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Keys to Market Recovery
KEYS TO MARKET RECOVERY
Deliver the Fails – Stop Naked Shorting

By Wayne Jett
© October 8, 2008

    Amidst the global meltdown in corporate equity share prices, one stock in Europe excels. In fact, it soars. As reported by Bloomberg News on October 7, Volkswagen AG is Europe’s largest automaker and best performing stock in 2008, up 190 per cent this year. Seemingly a miracle at first glance, VW rose 55 per cent Tuesday while market averages globally dropped sharply.
    As Bloomberg explains, VW’s historic move higher October 7 was fueled by bankruptcy of U. S. investment bank Lehman Bros. Until its recent bankruptcy, Lehman was a leading prime broker collecting high fees for delivery of borrowed VW shares sold short by Lehman’s hedge fund clients.
    VW was one of the most shorted stocks in Europe, so the squeeze of short positions is understandable in that context. Yet many other stocks are heavily shorted, too. Why have they not benefited by Lehman’s demise as VW apparently has?
Volkswagen Phenomenon Explained
    Bloomberg’s Alexis Xydias explains VW’s stock movement as follows:

Banks that lent Volkswagen's stock to Lehman for use in short sales by their clients probably recalled their loans when the brokerage collapsed on Sept. 15, according to the three people who declined to be identified because the transactions aren't public. In order to keep their client accounts balanced in the meantime, the lenders were likely forced to buy the shares in the open market, the people said.” (Emphasis added.)

This explanation must be parsed carefully to understand its implications.
    Banks are custodians of many stock portfolios of institutional investors. Under their custodial agreements, the banks may lend shares for use by short sellers, subject to certain reserved rights. One such right is that the loaned shares may be called back at any time for any reason (upon the owner’s sale of the shares, or just because the owner doesn’t want to lend them any longer). If the loaned shares are not promptly returned, the bank has the right to buy the shares in the open market and charge the account of the borrower of the shares.
    That is what is being reported here. Banks which loaned shares to Lehman and its clients for short selling are buying in the shares that have not been returned. Lehman and its short-selling clients are being charged for the expense. Short sellers have not covered their positions, but they are being bought in by banks which loaned them shares to sell short.
    To their credit, the lending banks are returning loaned shares to their clients’ portfolios. However, the cost of shares may become a claim against Lehman’s bankruptcy estate. Whether such claims are adequately secured by collateral is unclear, although banks are reluctant to spend their own funds for such buy-ins.
Broader Scenario: Undelivered Shares
    This is not about just VW, Lehman or bank custodians. This apparently extreme scenario actually depicts conditions affecting markets broadly. Share prices are sharply dislocated from underlying corporate values by trading practices and complex derivative instruments. The dislocation is perpetrated by short sellers with important assistance from the SEC and Wall Street’s allied self-regulating-organizations.
    Since 2004 and before, the SEC has permitted investment banks and hedge funds to sell short and fail-to-deliver (FTD) the shares to buyers. In 2005, with Regulation SHO, the SEC “grandfathered” all existing FTDs, meaning tens of millions of shares sold short could remain undelivered indefinitely. Reg. SHO itself was riddled with provisions enabling new FTDs to be created. Only last month, effective September 18, the SEC after long delay slightly tightened delivery requirements. But short sellers and their prime brokers still find plenty of wiggle-room to move FTDs among accounts so as to avoid delivering shares to buyers who have paid for them.
    Explaining its dilatory conduct, the SEC considers only the interests of Wall Street’s traders – never the interests of millions of investors whose accounts contain only “entitlements” to shares for which they paid in full. A year ago, SEC’s director of market regulation Eric Sirri conceded to a New York audience that investors would be “surprised” to learn their accounts really do not hold shares.
Ending Dislocation of Share Prices
    Severe dislocation of share prices from underlying value of corporations is caused by FTDs that dilute the share float. Extra (counterfeit) shares mean lower share prices, and unreasonably low share prices deprive businesses of new capital without dilution. Allowed to persist, lawless trading conditions destroy companies or drive them from the public markets. The most current consolidated balance sheet released by Securities Industry and Financial Markets Association (SIFMA) shows its member firms were exposed to risks of undelivered shares valued at $258 billion as of March 31, 2008.
    This is the cause of destruction in recent months of the private mortgage sector, the investment banking sector and significant firms in the banking sector, not to mention many other companies in all sectors. The SEC must require sold-but-undelivered shares to be delivered without further delay.
    By its actions to date, the SEC has chosen short sellers, particularly naked short sellers, to be winners in the markets by permitting extraordinary capabilities to sell shares without delivering them. SEC has justified its actions as necessary to prevent short sellers here from suffering the fates of those who sold VW short.
    By statute, the SEC is supposed to protect interests of average investors. SEC has failed in that duty by permitting hedge funds and others to fail in delivering shares sold short. If U. S. financial markets are to recover, and the credit seizure is to be relieved, the SEC (or Congress) must require all sold but undelivered shares to be delivered without further delay. ~