks on the internet. You have credibility. People might listen. Thank you for putting this out there in the face of reprecussions.
March 24th, 2008 at 1:32 pm
Patrick, Is it possible to just take our shares out in the form of certificates? Would that combat naked shorting? From what I understand, if you take your shares out, the certificates are basically a way to show that your shares are valid. Is that correct or incorrect? If that’s not true, then how to we combat FTDs or how do we combat these guys who are trying to scam us? If we can’t do that then I don’t see the point of investing and we might as well pull all our money out of investments. Thanks for the help,
JT
April 10th, 2008 at 4:58 pm
I think a lot of people don’t realize that market prices are determined by supply and demand of the shares being trading AT the market. Stock prices are determined solely to fill orders, and not reflect the value of the total and much larger sum of outstanding shares owned by long term investors. Thus, the market values of securities are not judged by the people who hold their positions but rather the people move their positions. So Patrick, I can see why a high volume of IOU’s could be detrimental to stock prices.
May 2nd, 2008 at 7:47 pm
Very interesting article. Opened my eyes about the potential abuses of short selling.
However, I think it ignores the benefits of short-selling. If a company is bad, i.e. the management corrupt or just completely incompetent, short selling can keep money from being wasted in that venture, and instead directed to better companies.
Also, its important to consider the potential abuses of big players who pump up cos by simply buying lots of stock. They can prop up corrupt and useless companies, sucking away precious capital from better companies, and eventually hurt naive shareholders once they “dump” the stock.
Seems like the real problem is that big players are not sufficiently regulated. They should be prevented from either buying or shorting too large a percentage of any particular company.
May 15th, 2008 at 2:17 am
As an investment advisor for many years I have witnessed first hand the type of naked short selling you refer to Patrick, and it is getting much worse lately.
As a response to “Joe” let me also say that legititmate short selling serves many useful functions in the market. It prevents abuses by potential “pumpers” and adds liquidity to the market.
Naked shorting however is another matter completely since the shorted shares are NEVER covered. Therin lies the crime and it needs to stop NOW.
Keep up the great work Patrick!!
June 5th, 2008 at 10:18 am
They cannot stop these IOU’s now that they have been used so much. If they do, trillions or more will be lost due to this fraud. It is cheaper to let it continue than face collapse of the system.
June 9th, 2008 at 6:00 am
Corporate synthetic CDOs may be next woe for investors
SIFMA Global SmartBrief | 06/09/2008
While investors are seeing the downside of synthetic collaterlized debt obligations linked to the fate of US homeowners, more trouble may be coming in similar investments tied to companies. Analysts are warning that corporate synthetic CDOs are on shaky ground as the economy cools. Additionally, credit-ratings agencies are taking a closer look at the synthetic CDO ratings, which may result in downgrades and trigger discounted sales.
Warren Buffett once described derivatives bought speculatively as “financial weapons of mass destruction.” In his Berkshire Hathaway annual report to shareholders he said “Unless derivatives contracts are collateralized or guaranteed, their ultimate value depends on the creditworthiness of the counterparties. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).” A typical CDO is for five years term.
http://www.marketoracle.co.uk/Article4984.html
Fitch Places Landgrove Synthetic CDO 2007-2 Class C1 Notes on Rating Watch Negative
NEW YORK–(BUSINESS WIRE)–Fitch Ratings has placed the following class of notes from Landgrove Synthetic CDO on Rating Watch Negative:
Landgrove Synthetic CDO
–CLP4,200,000,000 series 2007-2 notes due 2017, rated ‘A-’; Rating Watch Negative.
http://www.businesswire.com/portal/site/google/?ndmViewId=news_view&newsId=20080522006159&newsLang=en
LONDON (Standard & Poor’s) May 29, 2008-Standard & Poor’s Ratings Services said today that it has taken credit rating actions on 153 European synthetic collateralized debt obligation (CDO) tranches (see list below).
Specifically, the ratings on:
- 122 tranches were removed from CreditWatch with negative implications and lowered;
- One tranche was lowered;
- One tranche was lowered and placed on CreditWatch negative;
- 28 tranches were lowered and remain on CreditWatch negative;
- One tranche was raised.
The interesting part, though, is that while 39 of the tranches downgraded reference US RMBS, 113 are linked to corporates. Downgrades on corporate CDOs have been rare before now. Moody’s reported in March than just 10 tranches of synthetic corporate CDOs were downgraded in 2007, compared to 1,572 structured finance - MBS and ABS - CDOs.
http://ftalphaville.ft.com/blog/2008/05/30/13452/cdo-contagion/