Naked Short Selling Dominates the Markets

For more than two years, playing the blame game has become a popular pastime among Wall Street pundits. Who bears the most responsibility for the market crash? Was it the politicians, who egged on lenders and investment bankers to take foolish risks in the name of policy goals like widespread home ownership? Or was it the bankers’ greed that triggered the near cataclysm?

One argument that the bankers themselves, along with many in the regulatory community, can readily accept is that ruthless and unscrupulous short-sellers must take a big share of the blame for the collapse of both Bear Stearns and Lehman Brothers.

Mention the names of certain hedge funds or noted short-sellers in front of former senior figures at either firm, and watch their demeanor transform instantly from calm and well-spoken to vituperative. “They brought us down,” one senior player at Lehman Brothers told StreetWise only months after the investment bank was forced to file for bankruptcy court protection.

With Lehman’s bankruptcy court proceedings still underway, it came as little surprise to find the investment bank’s estate alleging in filings last week that Och-Ziff Capital Management was part of a plan to spin false rumors about Lehman in the months and weeks leading up to its collapse.

The subtext: If it weren’t for these deliberate malicious efforts by short-sellers to spread rumors, the investment bank would have stood a better chance of survival. (Among other targets of the wrath of the late Lehman and its estate is JPMorgan Chase. The Lehman side alleges the bank denied Lehman access to liquidity at crucial stage for reasons that went beyond the commercial requirements, a claim that JPMorgan Chase denies.)

Short-sellers aren’t a popular breed on Wall Street. When times are good, they are the naysayers, the people who look for the worm in the apple. And unlike regulators, who (when they are doing their job properly) are performing the same task in hopes of making the markets function more efficiently or tackling malfeasance, short-sellers just want to make money from the stupidity or misfortune of others. Celebrating (or envying) others’ success is part of the American way. Profiting from another’s misery, however, is seen as slightly less than respectable.

The unpalatable truth is that short-sellers serve a vital function in the financial markets, just as vultures do in removing carrion. No short-seller deliberately decides to bet against a powerful financial firm by shorting its stock for the fun of it.

A firm that decides to establish a short position usually does so in the wake of significant research—research that can often be more intensive than that conducted by long-only investors. After all, the latter stand only to use the sum they have invested while the rules of short selling mean that if the hedge fund shorting a stock gets their thesis wrong, it could end up in a short squeeze with losses many times the size of that original bet.

Not only do the “shorts” force the true believers to question their assumptions about a firm’s health and stability, they provide additional liquidity to the markets. “Without the hedge funds that short just aggressively as they will go long, it would be a lot harder or more expensive for other market participants to do what they want to do in the markets,” argues one veteran trader.

In the aftermath of the financial crisis, even former Bear Stearns CEO Jimmy Cayne had to admit to the Financial Crisis Inquiry Commission that his firm had substantial financial issues that would have led to its near collapse in the long term. His comments to the commissioners, in response to questions, seemed to confirm that to the extent that short-sellers had any impact on the investment bank’s demise, it was only in determining its timing. Naked short selling—the practice of selling stock that the short-seller doesn’t own and hasn’t borrowed to sell—may have pushed the bank over the edge, but it walked all the way to the cliff under its own steam.

The debate over whether and how to rein in short selling has lost no momentum in the years that have elapsed since the collapse of Bear and Lehman. But the real problem isn’t short selling, whether naked or fully-dressed in pinstriped suits.

Rather, it’s market manipulation. When Lehman’s estate tries to understand what hedge funds like Steve Cohen’s SAC Capital, Greenlight, or Och-Ziff were up to, that’s what they are really griping about. It’s not the fact of the short sale, but the rumormongering. And banning particular kinds of transactions—even the extremely risky practice of naked shorting—won’t fix that problem.

That didn’t stop the German government from trying, of course. Last May, it imposed an overnight ban on naked shorting of bonds, stocks of German companies, and credit default swaps on bonds issued by European Union governments in the midst of the efforts to bail out Greece and somehow stop the Euro from melting down. This month, the International Monetary Fund issued a report card on that ban. Rather than making the markets function better, the IMF concluded, “market efficiency and quality in fact deteriorated substantially.” Nor did it help put a floor underneath asset prices.

Meanwhile, Shang Fulin, head of the China Securities Regulatory Commission, sent a signal to the North American and European markets that if they were going to crack down on short selling, China may be willing to step into any void that is left.

Shang told a financial group in Shanghai last June that the country plans to expand margin trading, short selling, and the use of financial derivatives—a reminder to regulators elsewhere that attempts to rein in speculation are likely to be fruitless without some kind of global agreement.

Restrictions on short selling elsewhere may simply drive a significant amount of trading onto Asian markets, if that is the only place that hedge fund managers can execute their strategies.

Short-sellers—even those who are “naked short-sellers”— may be vultures, but vultures are useful creatures, even in the financial markets. In volatile and sideways-moving markets, investors in funds that are able to sell short have another way to make money. “That’s part of what being nimble is all about,” says one hedge fund trader, who admits that he occasionally shorts stocks he doesn’t own. “Yes, it’s a lot riskier, but that just means I have to have a lot more confidence in my judgment and my research. And if I get it wrong, I pay a much heavier price.”

The problem isn’t with short selling, per se, but with abusive behavior by some of those short-sellers. The solution, therefore, isn’t to ban short selling, but to better monitor the Wall Street rumor mill, watching for strange moves in asset prices and seeing whether they can be linked to particular short-sellers, strategies, or rumors.

It’s the people, not the trading strategy, that are the real problem. It’s always going to be harder to police what a handful of reckless short-sellers are saying and doing than it is to slap a ban on short selling itself. But it’s the right way to protect the integrity and the efficiency of our financial markets.

Read more: http://www.portfolio.com/industry-news/banking-finance/2010/08/20/wall-street-banks-can-revive-partnership-culture-by-making-top-bankers-liable-for-losses#ixzz0xR3X37UX

Forbes.com

Two years ago the Securities and Exchange Commission, in the middle of dealing with the worst financial crisis since the Great Depression, slapped a temporary moratorium on short selling in shares of 799 financial companies (well, some of them weren’t so financial, but whatever.) At the same time in Sept. 2008, it opened an investigation into the trading habits of hedge funds, particularly their short selling activities, much to the chagrin of the fund industry.

Nothing has ever come of those investigations, however, and a lawyer for Och Ziff Capital Management said in bankruptcy court Wednesday that it’s because there was nothing to see, after all. The probe “has gone nowhere because there is nothing,” said Kenneth Bressler, the attorney from Blank Rome who is representing the $26 billion hedge fund Och Ziff in a spat with Lehman’s bankruptcy representatives.

The SEC looked into most major hedge funds and their trading in shares of Lehman, Morgan Stanley, Goldman Sachs, American International Group, and Merrill Lynch, the lawyer said during the hearing. Contacted Thursday, a representative for Bressler said he wouldn’t comment beyond what was said in court.

Since the crisis days, the SEC has been busy slapping fines on Wall Street for misleading disclosures (Citigroup, $75 million, which a judge isn’t too keen on, and Goldman, $550 million) and cracking down on insider trading, but it hasn’t come up with an example to be made of nefarious short selling in bank stocks. It’s most recent cases involving short selling were brought against two small Los Angeles investment advisory firms in January and another two traders in Florida in May, all four for short selling before a secondary offering.

You’ll recall that back in the worst of the crisis, and even now, the chief executives of major Wall Street firms were crying foul about short-sellers targeting vulnerable financial stocks to make a profit. Lehman’s fallen chief executive, Richard Fuld, blamed short seller for driving Lehman into the ground. Conspiracy theories abounded in the weeks after the March 2008 collapse of Bear Stearns that hedge funds had colluded to drive its stock down.

Vikram Pandit, the chief executive of Citigroup, told a special Congressional panel this March that traders benefit when fear overtakes a market. “That’s the tool that short-sellers need to make money.”

Still, no smoking gun…yet. In February the SEC voted in new rules restricting short selling activity in stocks that have fallen 10% already.

Lehman’s bankruptcy representatives are tussling with Och Ziff over a document subpoena Lehman sent the fund to get records of its trading. Lehman accuses the fund in court papers of having either received or spread damaging rumors and it wants the bankruptcy court to tell Och Ziff to comply. Och Ziff is resisting the subpoena, saying it is too vague and the document production could cost an onerous $3 million. The judge on Wednesday didn’t make a ruling.

Och Ziff is the only firm to resist Lehman, the fallen Wall Street bank claims. Six subpoenas were sent out. Reuters last week identified some of the other recipients as Greenlight Capital (which famously went negative on Lehman in the fall 2007 and spring 2008), SAC Capital, Citadel Investment Group and Goldman.

Is there an answer?

Unless the SEC works with the DTCC and brokers to stop this, then no there is no answer, and given the amount of money involved in total expect those invested in short selling to continue to do so.

At Heffernan Inc we have come to realize that it is not a game that can be won on the OTC, in fact they only way around the issue that we could see was to plan a 100% shift to a foreign exchange where there is no naked shorting and was outside the reach of the market makers active in the practice.

As the company, BZTG as it is now, Changes to Heffernan Inc we will seek to remove all stock to a new foreign exchange making for a full and complete covering of the short sold stock, it will be interesting to see how that turns out, we think we are on a big winner!

Shayne Heffernan www.livetradingnews.com