Yes, Naked Short Selling IS a Real Problem

By Kevin Freeman
blog
February 02, 2012Feb 02, 2012

One of the prime arguments against the evidence we compiled in the DoD report and produced in our new book, Secret Weapon (www.secretweapon.org) is that if naked short selling were such a problem, surely the SEC would stop it. As a refresher, naked short selling is selling shares of a stock and then failing to deliver them to the buyer. This would seem to be fraud with the exception that the system creates a sort of IOU and keeps track so that at some point the short seller will have to "cover" his sale by buying back the shares. The seller hopes to buy back at a lower price, thus pocketing the profit from selling high and buying lower. This is similar to traditional (non naked) short selling with one key distinction. Traditional short selling requires that the seller "borrow" shares first. In this case, there is not a failure to deliver because the shares are legally borrowed. There is an IOU created but it is well understood by all parties and the number of IOUs is limited by the number of shares available for borrow. All readers should please understand that we are not against traditional short selling. This is a normal and potentially beneficial part of the market. But, we stand firmly against naked shorting.

What's wrong with naked shorting? In isolation, probably very little. An occassional failure to deliver on a sale has the same impact on share prices as a traditional short sale with borrowed stock. The problem, however, is that the act of borrowing shares provides a limitation factor. You can only borrow as many shares as there are available to lend. In the case of naked shorting, however, there is no such limit. The created IOUs essentially become the equivalent of counterfeit shares that flood the market. At the same time, the mass selling dampens demand because on Wall Street, mass selling suggests that something is wrong and new buyers are scared away. Thus, in large enough amounts, naked short selling simultaneously increases supply and dampens demand which results in falling prices according to the laws of supply and demand.

Is this significant? Well, according to research we reported in the book (pages 118-119) Secret Weapon (www.secretweapon.org), about half of the decline (Dr. Trimbath says between "30 and 70%") in Lehman Brothers share price was exclusively caused by "failed to deliver" selling (naked short selling). That doesn't include the psychological impact responsible for further panic selling. The amount of naked short selling in Lehman increased 57-fold in 2008 from the peak in 2007. Even former SEC Chairman Harvey Pitt referred to this mass naked shorting activity as "Fraud." The amount of naked short selling in September 2008 was 1,600 times greater than it had been just three months earlier, leading to Lehman's collapse. Even George Soros later admitted that unlimited short selling was a key cause of Lehman's collapse leading to the entire market meltdown (page 142). The SEC was so panicked by these facts at the time that they issued emergency bans on short selling of major financial institutions (page 147).

Memories are short, however, and Wall Street has returned to a more normal state. Now, conventional wisdom holds that Lehman was destined to fail and short selling helped it get there faster–something many even view as beneficial. None of this changes the facts, however. It was naked short selling that brought Lehman down and naked short selling is basically fraudulent. These things cannot be glossed over because as we have demonstrated, naked short selling is one of several "Secret Weapons" that can be used to target and bring down an economy. Even the former Prime Minister of Malaysia acknowledged as much after witnessing the effect first hand in Asia (page 58).

The main argument against the idea that naked short selling is a problem is based on the fact that it is already illegal (with a few exemptions, one being proposed by and named after Bernie Madoff and the other an allowance for Sharia Compliant Finance). Surely, if this were a problem, the SEC would have already addressed it. This argument falls apart for three reasons, one of which is a recent news item:

1) First, there are exemptions and these have been so broad that they rendered the restriction almost meaningless. The Madoff exemption, for example, allowed market makers to naked short sell, presumably to facilitate liquidity. Unfortunately, due to naked sponsored access rules (pages 153-155), this also meant that almost anyone could get an exemption at will.

2) Even outside of the exemptions, the practice was so pervasive that there were 5,000 complaints to the SEC according to the SEC Inspector General. Despite this, there were no enforcement actions and over 97% weren't even investigated.

3) Finally, the SEC has brought charges against a manipulative naked short selling scheme as announced on January 31, 2012 (http://www.sec.gov/news/press/2012/2012-22.htm ). This is big news but stems from activity that took place nearly six years ago (in 2006).  It does prove the point that such activity can and did happen. It also demonstrates how long it takes for such activity to be dealt with in a regulatory context. Lehman Brothers was dead and buried in a matter of days, nearly taking our entire economy down with it. If we are dealing with criminals, maybe a six-year time window is acceptable. In the case of financial terrorism, however, six days is unacceptable let alone six years. There were reports that Lehman was targeted by Middle Eastern funds because it was a "Jewish investment bank."

Keep in mind that this is just one of many Secret Weapons being used against our nation's economy. It is good news to see that the SEC is finally acknowledging a problem with naked short selling. But, our nation's future is at risk. We need far more than six-year old investigations after the fact. We need to prepare for the next attack that we have outlined as Phase Three. Stay Tuned!