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Shorts - naked or not - have to buy back their shares sooner or later. The best defense against naked shorting is to run a solid company with real earnings so the naked short sellers have to buy back your stock at a higher price than they sold it.

Although I think naked shorting should remain illegal, and I'm glad to see a crackdown, I really don't understand all the conspiracy theories and hyperventilation. Short sellers, naked or not, make money when they are right and lose money when they are wrong. Those who profit from spreading false rumors should be taken out and shot, whether the rumors are positive or negative, whether the positions are naked or clothed.

It's always seemed to me that the people who reserve their ire for naked short sellers, rather than observing the whole panoply of malfeasance on Wall Street (most of it long biased), generally have their own agenda of self interest.

Martin
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Shorts - naked or not - have to buy back their shares sooner or later. The best defense against naked shorting is to run a solid company with real earnings so the naked short sellers have to buy back your stock at a higher price than they sold it.

I do not think this is always possible. Let's say a bunch of hedge funds decide to naked short Berkshire Hathaway. Each of 20 of them short 100,000 A shares.

Now, whether or not Berkshire goes up, let us say after 3 days, most of those who bought those naked shares wish to sell, or even if they do not wish to sell, but their brokers insist on delivery of the shares. The hedge funds cannot possibly deliver because they do not have the shares, and furthermore, they cannot buy in because Berkshire has only about 1,500,000 shares outstanding. So somebody is going to lose money. Will the purchasers of the shares, who did no wrong, lose the money? Will the hedge funds -- since no amount of money will enable them to cover the naked shorts? Would Berkshire clean up by issuing some more class A shares at a $1million a piece?

I admit this is a far-fetched situation, but pushing things to the limits often shows the weaknesses of a model.
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Isn't the potential problem that with naked shorts, you can sell(short) exceeding the market cap ?
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Personally I'm shocked at all this. I never realized that the news media had a hidden agenda! :)

OTOH, I now have a better understanding of what happened to ENRON, WorldCom, etc.

Seriously, the SEC has vast resources at their disposal to ferret out market mamipulators.

Do they catch them all? Probably not. But something on the scale that this article is talking about, it would be a no brainer.

When there are big losses involved, some have to find a scapegoat, rather than own up to thier own inability to cut a loss short.

tdbear2
BTW I thought hedge funds had their worse performance when the markets really got out of whack and their Quant models were no longer working.
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Shorts - naked or not - have to buy back their shares sooner or later...

Extremely nice summary, Martin, from beginning to end.

Jim
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I do not think this is always possible. Let's say a bunch of hedge funds decide to naked short Berkshire Hathaway. Each of 20 of them short 100,000 A shares.

Now, whether or not Berkshire goes up, let us say after 3 days, most of those who bought those naked shares wish to sell, or even if they do not wish to sell, but their brokers insist on delivery of the shares. The hedge funds cannot possibly deliver because they do not have the shares, and furthermore...


This is why I think we also need rules that in effect restrict the short interest to something shy of 100%.

One such rule would be that a share which is currently borrowed for shorting, can't be re-borrowed. As the short interest plus non-borrowable shares (mostly in non-margin accounts) approaches 100%, it would become progressively more difficult and eventually impossible to borrow shares for shorting.

Another would be that when short interest exceeds some threshhold, there would be rent to pay on any further borrowing of shares - paid by the borrower to the owner being borrowed from. The rent is the current market price at the time of borrowing, times the short interest. Anyone shorting when the short interest exceeds 100% would be absolutely guaranteed to lose money (but there'd be no problem finding shares to borrow).

One of these rules, or something else along the same line, is in addition to actually enforcing the existing rules against naked shorting.

(Are there any other rules going unenforced? All such rules should be either enforced or repealed - after examination rule-by-rule to see which makes more sense.)
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The hedge funds cannot possibly deliver because they do not have the shares, and furthermore, they cannot buy in because Berkshire has only about 1,500,000 shares outstanding.

That's where your scenario is incorrect. After the hedge funds execute their naked short sales, Berkshire has 3.5 million shares outstanding on the market, only 1.5 million with voting rights. Following a massive failure to deliver, the hedge funds will sooner or later have to buy back 2 million shares, but they aren't restricted to buying back real shares. They can simply buy back the naked shares they sold, which then cease to exist. Any real shares they happen to buy can be delivered to the buyers of naked shares to settle their trades. Eventually all the trades are cleared, the hedge funds are flat, Berkshire drops off the threshold list, there are once again 1.5 million actual shares of BRK-A on the market, and all is right in the world.

This is why I don't worry too much about naked shorting. Even just starting to think about the horrible situation these hypothetical hedge funds put themselves into gives me the creeps. It makes my skin crawl. To be sitting on a vast short position that you have to cover in 3 days, and every day after that everyone from your prime broker to the clearing firms to the exchanges to the SEC is on the horn yelling at you, while the entire world can look at the SHO threshold list and knows that someone is f**ked, the entire market can smell the blood in the water and it happens to be yours... boy that is a tough spot to be in. You need big, brass balls to pull a scam like that which can so easily go so wrong.

Martin
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Martin,

How does one know if rumors are true or false? If true, are they then rumors? Hype is part of the market along with Caveat Emptor.

Our screens avoid deceptive hype, because they don't tap into it. But
I have owned a company that absolutely falsified the annual report, so even a screen couldn't protect you.

I also think I recently read that naked shorting is legal in either
Canada or Australia. I don't recall which.

rrjjgg
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The hedge funds cannot possibly deliver because they do not have the shares, and furthermore, they cannot buy in because Berkshire has only about 1,500,000 shares outstanding.

That's where your scenario is incorrect. After the hedge funds execute their naked short sales, Berkshire has 3.5 million shares outstanding on the market, only 1.5 million with voting rights. Following a massive failure to deliver, the hedge funds will sooner or later have to buy back 2 million shares, but they aren't restricted to buying back real shares. They can simply buy back the naked shares they sold, which then cease to exist. Any real shares they happen to buy can be delivered to the buyers of naked shares to settle their trades. Eventually all the trades are cleared, the hedge funds are flat, Berkshire drops off the threshold list, there are once again 1.5 million actual shares of BRK-A on the market, and all is right in the world.


What if the price went up too much and the hedge funds cannot afford to buy the m back? The hedge funds go bust, and the people who bought the naked shares are screwed, right?
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JeanDavid,

If they were bought through a broker, the money should be held by the broker until the
hedge fund delivers the shares. If the shares don't show up, I expect the broker has a clause allowing them to just return your money. Isn't this called a broken trade or something like that? If you could find out who failed to deliver, you could probably sue them, but most folks would probably go to the next interesting investment.

rrjjgg
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I think it means a lot of guys who were short these financials are running to cover, and it might still be worth a gamble on financials popping tomorrow again as they cover before the rules take effect.
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Although I think naked shorting should remain illegal, and I'm glad to see a crackdown, I really don't understand all the conspiracy theories and hyperventilation. Short sellers, naked or not, make money when they are right and lose money when they are wrong.


Naked shorting is actually not illegal. The recent SEC action made it against the rules for 19 specific financials only. I think it actually should be. The reason is that financials have a specific problem that makes the above quote questionable. They are subject to a "run on the bank" phenomenon. Simply by shorting and jamming down a stock combined with fear-mongering they can actually bankrupt a financial institution that relies on depositors or investment accounts by provoking their customers into withdrawing their money. At which time, their naked shorts don't really need to be paid back or at least not at the same levels of the short and so can still be profitable. Witness Bear Stearns supposedly sold at $2 but later popped back up to around $10. Still very profitable for the naked shorts even when they had to buy shares to cover up to $10.

-Greg
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What if the price went up too much and the hedge funds cannot afford to buy them back? The hedge funds go bust, and the people who bought the naked shares are screwed, right?

This isn't unique to naked short selling. Anytime a company goes bust between the execution date and the delivery date of any trade, long or short, you have the same problem. (Naked shorting just has the potential to leave a much longer window between execution and delivery, if there is a delivery failure at settlement.) There are established rules and procedures to handle this sort of situation; in fact this is the major reason why securities exchanges exist to begin with, to allow market participants to trade without taking on counterparty risk. If you had to evaluate the creditworthiness of your counterparty before making any trade, markets would grind to a halt.

In practice, in your scenario, the hedge fund's prime broker is going to be responsible for any losses that can't be covered by the assets of the fund (which are in the broker's custody). The broker is an exchange member, and their entire business relationship with the exchange is predicated on the broker taking responsibility for any credit problems at its clients.

The real nightmare scenario is where the prime broker fails leaving potentially days of unsettled trades from all of its clients. In that case the exchange itself is responsible for making good on the trades.

In no case is the person on the other side of the trade going to take a loss because of an unsettled trade. No trade is going to get busted simply because someone ran out of money. The very reason exchanges exist is to prevent this from happening.

Brokers, exchanges, and their regulators all have rules designed to limit their risk and limit the chance of taking losses in scenarios like this. These rules are called margin requirements, and I think we are all familar with them. One example is the Fed's Regulation T.

I am of course talking about public securities exchanges, which is where naked shorting occurs. However there are also private, "over-the-counter" markets where market participants have no such guarantee; the market for credit default swaps is one very timely example. One reason why the Fed had to act to prevent Bear Stearns from failing outright was that Bear Stearns was a major participant in these unregulated markets. If Bear Stearns failed there would be several days of unsettled trades which would be in a legal limbo. It would have been a shitstorm of monumental proportions. I hope that one outcome of the "present difficulties" will be a regulated exchange for credit default swaps.

Very long and meandering answer to a simple question. Sorry about that. :)

Martin
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If the shares don't show up, I expect the broker has a clause allowing them to just return your money. Isn't this called a broken trade or something like that?

Nope, broken trades do exist but they are only allowed in very strictly defined situations, where it is clear that you do not have a willing seller meeting a willing buyer at an agreed upon price. One example is a "fat finger" mistake where the decimal point is in the wrong place. Trades can only be broken in a very short time limit, typically a half hour after the trade takes place.

After that, the broker is responsible for any debts which their client cannot deliver.

Martin
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Naked short selling distorts the dynamic of supply and demand, at least temporarily. For example, if there are more sellers for a house then buyers the price goes down. But, if I could create an unlimited number of "phantom sellers" by creating houses that don't exist and then listing them for sale, I could drive the price down to absurd levels. Arguing that the phantom sellers will have to cover doesn't repay the unfair loss that some will sustain.

Naked short selling creates a hazard to me if I am shorting the same shares of stock.

Bigger picture... our entire system of capitalism is based on concepts like fair competition, supply and demand and property ownership. Naked short selling distorts these concepts and creates an un-level field where the most deceptive win.

Personally, I'd like to see the government enact rules that ensure a level playing field for all.
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Naked shorting is actually not illegal. The recent SEC action made it against the rules for 19 specific financials only.

It has always been illegal to intentionally enter a naked short sale, except in the course of legitimate market making. However, proving intention is a notoriously tricky thing.

Regulation SHO went into effect in 2005 to make naked shorting considerably more difficult, regardless of intention. It requires all brokers to locate shares to deliver before allowing a client to enter a short position. It also creates consequences for widespread delivery failures (the threshold list).

http://www.sec.gov/spotlight/keyregshoissues.htm

The recent rule changes basically strengthens Reg SHO for certain stocks. It requires brokers to actually acquire the shares before making a short sale, rather that simply "locating" them (getting a promise from another broker to deliver them). It makes it much harder to fudge the rules on delivery, and much more clear when an intentional violation has occured. It doesn't change the basic underlying legality of naked shorting, just the enforceability.

The reason is that financials have a specific problem that makes the above quote questionable.

I disagree. Any over-leveraged institution can be destroyed by a failure of confidence, be it a bank or a coal miner. The problem however is not the rumors, or the stock price, or the "run on the bank"; the problem is the excessive leverage. Merely shorting Bear Stearns or spreading rumors about Bear Stearns would have been a futile and expensive effort if Bear Stearns hadn't made itself uniquely vulnerable.

Witness Bear Stearns supposedly sold at $2 but later popped back up to around $10.

Don't get me started on this. Bear Stearns sold at $2 to JP Morgan because, without a bailout, that was what it was worth. I would argue that it was in fact worth $0. After JP Morgan took over Bear Stearns' operations and guaranteed their trades, suddenly Bear was far more valuable; probably worth $25 or $30 per share, not just $10. However that doesn't mean JP Morgan got some sort of screaming deal. They took a huge risk by stepping in, and only the fact that they were taking that risk made Bear worth more than $0.

(I'm glossing over the Fed's $29 billion backstop, we can argue that another day. My point is that you can't look at the $10 price on March 24 and argue that Bear Stearns was underpriced at $2 or even $0 on March 15.)

Martin
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Naked short selling distorts these concepts and creates an un-level field where the most deceptive win.

I agree, except the part about winning. I just don't think naked short selling is a particularly good way to win, and it sure is a great way to lose. For the most part I think it's just a scapegoat and a conspiracy theory.

Personally, I'd like to see the government enact rules that ensure a level playing field for all.

So would I, but that's a tall order. Any additional regulation has a cost, in this case making life more difficult and expensive for legitimate short sellers. Short sellers provide a valuable service to the markets, improving price discovery and hence making capital allocation more efficient. We could go to great lengths to discourage naked short selling, but that may do more harm than good for the markets as a whole.

Martin
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Naked short selling distorts the dynamic of supply and demand, at least temporarily. For example, if there are more sellers for a house then buyers the price goes down. But, if I could create an unlimited number of "phantom sellers" by creating houses that don't exist and then listing them for sale, I could drive the price down to absurd levels. Arguing that the phantom sellers will have to cover doesn't repay the unfair loss that some will sustain.

The absence of short selling can distort the market just as much. If a stock has 99% insider and institutional holdings with no inclination to trade actively, there can be insufficient liquidity to ever push that stock down when it richly deserves to come down.

This is exactly what enabled the housing bubble. When people perceived that house prices were never coming down, nobody was willing to sell for less than they bought, and the market could feed on itself for a very long time, until it got hit over the head with a two-by-four.

Elan
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This is exactly what enabled the housing bubble. When people perceived that house prices were never coming down, nobody was willing to sell for less than they bought, and the market could feed on itself for a very long time, until it got hit over the head with a two-by-four.

Exactly. One could argue what is more disruptive for the economy: a forced short-selling action by a few participants spreading a rumor or a collective madness. I vote for the second.
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