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Short Sales: The Real Issue

Karl Denninger presents a compelling argument that market makers should not be exempt from rules preventing short-selling shares that cannot be borrowed (naked short selling). Because the quantity of a given stock in "float" is fixed, traders and market makers should not be allowed to create unreal and illogical bets on stocks that result in perversion of market dynamics and wild price swings. That’s my summary, Karl explains in detail. – Ilene

Short Sales: The Real Issue 

Stack of red gambling chips over two numbers on roulette table

Courtesy of Karl Denninger at The Market Ticker

Matt Taibbi once again writes in Rolling Stone, this time on naked short sales, and while he gets a good part of the issue right, he (and many others who have opined on this situation over the years) miss the forest for the trees.

Matt writes:

But the most damning thing the attack on Bear had in common with these earlier manipulations was the employment of a type of counterfeiting scheme called naked short-selling. From the moment the confidential meeting at the Fed ended on March 11th, Bear became the target of this ostensibly illegal practice — and the companies widely rumored to be behind the assault were in that room. Given that the SEC has failed to identify who was behind the raid, Wall Street insiders were left with nothing to trade but gossip. According to the former head of Bear’s mortgage business, Tom Marano, the rumors within Bear itself that week centered around Citadel and Goldman (GS). Both firms were later subpoenaed by the SEC as part of its investigation into market manipulation — and the CEOs of both Bear and Lehman were so suspicious that they reportedly contacted Blankfein to ask whether his firm was involved in the scam. (A Goldman spokesman denied any wrongdoing, telling reporters it was "rigorous about conducting business as usual.")

Matt gets so close, but fails in the closing.

See, there are two area of naked shorting that nobody wants to really deal with, yet both have to be if we are ever to make a difference. Let’s deal with them in turn.

The first, the writing of "naked" swaps, is one that I’ve written about before. The essence of a "credit default swap" is a contract whereby the buyer of protection insures against the default of a credit instrument (usually a bond of some sort.) If the bond issuer doesn’t pay principal and/or interest, the buyer collects the face value of the bond from the seller of protection – but in turn must tender the defaulted bond to the seller.

This "tender requirement" is due to the fact the most of the time a default bond is not worth zero – even in a bankruptcy most companies have some value, and the bondholders are entitled to that recovery.

This is pretty much like homeowners insurance if you think about it. Your house might have a fire, but odds are it won’t be worthless if there is. Same with auto insurance – you buy insurance against a wreck, but if you have one, the insurance company can pay you the market value of the car prior to the crash and in turn they get to keep the (wrecked) car.

Now envision that we allow any number of people to buy fire insurance against your house. There’s only one house, but ten fire insurance policies. Only one of those people (you) owns the house and only one of them (you) lives there, but ten people stand to collect whatever the damage amount is if there’s a fire.

How likely would it be that someone would be sneaking around with a gas can at 3:00 AM were this to be allowed?

Now let’s add another wrinkle to the mix – to collect on any of the insurance policies you must have possession of the house!

Tonight, you have a real fire and the house burns to the ground. The recovery value is zero; indeed, it might be negative (since you have to hire a bulldozer and cleanup crew to clear away the mess before you can rebuild.)

But if there are ten insurance policies, suddenly that burned out smoking hulk has value that doesn’t really exist, and a bidding frenzy is likely to develop for the (one) house. See, without the (burned out) house to tender those insurance policies are worthless.

Tree Burning in a Forest Fire

We don’t allow this sort of thing in the insurance business because it both distorts the market and creates a reason for people to intentionally start fires.

Why do we allow it in the "credit default swap" business?

Did a few people intentionally start some (financial) fires?

The same thing applies, ironically, when it comes to options. See, if I buy a PUT option the market maker who sells it to me immediately hedges his exposure. If the market maker does not hedge and the price collapses, I will put the shares upon him at vastly more than their value and he will suffer a huge loss. He has no reason to take that risk; his money is made on the bid/ask spread, and he has no reason to take a directional bet on the stock’s price (he may, for that matter, agree with me on which way he believes the prices will move!)

Market makers are exempt from the prohibition on naked short sales. They should not be. To allow them to be is to remove one of the actual risks in an option transaction – execution risk. That is, it is entirely possible to have more PUTs (or CALLs) outstanding than there is public float of the underlying issue! It is also possible for those to go out in the money and be exercised, and if that happens then you have created exactly the same sort of counterfeiting fraud that exists with a raw naked short.

The same problem exists on the long side. When a naked short has to be bought back, there are insufficient shares available to do so. This creates a dislocation in price to the upside. While everyone talks about "bear raids" nobody talks about synthetic and fraudulently-generated short squeezes – yet they are just as pervasive in impact as naked shorting, but in the opposite direction.

How many of the so-called "vertical" moves we have so often seen in stocks since last fall, in both directions, can be attributed to this?

The answer? Most of them.

The only check and balance on this is to not exempt market makers from the constraints that everyone else must follow – that is, you can’t short shares you cannot actually borrow, and you can’t buy something that nobody is willing to sell at the desired price. Put more simply, the quantity of a given stock in "float" is in fact fixed, determination of the float is made by the corporation when they decide how many shares to issue, and nobody can be allowed to count a given share twice, no matter how that double-counting would otherwise occur.

Removing this pervasive fraud from the markets would cause option premium to rise a lot when the open interest began to approach a meaningful fraction of the float, and it would bar the writing of credit default swaps in amounts that exceed, in total value, the underlying reference. That’s how it should be, and it would have made the sort of bets placed last year uneconomic, as execution risk, which in fact exists, would have to be computed into the option’s (or CDS’) value. Today, it is not.

Matt gets so close, but then fails in the end.

The reality is that this sort of "counterfeiting" is in fact part and parcel of both the option and credit-default-swap markets, and in each and every case, including old-fashioned naked short sales, it is in fact an act of fraud.

We don’t need new laws – we simply need the existing laws that deal with forgery and counterfeiting enforced across all investment products, and the "special exceptions" that legalize certain sorts of fraud must be removed.

 


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