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NYSE Firms Naked Short?
$192 Billion Shares Undelivered June 30, 2007
By Wayne Jett © November 21, 2007

    Despite troublesome mismanagement of monetary policy by the Federal Reserve causing heightened concern for the dollar, U. S. financial markets fared well during the first half of 2007. The Dow industrials index rose 950 points, or 7.6%, while the Nasdaq rose 188 points, 7.7%, during those two quarters. But market performance since then has been a different story. Nasdaq is essentially even since July 1, and the Dow is down 3.3%. Just fluctuation, or is there more to the story? The “credit crunch” of August has been the news, but liquidity issues may be symptoms rather than underlying causes of market volatility and weakness.
SIFMA Data on NYSE Member “Fails”
    The Securities Industry and Financial Management Association consolidates financial data showing balance sheets and profit and loss statements of NYSE member firms. The balance sheet data include assets and liabilities arising from undelivered shares (commonly called “fails”) in completed securities trading transactions. On the next page is a chart of year-end fails-to-deliver and fails-to-receive since 1980 compiled by SIFMA and its predecessor, SIA. When SEC considered adopting new regulations (Reg SHO) governing short sales to curtail the fails problem in 2004, its staff reported the outstanding fails as about $6 billion. In July, 2006, in considering amendments to the regulations, SEC said “Reg SHO has achieved substantial results.” The chart shows a very different picture.
    Except for a spike to $60 billion during 1997-1999, total fails outstanding on the last day of each year were about $20 billion until 2000. Since 2000, fails spiked to $140 billion in 2002 and 2004 and ended 2006 at about $82 billion. These facts are shocking, considering that “fails” are shares of securities bought and paid for by an investor, yet the shares remain undelivered without disclosure of that fact to retail investors.
    Even more unsettling is recent SIFMA data that total fails spiked from $82 billion at year-end 2006 to $192 billion on June 30, 2007. NYSE member firms were owed $42 billion in shares (FTDs) and they owed to others shares worth $150 billion (FTRs). These numbers had already been marked to market, presumably downward considering the dilutive effects on share prices of the sale of shares that are neither owned nor delivered. Thus, the parties who sold short without delivering the shares almost certainly received from retail investors considerably more than $192 billion. The buyers were retail investors because institutional investors are informed by their brokers when shares are not delivered and they are allowed to get their money back. Not so with retail investors. Think of 192 companies with a billion dollars each in share dilution (after markdown). Or 400 companies with a half billion in dilution. Effects on share prices and capitalization of the target companies are devastating. So the markdown from the original share prices to the $192 billion might easily be 50% or more.
    Consider that the NYSE firms were effectively short $150 billion on June 30 (or their counter-parties or clients were) and were at risk for another $42 billion in shares that might not be delivered to them. They owed $150 billion in shares, apparently having neither borrowed nor bought them yet. Counter-parties were short $42 billion in shares owed and undelivered to the NYSE firms. These amounts compare to total net capital of $79 billion and total ownership equity of $119 billion in the 193 NYSE member firms. This is high risk exposure.
When Banks/Brokers Need Share Prices to Drop, Is It Bullish or Bearish?
    In two words, the NYSE firms and their counter-parties were “naked short” $192 billion on June 30, although the exposures exist through “brokers, dealers and clearing organizations.” Regardless of whether they act as principals, brokers or prime brokers in the transactions, the NYSE member firms needed the shares involved to drop in price, or at least they didn’t want the share prices to rise. In such circumstances, they needed the markets to encounter “headwinds” after July 1.
    Without more current data, whether the $192 billion total fails exposure has risen or been partially covered since July 1 is presently unknown. Technical analysts might view the gigantic overhang of “fails” as a significant bullish condition, deducing that the presumed obligations to buy and deliver such large numbers of shares must eventually cause share prices to rise.  However, trading activities of this scope and nature largely disable conventional fundamental or technical analysis as guides to investment tactics. Absent enforcement by the SEC of an obligation to cover and deliver shares owed within a time deadline, targeted companies historically have continued to decline in capitalization, eventually being de-listed from NYSE. This consideration turns the “bullish” condition into something more problematic.
Senate Report on SEC Scandal
    In August, 2007, a minority report (Republicans only) of the Senate committees on judiciary and finance reported results of their inquiry into the SEC’s handling of an investigation of insider trading by a major hedge fund (Pequot Capital). SEC senior staff had fired their enforcement attorney heading the investigation when he told them evidence pointed to a major Wall Street executive as the “tipper” and primary target of the investigation. The Senate report found that SEC senior staff delayed completion of the investigation until the statute of limitations had expired, and then a key staff member accepted employment by the law firm that represents the investment bank (Morgan Stanley) which employs the target “tipper.” The report further charges that the Inspector General of the SEC failed to conduct a proper review of the fired attorney’s complaint. Since issuance of the Senate report, five of the top seven officials of the SEC have resigned: the Inspector General, the Chief Economist and three of the five commissioners.
     As this historically unparalleled scenario at the agency unfolded during mid-2007 (before three commissioners resigned), the SEC terminated its long-standing “up-tick” rule previously applicable to short sales of securities. This remarkable action was based on a brief “pilot” test which concluded short-side investors had not misbehaved (surprise!) when the up-tick rule was suspended on certain named stocks. No doubt the SEC staff views this brave new world of shorting without the up-tick rule as “working well” regardless of high market volatility experienced since its elimination. On the slightly positive side of the ledger, the SEC eliminated as of October 15 (plus 35 additional consecutive settlement days) the “grandfather clause” of Reg SHO that permitted many fails to remain uncovered. However, SEC still provides no effective enforcement mechanism against those who ignore the requirement to cover the long-existing failures to deliver shares.
AMEX Steps Up
    In this dismal and murky atmosphere, a ray of hope emitted from the American Stock Exchange in disciplinary cases involving Scott H. and Brian A. Arenstein and their related business entities. The disciplined parties stipulated details of their violations of rules of the AMEX and Reg SHO by selling short without borrowing or delivering shares and by hiding their failures to cover deliveries as required by law. Those cases entered orders against the disciplined parties including disgorgement of profits ($1.4 million and $1.8 million, respectively), fines ($3.6 million and $1.2 million, respectively) and suspensions from AMEX in any capacity for five years in each case. These penalties are stiffer than ordinarily imposed by SEC.
    Meanwhile, SEC presently ponders, under heavy lobbying by the securities industry, whether options market makers should retain permission to hedge options by selling short without borrowing or delivering shares. Despite public statements by SEC chairman Christopher Cox that naked shorting is illegal and a serious problem, SEC staff has said Reg SHO is working and has been slow, at best, in addressing this burgeoning overhang of the financial markets. One Nasdaq-traded company has presented evidence of illegal trading in its shares comparable to the trading practices punished by AMEX in the Arenstein cases, and has asked SEC to take action. ~