Matt Taibbi is apparently back on the finance beat with a story on the collapse of Bear Stearns and Lehman that goes "deep into the weeds" of naked shorting. It's not clear to me why, since the only academic paper I'm aware of that actually studied the question found that the volume of shorts and naked shorts intensified after the bad news that caused the stock to plummet, not before, and at any rate, was never done in a large enough volume to cause price declines of the magnitude that we saw.
Taibbi seems to be more worried about the moral offensiveness of the practice than its actual impact:
The real significance of the naked short-selling issue isn't so much the actual volume of the behavior, i.e. the concrete effect it has on the market and on individual companies -- and that has been significant, don't get me wrong -- but the fact that the practice is absurdly widespread and takes place right under the noses of the regulators, and really nothing is ever done about it.
It's the conspicuousness of the crime that is the issue here, and the degree to which the SEC and the other financial regulators have proven themselves completely incapable of addressing the issue seriously, constantly giving in to the demands of the major banks to pare back (or shelf altogether) planned regulatory actions. There probably isn't a better example of "regulatory capture," i.e. the phenomenon of regulators being captives of the industry they ostensibly regulate, than this issue.
There are much better examples of regulatory capture, even in the financial industry, such as the SEC's ban on shorting financial stocks last summer . . . but that is neither here nor there. Naked shorting has benefits as well as drawbacks--it enhances the efficiency of the market in price discovery, as well as its liquidity. It is often done by exchange market makers who fill orders on the fly, and then hunt down the actual stock later, in order to keep orders flowing. It is also, of course, hated by CEOs, who like to blame evil short sellers, rather than their own mismanagement, for driving down the stock price.
In theory, a "bear raid"--selling a flurry of shares in order to push the stock price into a downward spiral--is possible. In practice, counterattacks are possible, making this a very risky strategy for shorts who can end up bankrupt if they can't find shares to buy at a reasonable price. It's also difficult, with a large and liquid stock, to sell enough volume to permanently depress the price; your counterparties start wondering where you're getting all this stock to sell. That's why, while there's pretty decent evidence that shorts, and naked shorts, can speed the mean-reversion of overpriced stocks, there's a lot less evidence--virtually none--that it can cause stocks to become underpriced for any length of time.
Even if there were evidence for successful bear raids, Lehman's creditors had ample reason to worry without a decline in the stock price. By the time the volume spiked, Lehman's fate was already sealed; either they were going to find a buyer, they were going to get a bailout, or they were going to bankruptcy court.
So why should this be priority #1, or even #30, for the SEC? Obviously, CEOs do not like any practice that speeds up negative price discovery in their stock, but this is not supposed to be the SEC's concern. There's legitimate reason to punish people for failing to deliver--after all, they're in breach of contract. But this is a problem for the contractees, or the exchange, not the SEC.
Update: Someone in the comments asks if I'm not conflating regular shorting and naked shorting. Answer: no; the paper I linked deals specifically with naked shorts, and finds that at least since the introduction of Regulation SHO in 2005, they have functioned primarily as a liquidity enhancer and a price discovery mechanism, rather than a market manipulation mechanism.
Our results are in sharp contrast with the extremely negative pre-conceptions that appear
to exist among media commentators and market regulators in relation to naked short-selling. While unregulated naked short-selling could be potentially manipulative, and the associated settlement failures could be somewhat disruptive to the smooth functioning of financial markets, the duly regulated naked short-selling that has existed after Regulation SHO appears to havebeen net beneficial for pricing efficiency and market liquidity, and Regulation SHO also appears to have successfully curbed the impact of manipulative naked shorting, and this reduction in the impact of manipulative naked shorting has continued through the 2008 financial crisis.
Here is an article about it
Rolling Stone Explains Role of Naked Short Selling in Financial Crisis
New York City, NY
Former DTCC operations manager Susanne Trimbath is interviewed by Matt Taibbi for his latest article in Rolling Stone. She blows the whistle on the world’s largest central depository by revealing that she warned them 15 years ago of an impending financial crisis.
Rolling Stone’s own Matt Taibbi interviewed industry expert Susanne Trimbath, Chief Economist at STP Advisory Services, LLC in Omaha, for his latest article in the magazine explaining “how we got into this financial crisis.” Taibbi’s latest piece looks at the history of the Bear Stearns and Lehman Brothers failures. His controversial article earlier this year, "Inside the Great American Bubble" on the undue influence of Goldman Sachs in contributing to and benefitting from the recent economic collapse and the subsequent bailout gained significant attention from media, investors, shareholders and companies.
In his new article, Trimbath tells Taibbi the story of how, in 1993, she tried to get senior management at the world’s largest central depository (Depository Trust Company) to stop allowing shares of stock in US companies to be multiplied through stock lending and excessive short selling. “You can’t balance the world,” was the response she got from regulators. She contends this is because "Wall Street is self-regulated and they don’t want to write regulations against themselves." By 2003, the size of the problem had increased ten-fold; by 2008 it contributed to the collapse of major financial institutions and the global financial crisis. Trimbath goes into more detail about this, and the impact of naked short selling and failed trades on shareholders in the recently released Hollywood movie, “Stock Shock: The Short Selling of the American Dream.”
Susanne Trimbath holds the Ph.D. degree in economics from New York University. She is an expert on post-trade securities operations and is featured in several films about Wall Street. She frequently acts as an expert witness in securities litigation. Trimbath is a former mid-level operations manager at Depository Trust Company (now a subsidiary of Depository Trust and Clearing Corporation in New York). Matt Taibbi, who is best known for his articles and books on politics, turned to writing and blogging on finance after the 2008 Presidential election. His new expose will be featured in the upcoming issue of Rolling Stone magazine due out in early October.
Susanne Trimbath can be reached through www.stpadvisors.com .
From: Dan Heilman
Sent: Thursday, September 14, 2006
To: rule-comments@sec.gov
Subject: File No. S7-12-06
To Whom It May Concern,
It is totally obvious to the world that Naked Short Selling, Counterfeit Shares, is nothing but a scam on the investing public, and Regulation SHO is toothless. Please put some teeth in Regulation SHO, before the whole Market collapses. Please read the letter below that the illustrious Robert J. Shapiro has to say on the matter, you need to take his suggestions.
Rule Number S7-120-06: Comments on Proposed Amendments to Regulation SHO
Robert J. Shapiro
September 14, 2006
I am Robert J. Shapiro, chairman of Sonecon, LLC, an economic analysis and advisory firm in Washington, D.C. From 1998 to 2001, I was Under Secretary of Commerce for Economic Affairs. Prior to that, I was Vice President and co-founder of the Progressive Policy Institute and Vice President of the Progressive Foundation, and continue to be a Senior Fellow of the Progressive Policy Institute. I also served as principal economic advisor to Governor William J. Clinton in his 1991-1992 presidential campaign, senior economic advisor to Vice President Albert Gore, Jr. in his presidential campaign, Legislative Director and Economic Counsel for Senator Daniel Patrick Moynihan, and Associate Editor of U.S. News & World Report. I have been a fellow of Harvard University, the National Bureau of Economic Research, and the Brookings Institution. I hold a Ph.D. and M.A. from Harvard University, a M.Sc. from the London School of Economics and Political Science, and an A.B. from the University of Chicago.
I currently advise the law firms of O'Quinn, Laminack and Pirtle and Christian, Smith and Jewell on economic issues related to failures to deliver, including matters raised in the proposed amendments to Regulation SHO. The views expressed here are my own and do not necessarily represent the views of any person or firm that I advise.
In these comments, I will provide new data and analysis supporting the Security Exchange Commission's (SEC or "Commission") judgment that Regulation SHO has failed to substantially resolve the problem of large-scale, strategic failures-to-deliver ("fails"). As the Commission notes, these fails affect significant numbers of stocks and, in many cases, harm their markets. I will urge the Commission, first, to create and enforce total transparency on this matter for both investors and corporate managements by directing the Depository Trust and Clearing Corporation (DTCC) to release historical data on large-scale fails in individual stocks, so that independent analysts at the SEC and elsewhere can analyze and assess the extent to which these fails have damaged particular public companies. To ensure the efficient operations of financial markets in the future and relieve the DTCC's serious conflict of interest in this area, I will urge the Commission to direct the DTCC in the future to release data on large-scale fails in individual stocks on a daily basis, as the exchanges do today with respect to the trading volume and short sales in individual stocks.
I also will urge the Commission, as it has proposed, to promptly phase-out the current grandfather provisions of Regulation SHO, which enable investors or broker-dealers to maintain large-scale fails in individual stocks for extended periods, potentially damaging the market for those stocks. These fails reduce the efficiency of U.S. financial markets, in many cases seriously damage individual stocks and, in some such cases, provide a means for stock manipulation and other criminal activities which have been widely documented. Large-scale, extended fails represent a threat to the basic integrity of our markets and consequently warrant careful and decisive regulation.
I strongly urge the Commission to re-establish the basic principle that, just as one cannot sell long what ones does not own, one cannot sell short what one does not borrow. Under this principle, the Commission should require short sellers to actually borrow shares before selling them short, or at a minimum to affirmatively locate them before selling them short, in all instances and not merely those in which the stock already carries substantial, extended fails meriting "threshold security" status. The Commission also should eliminate the existing perverse economic incentives for short sellers to fail to deliver: In cases in which a seller receives payment for shares that have not been delivered, the short seller should be liable for a charge that at least equals the borrowing costs avoided by his failing to borrow and deliver the shares; and in cases of large-scale, extended fails, the charge should reflect the profits earned by the naked short sale. These new requirements would not affect those who document that their delay in delivering shares arose from paperwork or other innocent administrative problems or from legitimate market making activities.
With the increasingly significant role of short sales in U.S. equity markets, effective measures to ensure the integrity of short sales has become a matter of genuine urgency. I recently analyzed data covering trading on the New York Stock Exchange from February 1, 2006 to July 31, 2006 and found that more than one in every four shares traded every day are sold short. The data show:
Short sales account for 25.5 percent of all NYSE shares traded on a daily basis, or an average of 297 million shares per day out of an average of 1,163 million total shares traded every day.
The lower a company's share price, the greater the proportion of short sales in all trading in its shares: Among NYSE companies selling for $20 or less per share, short sales account for about 28 percent of all shares traded, compared to about 24 percent of all shares traded in companies selling for $40 or more per share.
The lower a company's market capitalization, the greater the proportion of short sales in trading in its shares: Among NYSE stocks with market caps of $2 billion or less, short sales account for nearly 28 percent of shares traded, compared to less than 24 percent of shares traded in stocks with market caps of more than $10 billion.
The complete analysis and database are available for the Commission's review on request.
I also will strongly urge the Commission to not only eliminate the two grandfather provisions in Regulation SHO, but also appreciably shorten the periods in which large-scale extended fails are tolerated before being subject to mandatory buy-ins. The proposed, additional grace period of 35 days for failures currently grandfathered creates a special tolerance for extended fails established in the past. It has no economic justification, especially as the final regulation will be issued weeks or months before its date of implementation. I will recommend that currently grandfathered fails be subject to mandatory buy-in five days after implementation of the amendment. I will also urge the Commission to shorten the grace period before mandatory buy-ins for non-grandfathered fails in threshold securities, a total of T+11, to reduce the likelihood of large-scale fails doing serious damage to the market for stocks so affected. Additional time could be provided for investors who can document that a delay in delivering shares arose from normal paperwork problems or legitimate market making operations. I also will urge the Commission to consider applying mandatory buy-ins to cases of failed deliveries whether or not they occur on the scale required for a stock to be designated a threshold security. This approach is used in Germany, Austria and Singapore, and the Commission could apply it initially in a pilot program limited, for example, to stocks designated as threshold securities in the previous year. .
Finally, I will urge the Commission to investigate the extent to which substantial and persistent fails to deliver may occur outside the DTCC's normal clearance and settlement system, through "ex clearing" arrangements between private financial institutions. The potential harm to the efficiency of the markets and to individual stocks of large-scale, extended fails should be the same, whether they are transacted through the normal DTCC clearance process or through ex clearing arrangements. The critical difference is that fails occurring through ex clearing may elude the requirements of Regulation SHO, both in its current form and under the proposed amendments. Should the Commission's investigation establish substantial activity in fails and naked short sales through ex clearing arrangements, I strongly recommend additional regulation to ensure that all transactions are subject to the same scrutiny and investor protections.
Before addressing each of these matters in more detail, I want to commend the Commission for its clear recognition and cogent analysis of the inadequacies of Regulation SHO in resolving the problem of large-scale, extended failures-to-deliver. I also have analyzed the effectiveness of Regulation SHO and found similarly disturbing results. I examined the threshold security lists issued by the New York Stock Exchange (NYSE) and NASDAQ-NM over the period January 7, 2005 to April 3, 2006. The analysis of the companies listed over that period found:
Regulation SHO has not prevented brokers from continuing to transact sales without delivery in the stocks of large numbers of companies. Over the 15-month period, a total of 500 NYSE companies and 516 NASDAQ-NM companies were designated threshold securities.
Over the 15-month period, Regulation SHO also has not prevented brokers from failing to deliver large number of shares in the same company on multiple occasions: 175 of the 500 NYSE threshold securities, or 35 percent, were listed as threshold stocks multiple times, as were 224 of 516 NASDAQ-NM threshold securities, or 43.4 percent.
Regulation SHO's buy-in requirements failed to resolve the extended fails in 25 percent to almost 30 percent of all threshold securities: 147 of the 500 NYSE threshold securities or 29.4 percent remained on the list for more than 18 days (the 13-day cut-off, plus five days following), as did 130 of 516 NASDAQ-NM threshold securities, or 25.2 percent.
Regulation SHO does not prevent large-scale fails in a particular stock from persisting for very extended periods:
Over the 15 months examined here, 66 of 500 NYSE threshold securities, or 13.2 percent, were listed for at least 30 consecutive trading days (6 weeks); 36 were listed for at least 40 consecutive trading days (8 weeks) ; and 16 were listed for at least 60 consecutive trading days (12 weeks).
Of the 516 NASDAQ-NM threshold securities examined here, 80 or 15.5 percent, were listed for at least 30 consecutive trading days; 54 were listed for at least 40 consecutive trading days, and 32 were listed for at least 60 consecutive trading days.
The complete analysis and database are available for the Commission's review on request.
These findings reinforce data reported by the Commission in the narrative accompanying the proposed amendments, documenting the failure of Regulation SHO to drastically reduce the aggregate number of fails, the average age or duration of those fails, the number of stocks with large-scale, extended fails, and the average number and duration of those large-scale, extended fails. The SEC analysis found that in the 17 months following implementation of Regulation SHO (January 1, 2005 to May 31, 2006), compared to the eight months preceding its implementation (April 1, 2004 to December 31, 2004),
The average number of securities with at least 10,000 fails declined by only 6.5 percent, while the number of those securities with fails also exceeding 0.5 percent of their outstanding shares declined by 38.2 percent;
The average total number of fails for all companies with at least 10,000 fails declined by only 15.3 percent;
The average duration of a fail position declined by only 13.4 percent.
A close examination of the SEC data behind these findings reveals that the most recent results are even more disturbing. While the average monthly number of threshold securities was 38.2 percent lower for January 2005 through May 2006, compared to April 2004 to December 2004, the SEC monthly data provided in the analysis (Memorandum from the Office of Economic Analysis, August 21, 2006, Table 2) show that the entire decline occurred from June 2005 to January 2006. Since February 2006, the average monthly number of threshold securities has increased significantly and now matches the numbers meeting the criteria in the pre-Regulation SHO period.
In addition, roughly one-third of the modest, 15.3 percent improvement in the average daily number of fails for securities with at least 10,000 fails reflects the 6.5 percent decline in the number of securities meeting that criterion, not the decline in average fails per-security. Furthermore, DTCC data for January 2004 through March 2006 released under the Freedom of Information Act show that the decline in the total number of fails for securities with at least 10,000 total fails occurred entirely from January 2005 to November 2005. Since that time, the total number of these fails has risen sharply again.
While month-to-month data on the average duration of fails for securities with at least 10,000 fails are not provided, data on the average duration of fails for threshold securities are provided. These data also show that the average duration of fails in threshold securities has shown no improvement from January 2005 to May 2006.
The most encouraging data reported by the Commission staff purports to show that among threshold securities, average daily fails declined by 52.4 percent. Once again, however, this result came from comparing average monthly data for the entire period January 2005 to May 2006, with data for April 2004 to December 2004. The Commission has released data showing that since December 2005, the average monthly fails for all companies with at least 10,000 fails rose sharply. The SEC now should provide a month-by-month breakdown - or better yet, a daily breakdown - of fails for threshold securities, so one can determine whether the number of average fails per threshold security has risen or fallen in recent months, as the average monthly number of threshold securities and the average monthly number of fails for companies with 10,000 fails have both increased.
Finally, without data showing the distribution of those fails by company, month by month and day by day, we cannot say whether any decline in the total fails of the threshold securities represents a meaningful reduction in the incidence of the large-scale extended fails that can harm the market for individual stocks.
Thank You,
Dan Heilman
Golden, CO