classical economics
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Naked Short Demons
NAKED SHORT DEMONS
By Wayne Jett
© August 19, 2008

    The emergency order issued July 15 by the Securities & Exchange Commission protecting 19 named banks from naked short selling of their shares in U. S. markets expired after four weeks at midnight August 12. The SEC stated the favored 19 banks had not been targeted by heavy naked short selling, but the risk of financial loss to the federal government if any one of the 19 collapsed due to naked shorting was too great to take the chance.
    On August 12, Bloomberg News reported the market capitalization of those 19 banks rose 26 per cent - $270 billion – during the four weeks of protection from naked short selling of their shares. Imagine how much more they might have benefited if their shares had actually been the targets of the naked short sellers. Now that would have been something!
View from the Bulls-eye
    That is the perspective of all other publicly traded companies in U. S. markets – and their shareholders – who would love to have it but did not enjoy protection by the SEC’s emergency order. Evidence is abundant that hundreds of stocks are targets of concerted naked short selling in U. S. markets every day. Those targeted stocks are traded on the New York Stock Exchange, NASDAQ and every other U. S. exchange.
    How much is naked short selling stealing from other investors in U. S. markets? Add 26 per cent to the DJIA and it would be near 15,000 rather than languishing near 11,650. Add 26 per cent to NASDAQ shares and that index would be above 3,000 again. When protecting 19 large financial firms increases capitalization by $270 billion, how much would capitalization be improved by extending legal protection against naked shorting to the entire market? Add 26 per cent to the capitalization of the S&P 500 alone and the rise is a staggering $2.9 trillion. That is the horrifying scale of the cost to investors of enduring a captured regulatory agency, rather than one which vigilantly enforces laws prohibiting fraudulent and manipulative practices.
    The loss of capitalization in the S&P 500 between its peak last October and its trough in July was less than 26 per cent. What portion of that loss was caused by naked short selling? Perhaps all of it. Maybe even more than all of it. The S&P 500 might have risen in the absence of naked short selling. We do not know. The SEC’s actions and statements demonstrate that the agency did nothing to interdict naked short selling of shares of companies in the S&P 500 during that period.
Follow the Money
    Naked short selling rampant in U. S. markets is not just about how high or low share prices are. It is about whether U. S. regulators provide a fair, level playing field for companies and investors. It is about who wins and who loses – who gets the money – from trading transactions in the stock markets. When naked short selling prevails, fraudulent bad guys get the money and honest investors lose it. In the process, good companies are starved of capital essential for their growth.
    Consider, for example, trading of shares in the 19 favored banks before the SEC’s emergency protective order became effective July 15. In light of what happened during the term of the order, before July 15 share prices must have declined by $270 billion more than they otherwise would have, as honest investors lost confidence and sold shares while naked short sellers drove the share price down.
    That trading activity puts illicit gains into the pockets and accounts of fraudulent people. Presumably the SEC emergency order took some of those people by surprise and they covered naked short positions as the share prices rose during the protective order. Others, however, may have retained their naked short positions based on confidence that the SEC order would eventually expire, as it has. Now they profit again as share prices of firms in the favored 19 are pounded anew in the nearly lawless environment of U. S. financial markets.
Better Act Now
    Naked short selling is stripping hundreds of billions of dollars from the portfolios of institutional and retail investors in U. S. financial markets. Yet most professional investors remain silent. They concentrate efforts on assuaging discomforts of their clients with assurances that the entire market is weak and their performance is beating the averages or nearly so.
    Oh, and they do one more thing. They avoid investing in companies that are identifiable (through the SEC’s Reg SHO “threshold list” and hard-to-borrow lists) as being targets of naked shorting, thus giving the predators even stronger hands to play in the markets.
    On Monday, August 18, Fannie Mae lost $1.88 billion (22.25%) of its market capitalization and Freddie Mac lost $945 million (24.96%), taking each to a lower share price than before the SEC’s emergency order was issued. Yesterday’s especially savage attack was helped along by a Barron’s piece passing along the shorts’ story line that common shareholders will be wiped out. Such published reports commonly provide workable alibis for whatever damage naked short selling can do to the share price, so long as the SEC allows the data on failed deliveries to be kept secret from the public. You can bet with a high degree of certainty that naked short selling played the predominant role in the sharp fall in share prices during the five trading days (including last Tuesday) that the bear assault has proceeded anew. If the SEC fails to act anew, its previous emergency order protecting Fannie and Freddie may well have been for naught.
    This must end. The SEC must do its duty to protect all companies and investors from fraudulent and manipulative trading practices, certainly including naked short selling – which is selling shares that the seller neither owns, nor borrows, nor delivers to the buyer who pays for them. No “grandfathering” of previously sold and undelivered shares this time – all must be bought in without further delay.
    Those who ought to pay for the buy-ins will be no more inconvenienced financially than have the millions of Americans whose investments have been ravaged by these fraudulent practices. Let the perpetrators go broke for a change. And catch them before they get to their jet aircraft and yachts. ~