Thursday, July 17, 2008

We Told You So: “Naked Shorting” Unveiled!

Street Gears Up for Short Changes
Brokerages Parse New Rules' Details; The 'Naked' No-No

The Federal crackdown on short selling is causing a scramble on Wall Street, with brokerage firms racing to implement new controls before the rules take effect on Monday.

The unprecedented get-tough action by the Securities and Exchange Commission means that securities firms will have to fine-tune their back-office operations to comply with the requirements.

The biggest potential headache: Existing rules allow brokers to sell stock short as long as they reasonably believe they can locate the shares and deliver them on time [emphasis added].

—The Wall Street Journal

Well, we told you so.

Thanks to the SEC’s move to restrict “naked short-selling” in a handful of financial stocks, we now know that the problem is not that hedge funds deliberately short stocks without properly borrowing them—the main charge of at least one CEO looking for a scapegoat to draw investor attention away from his own performance.

It resides with the brokers themselves.

Let's re-read that last sentence from the excerpt quoted above:

The biggest potential headache: Existing rules allow brokers to sell stock short as long as they reasonably believe they can locate the shares and deliver them on time.

Now, several years ago we here at NotMakingThisUp laid out how every hedge fund we’ve ever known goes about shorting a stock: they ask their broker for a "locate." If the broker says the shares are located, the hedge fund borrows the shares and shorts them. If shares can't be located, the hedge fund doesn't sell them.

No borrow, no short-sale.

We described the process in response to a bizarre earnings call in which the CEO of the company hosting the call pretended not to know one of the questioners. The CEO did this in order to allow the questioner to describe a supposedly vast conspiracy against the company on the part of hedge funds selling the company's stock without borrowing it.

For our efforts to set the record straight, we received a number of vituperative comments from fans of the CEO, nearly all overwhelmingly irrational, paranoid and ignorant of the facts of the case.

It was as if we had suggested that Area 51 was not the underground meeting place of government officials and extra-terrestrials, or a lab for time-travel experiments, or the headquarters of the One-World organization known as the Majestic Twelve, but merely a top-secret military base.

Thanks to the SEC's move to limit the so-called "naked no-no," however, we now know that the brokers themselves have been giving "locates" without always actually locating the stock.

Looks like we weren’t making it up after all.

Oh, and Area 51 really is just a top-secret military base. Sorry about that.

Jeff Matthews
I Am Not Making This Up

© 2008 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.


Bamass said...

The way I heard it explained on CNBC just now, there is a distinction, if an ever-so-slight one. Up until now, a "locate" was sufficient to green-light a short sale. Now, in the specified finanicals, the borrow transaction has to actually be executed, and the shares removed from the locate that everyone else sees, before a short sale can go through.

Then again, the guy explaining that went on to imply that cracking down on rumormongering was an easy task, so perhaps he didn't know what he's talking about as far as the borrows go either. But at least it would answer the question of "what's changed".

Its_strange said...

Cox doesn't like rumormongering ? Well why hasn't he stopped Saunders ? Or Patrick . Both put the rumormongering in writing

Tim said...

What?? No aliens or UFOs at Area 51????

Note: At one point in my life I flew by said area every day for 3 years.

Jeff Matthews said...


And what did you observe? Inquiring minds want to know!

I'm sure most of our readers will tell you Area 51 is a lot more interesting than naked short rules.


Mark said...

>>I'm sure most of our readers will tell you Area 51 is a lot more interesting than naked short rules.<<

Yes, we far prefer naked short aliens.

CurmudgeonlyTroll said...

Seems odd the industry always said naked shorting is a once in a blue moon technical error, but when Wall Street firms are involved it immediately gets banned.

Can't wait to hear what that well-known CEO has to say about this.

John Hempton said...

Babe - I can't find a borrow.


I have never managed to find a broker who will let me fail to deliver.

I used to work for a fund that was short more than a billion dollars worth of stock.

We still had to find a borrow.

I still need to find a borrow and sometimes it is agony.

I blog about the agony here...

Brokers might short liquid stocks without actually finding a borrow. But in that case there is no trouble getting the borrow before delivery.

But when it comes to things which are notoriosly hard to borrow my experience is that brokers - all that I have dealt with - simply will not allow you to short when they can't find stock. (I have known brokers refuse business because they can't find a borrow.)

BelowTheCrowd said...

Area 51 (more specifically, the airbase at Groom Lake) is mostly abandoned these days. Contaminated with radiation and other toxic junk from years of use. And probably obsolete for the purposes of today's top secret programs which are not stealth planes, but most likely involve suborbital space vehicles.

Some speculation has focused on potential launch sites near Green River Utah (the complex there has seen a definite increase in activity, ask any local resident) and the Michael AAF which is deep in the middle of the Dugway proving grounds in western Utah.

The alien bodies, I'm told, have been moved to one of the vaults at Fort Knox, which are empty since the government actually sold off its gold to pay for all this stuff.


Anonymous said...

Jeff: I think the new short-selling rules by the SEC are only meant to protect the financial interests of the "gang of 19", mainly broker-dealers excluding Fannie and Freddie, whose "stock in trade" (pun intended) is finding shares of stock to short. I wonder however what these new rules will do to the broker-dealer commissions when the potential profit of "locating" shares to short doesn't justify the cost of being wrong, of which I could be.

Len said...

The naked "aliens" in Roswell New Maxico are actually more interesting than naked short selling.

Actually, Roswell is a nice little town and the drive north on highway US 285 is a lovely way to get to Santa Fe.

Try to get your broker's back office to come up with this kind of evidence.