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Oct. 5 2009 - 11:02 am | 1,444 views | 5 recommendations | 24 comments

Caught On Tape: A Naked Swindle

Continuing with the theme of naked short-selling, I have a video that was given to me last week that will allow people to see how naked short-selling can take place.

This video is only 31 seconds long (scroll on down to view it), and what it shows is a day-trader trying to sell short shares in a major NYSE-traded stock. To disguise the identity of the trader, I’ve had to edit out the name of the company in question — I’ll call it BANK X for short. What I can say is that the stock in question is one of America’s largest financial companies and the recipient of an enormous amount of public bailout money, so the fact that its stock can be manipulated is something that should be a concern to everyone.

In the video, which believe me doesn’t look all that sexy, the trader is using an online trading platform. His clearing firm is a company called Penson Financial Services, which, though not particularly well known, has in recent years suddenly become (by volume anyway) one of the biggest such firms in the country.

A quick aside, before I get to the specifics of this video. My recent Rolling Stone article doesn’t talk much about day-trading, which in retrospect is probably too bad. Day-trading is an increasingly large percentage of all trading on Wall Street, and day-traders have a unique ability to impact the value of stocks via naked short-selling. One the big reasons for this is a loophole in the existing rules governing naked short-selling, called Regulation SHO or Reg SHO.

As it stands, when a day-trader puts an order in to his broker to make a short sale in this or that stock, the broker does not have to actually locate those shares right away. Instead, all he has to do is have “reasonable grounds”  to believe that he can locate those shares. Here is how the rule reads, even now, even after the so-called “tightening” of the Reg SHO rules last fall:

Reg SHO “requires broker/dealers, prior to effecting a short sale, to borrow or arrange to borrow the securities, or have reasonable grounds to believe that the securities can be borrowed so that they can be delivered on the date delivery is due.”

Now, this is already a very funny piece of regulatory policy — asking greedy-ass financial companies to determine what to them is a “reasonable” effort to follow the rules. But it gets funnier when you throw the peculiarities of intra-day-trading into the mix.

Say you’re one of those big brokers, and you’ve got a day-trader who wants to make a short sale. You know he is going to close out his position by the end of the day. You know, in other words, that as far as he’s concerned, you’re going to be net flat by the time the business day ends.

Under that standard, a “reasonably” greedy broker might just determine that any amount of any security can be approved for this trader to sell, regardless of whether he, i.e. the broker, can locate it or not.

Why? Because his trader is going to close out his position by the end of the day anyway. So why bother properly locating the stock? It’s not like you’re going to have to run around three days later to find the stock to deliver for legal settlement. Your customer isn’t even holding his position overnight.

This is why Reg SHO doesn’t really work. If there was a hard pre-borrow requirement that actually forced traders to physically locate and borrow shares before they sold them, you wouldn’t have this problem. But what they have instead is a system that leaves three days of wiggle room. As it stands, shares must be delivered within three days after the sale, or else the clearing firm must buy shares to close out the failed trade.

But for a day trader, none of this matters. You’re buying and selling within the space of one day. Who gives a damn about three days?

These big clearing firms know this. They also know that competitive advantage in getting the business of these intra-day traders depends on providing locates and providing them fast. A clearing firm that worries about the rules and whines about not being able to locate this or that stock is not going to keep the business of a lot of these day traders. So you see a lot of cut corners.

This video is an example of a cut corner. A second-by-second explanation:

:00 If you look at the display in the first seconds, you will see that the customer is trying to sell 100 shares of BANK X short. You can tell it’s a short sale by the purple box near the top marked “Short.” To the left of that, you’ll see that “order quantity” is 100.

:01 Now if you look at the bottom of the display, you can see that the trade has been rejected, because BANK X that day is on the hard-to-borrow list. It reads REJ – HARD TO BORROW: SHRT 100. Without getting too technical, you don’t need a formal locate when a stock is on something called the “easy to borrow” list. But BANK X shares that day were not easy to find (without digressing too much into other complicated realms, there was something going on with BANK X that day that was inspiring lots of people to snatch up its shares). So the trade was rejected temporarily, and the trader was then forced to ask for a formal locate of BANK X stock.

:07 A prompt comes onscreen. Through this box, the customer is going to ask Penson to locate shares in BANK X. But how many shares? This is where it gets interesting.

:11 At eleven seconds, you can see the customer start to fill in the box in the middle of the prompt where it reads, “Locate quantity.” To disguise the identity of the trader, I’ve blocked out the first number in the sequence. But you can see that the number is in the tens of billions of shares. Now, the float for BANK X that day was only five and a half billion, meaning there were only five and a half billion BANK X shares in circulation. Without disclosing the actual number, I can tell you that the customer asked for a locate of shares in an amount that was at least five times the number of BANK X shares actually in circulation. Such a locate, in other words, could not possibly be filled.

:17 At seventeen seconds, at the bottom, you see that the firm Penson has now approved the trade and” located” the multibillion amount of shares. The trade goes through.

This doesn’t sound all that dramatic and as video sequences go, it sure as hell isn’t the Paris Hilton sex tape. But this is an example of how naked short-selling can happen. If you don’t need to actually find the stock before you sell it, there’s no real brake on speculative naked short-selling. If a clearing firm will give you a locate no matter how big your request is, there is no real barrier out there to stop this kind of activity.

Why does this matter? Let’s say there’s a big company that is coming under attack by short-sellers — let’s take Bear Stearns for example. Let’s say it’s March 11, 2008, and Bear stock is trading at $62, but dropping. Once the run begins and the stock price begins to fall, you might see day traders piling on. If they don’t need to actually locate Bear stock, they can simply sit there and batter the hell out of it all day long by continually selling short without locating the shares first.

The best explanation I’ve seen of this problem comes from John Tabacco, the founder and CEO of Locatestock. Full disclosure: Tabacco’s company offers services designed to avert the problems of naked short-selling by using a new technology (invented by Tabacco) that provides real and legal locates to traders. So he has a financial interest in outlining these problems. He’s also a garrulous right winger who has a Sean Hannity-style TV show and probably doesn’t agree with me about anything outside finance. But he’s a great guy and has taken a lot of time to talk to me about Wall Street in recent months.

Tabacco gave a speech about this issue back in April in which he talked about the effect of day traders repeatedly hitting a stock without locating the shares first. He speculates that some of this played a role in the Bear and Lehman episodes, among others.

“The more artificial intra-day selling pressure is impacted on a single stock, the more the pool of real shares is diluted,” he said. This, in turn, creates a “cyclical spiral” in which the issuer’s “real shares are detrimentally harmed, and in some instances that we’ve seen lately, beyond repair.”

Again, a lot of this stuff is complicated and not only hard for people outside the finance world to follow, but kind of, well, boring as well. But it’s through these tiny regulatory loopholes, these little nooks and crannies, that the economy gets manipulated. The effect of all of these regulatory gaps has been to transform Wall Street from a means of connecting capital to good business ideas into a giant casino, where the object of the game is shaving little slices off the great flows of money as you push them back and forth using a great big toolbox of manipulative techniques. This is one of the tools.


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  1. collapse expand

    Who has been the biggest loaner of stocks for short selling: none othe than the california public employees retirement system, CALPERS, which has loaned ot nearly one trillion in stocks

    http://www.calpers.ca.gov/index.jsp?bc=/about/press/pr-2008/sep/halts-lending-four-investment-stocks.xml

    • collapse expand

      Let’s not forget that CALPERS, the $200 billion california public employees retirement system….was ENRON’s cash cow and direct business partner….

      If CALPERS hadn’t pumped the taxpayers cash into ENRON…there would not have been any ENRON collapse….

      …..and CALPERS, which pays no taxes, was a big winner with ENRON, while everyone else was losing

      In response to another comment. See in context »
  2. collapse expand

    I propose the phrase “dilution capitalism” or “counterfeit capitalism” to describe the above process as well as the practices of the Fed and fractional-reserve lenders upon the dollar.

    In both areas, a fixed number of objects (float in the case of a stock issue, M3 money supply in the case of the dollar) is ignored and diluted in order to create liquidity on-demand.

    It turns out you can get blood from a stone after all…

    • collapse expand

      Sorry, Rob, but someone (I’m not sure who to credit) came out with a much better name some time back: The Great Financialization.

      What we are presently living through, best termed as from 2000 to (probably) 2020, or until the Ameritards start coming to their senses (assumption: they actually have senses) and revolt!

      Until that time, biz as usual, baaaah…baaaah….baaaah…And thanks again to The Taibbi. (No doubt this was indeed utilized by GS, JPM and Deutsche to take down Bear and Lehman.)

      In response to another comment. See in context »
    • collapse expand

      Why can’t we pay our income taxes in newly purchased government bonds….at the face value of the bond…what’s the difference?

      In response to another comment. See in context »
  3. collapse expand

    And you want me to tell you which shell the pea is under? Right. I had this experience at a carnival once, and lost all my money.

    Thank goodness I trust the people taking care of my retirement funds. NOT

  4. collapse expand

    You might be interested in this wikileaks memo from JP Morgan as a how-to-drive-the-mack-truck-through-the- regulatory loophole of the 10b5-1 rule on insider trading.

    http://wikileaks.org/wiki/JP_Morgan_Private_Bank_insider_trading_how-to

  5. collapse expand

    I guess the smoking gun would be solid data linking naked short selling to outsized sell-offs (which empirically might not be enough to prove the correlation).

  6. collapse expand

    If someone tried to design an operating system around the principles of Wall Street’s trading rules, it would crash faster than you can say “Windows 7″!

    These trading rules are remnants of the archaic days when stocks were actually issued as pieces of paper. In today’s electronic marketplace, there is absolutely no reason that it should take 3 days for a stock trade to “settle”. This just leaves lots of room for Wall Street traders to practice their shenanigans.

    Just look at what the HFT (High Frequency Traders) can do in milliseconds, or how Google can search the whole internet in a flash. This proves that the technology exists, but the Wall St. traitors that control the economy obviously don’t want to give up milking their cash cow. And every pint that they extract comes directly out of the pockets of small investors, and the taxpayers.

    For my pre-review of Matt’s “Wall Street’s Naked Swindle” see here. Good luck to Matt in his battle against Wall Street. I’m expecting them to come out with guns blazing to shoot down his arguments.

  7. collapse expand

    Certainly not sexy stuff, but necessary and appreciated by your readers like me, who ‘don’t know preferred stock from livestock.’ I believe what you do, breaking your arguments down to the smallest details while keeping it accessible for the layman, is the only way to take on the herculean task of exposing the grotesque machinery of our financial captors and the direct link they have to our political heroes/villains. I’m learning more from you than from all the other interpretations I’ve read of the collapse, because you can back up what you say. I’ve followed your work since Wimblehack, also rigorously researched to the point of being nearly uncriticizeable from any perspective.
    One question as I conclude this love letter, who else would you recommend to follow who is battling the absurdity we can no longer take for granted as fervently as you are (aside from zerohedge who seem mainly anonymous, and Ron Paul). Also, please be careful: ‘Everyone that know about the brief is dead.’

  8. collapse expand

    Since this current financial “crisis” started, I was amazed to see how quickly it turned to one of opportunity for banks JP Morgan and Goldman Sachs. I believe the Lehman execution by Hank Paulson was the pretext for launching yet another restructuring of the US banking system. Similar to the time when US banks began internationalizing at the turn of the last century, particularly as a result of JP Morgan bankrolling the Boer War on behalf of Britain earning the bank its reputation as the first American bank capable of financing global credit agreements.
    What’s at stake this time around is the defense of that preeminence, which has been openly questioned by many investors and political leaders like Medvedev and Hu Jintao. With the tacit approval from the White House JP and GS have arrogated themselves the role since 1913 as de facto defenders of the US dollar because their very existence as the world’s richest banks hinges on the Federal Reserve system and the dollar. What JP and GS are hoping to achieve is nothing less than a sort of ‘back to basics’ when Morgan and Sachs ruled and it is being done once again by perhaps the two banks that started this process that coincided with: Morgan and Sachs.
    In the decade leading up to 1913, Secretary of State Warren Harding and President Wilson oversaw the emerging preeminence of the Almighty dollar as the world’s currency reserve largely as a result of JP Morgan. After all JP Morgan was actually a man who came up with the idea of a Federal Reserve way before its inception in 1913. He also thought of the idea of a standardized US currency too that could only come from one bank: The Federal Reserve. Up until then there were about 7,000 different US currencies in circulation in the US. Consider the institutional structure of the Fed to discern just how bias in favor of JP and GS it actually is and then you can see just how rigged at the financial and political level the US banking system is:
    According to their website, the US Fed is actually made up of 12 Federal Reserve Districts. The Fed, although nominally an “independent government entity” (sic) also has an institutional bias in favor of banking interests that have so far been dominated by Morgan Stanley and Goldman Sachs.
    How? The Fed can be thought of as structured in a three part system: the top layer is headed by the Board of Governors, which is led by our friend Henry Paulson and are appointed by the President following Senate approval.
    The middle layer, the 12 Federal Reserve Banks is headed by presidents nominated by the nine-member board of directors.
    Who chooses the nine-member board of directors? Well, three are chosen by the biggest banks in each of the 12 districts (of which Morgan and Goldman Sachs have the most influence in the most financially powerful district, NY.)
    Three of the remaining six are chosen by the member banks i.e. the ones with the most influence (I guess Morgan and Sachs) and three by the Board of Governors (the current ones all worked for Henry Paulson.)
    However, what’s important is that the NY Federal Reserve is not only part of the US Federal Reserve as it is officially recognized as belonging to one of the 12 Federal Reserve Districts. (As the NY Reserve is the wealthiest it is therefore the biggest stakeholder in the Fed itself.)
    The point is: The boss of the Fed was Henry Paulson, who was boss of Goldman Sachs. It’s also interesting to note that the current treasury Secretary, Timothy Geithner was a Paulson protégé during his time at GS. As for Ben Bernanke, a government appointee, the former Princeton professor came from the same university that includes former President Wilson among its alumni and performs a ceremonial spokesman role at the Fed… (He is government employee after all and not golden crumb grabbing broker/hedge-fund manager.)
    Again, I can’t help but think that faced with this enormous financial crisis – and it is much bigger than we think – there is a genuine threat facing the US: a potential end to the internationalization of American credit, which has underpinned US development since the creation of the US Dollar.
    Further evidence that the US financial system has been restructured to benefit the JP/GS monolpoly: the bailout of AIG: Although viewed as a moribund entity, it remains a fact that insurance companies are also key to providing stability in financial markets anywhere in the world. Banks love stability and liquidity and insurance companies offer both.
    Remember that AIG was not only bailed out by the NY Fed to the tune of over $100 billion, surely at the behest of its largest shareholders? Those crisis talks involved bankers from JP Morgan Chase, representing AIG, Goldman Sachs, representing potential investors, and Morgan Stanley, representing the Fed, all of whom were working towards some form of arbtitrage/commission dressed up as a “solution”.
    Therefore, in order to safeguard the internationalization of US backed credit the Fed and it’s two most trusted banks are taking charge of the situation now.
    So, there’s a little more proof to add to the insurmountable evidence favoring the argument that the US financial and regulatory system is hell-bent in favor of just two banks and has been for over 100 years…
    I guess we can only look forward to the next phase of US expansion funded by a new internationalization of credit…

  9. collapse expand

    Actually, the system worked well. It turns out at the :27 second mark, there’s an alert that says the trade didn’t go through.

    http://www.businessinsider.com/john-carney-the-naked-short-sale-in-taibbis-video-was-actually-rejected-2009-10

  10. collapse expand

    Just curious. So this is a ‘noob’ Q!. So if the trading company accepted that they did ‘locate’ the said # of shares. Aren’t they obliged to hand over the shares to whosoever that buys them from this shady day-trader!?

  11. collapse expand

    Per an email exchange I had with Matt.

    I should clearify that those above comments from “Joe” are me Joe Weisenthal from BusinessInsider. Hope that clears that up.

    I forget not everyone realizes that TheStalwart is me — that’s my Twitter handle and blogname for several years.

    Cheers.

    • collapse expand

      Oh, THAT’s cute! You log on with a fake name and dump on Matt for opposing naked short selling, plus you call Matt’s video a ‘hoax’.

      It’s bad enough you’re proven wrong about that ‘hoax’ accusation – but it gets worse when Matt exposes who you really are. Yep, ‘the stalwart’ is actually Joe Wiesenthal, Editor of Clusterstock (duhh! the very same Clusterstock who’s erroneously called Matt’s video a ‘hoax’). And what’s your defense? It’s OUR fault for not realizing who you really are because (wink! wink!) you’ve been using that fake name ‘for several years’.

      Look, if you want to oppose Matt, please do it out in the open like he does. Otherwise, if you use a fake name, I can only conclude that your ‘facts’ are the same.

      In response to another comment. See in context »
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    I'm a political reporter for Rolling Stone magazine, a sports columnist for Men's Journal, and I also write books for a Random House imprint called Spiegel and Grau.

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