Documents Show How Goldman et al Engaged in 'Naked Short Selling'

http://www.rollingstone.com/politics/blogs/taibblog/accidentally-released-and-incredibly-embarrassing-documents-show-how-goldman-et-al-engaged-in-naked-short-selling-20120515

by llambda • 14 years ago

102 50 14 years ago

rollingstone.com

tedunangst3• 14 years ago

Article lists a bunch of interesting details, and even is very careful to make sure the term 'muppets' gets incorporated twice, but doesn't quite connect the dots and explain just exactly how the naked shorting fucked the muppets. For example:

    More damning is an email from a Goldman, Sachs hedge fund client,
    who remarked that when wanting to “short an impossible name and
    fully expecting not to receive it” he would then be “shocked to
    learn that [Goldman’s representative] could get it for us.”

I mean, there are all sorts of reasons why naked shorting is bad, but the most damning thing we can say is "Goldman offered to make their customer happy"? That's what passes for screwing the 'muppets'?

waterlesscloud2• 14 years ago

I'm lost on the mechanics here, but doesn't this mean that any profit on the part of a short-selling customer was actually coming out of the pockets of GS?

I mean...where does the money to cover the customer's profit on a naked short come from?

asmithmd1• 14 years ago

Come on, you know it was not coming out of GS pockets. It was a heads I win tales you lose situation.

Evidently there is some amount of time between when a stock transaction is booked and when it clears - like a purchase made with a check. They were essentially writing bad checks by selling stock they didn't own. If the price of the stock went down, they would actually go out and buy the stock at the new lower price. If the stock went up they would say, sorry that stock transaction "failed" - darnedest thing, just happens sometimes.

"Instead, he preferred to just sell stock he didn’t actually possess. That is what is meant by, “We want to fail them.” Trafaglia was talking about creating “fails” or “failed trades,” which is what happens when you don’t actually locate and borrow the stock within the time the law allows for trades to be settled."

paperwork• 14 years ago

No, the profit doesn't come from GS.

Say you think XYZ, currently priced at $100 is going to go down in price. You tell your broker (GS in this case) to short 1 share in the market. GS sells XYZ (someone else buys it) and you get $100 in your account while the quantity of XYZ shows up as -1. Later, the price does drop to $90. You tell GS to buy 1 share, and you pay $90 for that share.

You now have $10 in your account ($100-$90) and the quantity of XYZ in your account it zero (-1 +1).

Someone else in the market lost this money, you gained it. GS was supposed to have borrowed this 1 share from someone, but they didn't. In other words, for a short time, this 1 share was created out of this air.

If there was a system to make sure that every single transaction was backed by an actual share, then this would not have been possible. However, transactions are not actually reconciled on a real-time basis.

Someone with more knowledge of the back office will have to explain how such naked shorts can exist in books for longer than 3 days (perhaps GS was rolling over these shorts?)

jblow• 14 years ago

I think you didn't understand that paragraph. The implication is that Goldman couldn't get the stock, and in fact did not bother, and just lied and said they did.

tedunangst3• 14 years ago

I get that. But there's no explanation as to why that's bad for the client, as is implied by the article.

quantgenius8• 14 years ago

I think the paragraph means that the client THOUGHT Goldman couldn't get the stock and did not expect them to be able to get it but Goldman was able to get the stock.

lmkg2• 14 years ago

I'm not 100% up to speed on this particular topic, but I think that the damage is diffuse, i.e. it distorts the market but doesn't affect any particular involved party. Therefore, it doesn't make a good story, and doesn't show up in the news.

Basically, you're increasing the amount of good for sale, without the corresponding purchases that would normally balance that out. It's the converse situation of buying things even when you don't have the money (not even in the form of credit or loans), and distorts the market in corresponding ways. The market is robust to a certain amount of shenanigans like this, but when a player the size of GS is doing it willy-nilly, the distortions can become measurable.

According to econ 101, naked-shorting is observationally equivalent to a sudden inflation of supply, which should drive the price down. Lowering the price benefits those in a short position, at the cost of people who are taking a long position, like value investors, or the companies themselves. If you have weight to naked-short enough volume that it actually effects the market, you would in theory be pushing the stock market down and pocketing the difference.

Again, I'm not an expert and this is a pretty naive analysis. I am willing to be corrected. Eventually you have to cover your short, which in theory should un-do all the market effects you've done, but my gut says that in practice the sudden drop has lasting damage to intangibles like "investor confidence" and "market volatility."

pppttt• 14 years ago

It's actually quite clear. Much like printing money takes value away from savers, naked short selling takes value from existing stock holders.

  The lawsuit between Overstock and the banks concerned a phenomenon called 
  naked short-selling, a kind of high-finance counterfeiting that, especially 
  prior to the introduction of new regulations in 2008, short-sellers could 
  use to artificially depress the value of the stocks they’ve bet against.

tedunangst3• 14 years ago

Overstock's shareholders were not Goldman's clients. I want to know how the 'muppets' were harmed, as the article claims.

There is a story here, but this is not the author who's going to write it.

quantgenius8• 14 years ago

No, it just means the Goldman salesman was able to find someone who owned OSTK stock and was willing to lend it out at the rate the hedge fund client was willing to pay to borrow it. It's called good customer service.

casca• 14 years ago

That naked short selling is allowed is an anachronism coupled with the lobbying of the self-interested. In the olden days, it was reasonable to give a time delay to deliver the physical paper that proved ownership. Now everything is electronic so _could_ be verified instantly. But there's a lot of money to be made by doing it and the government will covert catastrophic losses, so it should be expected that everyone does it.

Fortunately the solution is quite simple. Force short sellers to make the shares available instantly at the time of the short. They could be held in escrow by the exchange until settlement either way. Go go gadget SEC?

roel_v4• 14 years ago

What's the problem with it, really? If A promises B to sell him something and then A can't deliver for some reason, then B will stand to be compensated by A for any damages resulting from that. Why would it be special for stock? Of course there is the risk that massive naked trades will influence the price of stocks, but that should just be priced in, like any other risk, no? What am I missing?

joe_the_user3• 14 years ago

Uh,

The risk of massive short sales are not to the naked short-sellers. Thus the market does not work as an automatic way system taking this into account.

Moreover, the hypothetical that the market prices in bad behavior is not a justification for bad behavior.

Yrlec2• 14 years ago

When you're selling something you don't own you're distorting the market's price discovery mechanisms. In many contexts I think most people would consider it fraudulent to sell something before you've bought it.

quantgenius8• 14 years ago

The solution is NOT simple. I suppose it always seems simple to impose rules on a system you don't understand.

Thousands of systems would need to change at brokers, banks, clearing firms, trade processing firms etc including mainframes running Cobol software that was written in the 70's at quasi-governmental firms like the DTC. Documentation for these systems is mainly non-existent or incorrect.

What happens now is that at the end of the day registered brokers net out all trades done by them and send files which include trade details and net trades to the DTC. On T+1, you and T+2 you figure out what would fail and why. For example, let's say Zuckerberg sells some FB. Based on FB's corporate bylaws his shares change class when he sells them so they have fewer voting rights. So when he sells them the system at his brokerage barfs because the cusip does not match the publicly traded share cusip which then leads to a cascade of fails down the line because whoever he sold it to may have sold it to someone else.

You can't just automate rules like change the class of stock if Zuck sells it because the rules are different for every company and the rules change as the board adopts new bylaws and companies change their capital structure and the systems can't change that quickly because they have to be super, super reliable. If the DTC's clearing systems go down, the US economy has a BIG PROBLEM.

About 1% of trades result in a potential failure to deliver on T+1. The vast majority of these are resolved between T+1 and T+3 so that the trade clears. Some don't. It could be something like an investor who still holds paper certificates delivering them to the broker but the courier was late etc. Resolving these fails often involves the company's registrar in addition to financial systems, for example FB's registrar would have to change the class of stock if Zuck sold his stock.

Company registrar's aren't exactly paragons of customer service. Companies generally want to hire the cheapest firm because to them it's just an added arcane expense. The registrar provides service to a back office guy at a broker, and he back office guy really doesn't have a channel to complain to the company's CFO. So the registrar generally has no incentive to provide good service and the company has no reason to fire them and change them because as far as the company is concerned it's just a expense they want to minimize and changing registrars is a huge headache.

A failure to deliver does not mean the trade is somehow cancelled. It means that either the broker or the seller needs to find stock that is good to deliver. If you go out to T+10 and there isn't a VERY GOOD DOCUMENTED reason for the fail, like a tardy registrar, the buying broker and DTC will demand deliver and buy you in if necessary, ie buy the stock in the open market and deduct your account for the cost including a generous commission for themselves. So a fail is generally a very bad thing that a seller and his broker really, really want to avoid.

Pre-2008 the rules around short selling were that if a stock was widely available for borrow, you could short it without checking. Widely available means many different owners willing to lend the stock at reasonable prices.

In 2008 in a totally made up frenzy the, same SEC which failed to stop Madoff decided to impose a new rule stating that you needed affirmative determination of a borrow before you shorted a stock. The rule makes no sense because if there were to be an event that would cause a widely available stock to suddenly become not available, you would still have fails. Remember settlement is T+3, so you would check the accounts of the people willing to lend the stock and see that they still had the stock there without realizing that it would be gone in 3 days.

The SEC subpoenaed pretty much everyone because they decided that of course the market and particularly financial stocks were going down due to naked shorting as opposed to uh'm the economy and found essentially no evidence of manipulative short selling. They brought one case against a tiny broker who made a minor paperwork error essentially unrelated to affirmative borrow other than a truly tortured link link between the two made in the SEC's press release.

Short selling is a GOOD THING. Remember in any market, the people who have the biggest influence on prices are the ones who have amassed the most capital by consistently being right. When someone who has been consistently right decides to sell a stock short, s/he is providing a very valuable service to the economy by signaling that what she's shorting is overpriced. Remember shorting is very risky. The price of a stock has no upper limit but can only go as low as 0. So when you short you can make at most the current price of the stock but lose an infinite amount. Also remember that when you short, you also have to buy the stock back at some point. There are those pesky people you borrowed the stock from who want you to return it. So on average you are selling the stock when it's overpriced and buying it back when it's underpriced and the price is under pressure. The overall mechanism creates a very valuable self correction mechanism that is absolutely essential for a healthy market. If the SEC really cared about the market's health as opposed to PR, they would be working to make shorting easier because it prevents bubbles.

Remember that the total amount of short interest in a stock is a publicly available number. If the stock of a company you are an insider of is heavily shorted and you think it's cheap and you actually believe it as opposed to want to create a huge hullabaloo, you can go out and buy it, make noise about the fact that you are buying it. If the stock is genuinely cheap or even fairly priced, you will generally create a short squeeze where shorts are forced to buy back quickly as the stock shoots up in their face. OSTK insiders did not do that.

I don't actually know of a single instance where an insider or corporate inside has complained about a short seller shorting their stock and pushing the price down where there actually weren't genuine problems with the company. Remember it often takes 2-3 years for the whole story to come out and by then the media may not want to acknowledge that they breathlessly repeated every bit of tripe the CEO said about the evil, faceless short sellers. Usually a CEO complaining or a company filing a lawsuit against a short seller is a very high probability sign that the company is in genuine trouble because otherwise you would see insiders backing up the truck to buy the stock.

I find it truly amazing that the press and from the comments even the supposedly informed set at Hacker News would get worked up about this when it's about OSTK, Overstock.com. They sued people for shorting the stock and driving the price down for 60 dollars a share!! by making negative statements about the company that weren't true. With the benefit of hindsight it's clear that pretty much everything negative publicly said about OSTK was not just true but probably too optimistic, and the management has been lying which is felony under US law. Yet the SEC refuses to prosecute the management which is who is truly responsible for fleecing gullible retail investors.

It's truly astounding that OSTK is now choosing to go after GS based on snippets of emails etc which sound bad if you don't understand financial terminology and also don't have context but really aren't anything particularly bad, unless of course you let Tabibi self-aggrandize himself by claiming he understands stuff he has absolutely no clue about.

CUR10US2• 14 years ago

Should the public have the right to see the full details of "fails"?

The SEC website says disclosing this info would put firms like GS at a competitive disadvantage.

But someone has to know which sales cleared and which did not.

How can we accurately set a market price for something based on historical sales data that may in part be false (i.e. sales that were never cleared)?

rapind2• 14 years ago

Every time I read about complex wall street scams I get so unreasonably infuriated. At this point I can't help but unfairly assume that anyone who works at an investment bank is a complete douche. Just thinking about the bailouts gets me worked up.

twoodfin• 14 years ago

The bailouts that have largely been paid back? At this point, even if you're a high income taxpayer, these guys lost very little money that you didn't choose to give them.

And really, getting your blood boiling is just about all Taibbi is good for.

rapind2• 14 years ago

I'm not sure I'd say largely paid back. http://projects.propublica.org/bailout/main/summary

asynchronous13• 14 years ago

Ok, here's the full quote:

  Last week, in response to an Overstock.com 
  motion to unseal certain documents, the 
  banks' lawyers, apparently accidentally, 
  filed an unredacted version of Overstock's 
  motion as an exhibit in their declaration 
  of opposition to that motion. In doing so, 
  they inadvertently entered into the public 
  record a sort of greatest-hits selection of 
  the very material they've been fighting for 
  years to keep sealed.

And now let's parse it:

  Last week, the banks' lawyers filed an 
  unredacted version of Overstock's motion 
  as an exhibit in their declaration of 
  opposition to that motion.

This means that Overstock's accusation is now public. This says nothing about the veracity of the accusation.

Natsu• 14 years ago

> This means that Overstock's accusation is now public. This says nothing about the veracity of the accusation.

The information about this comes from internal Goldman emails produced during discovery which admit to the practice. Emails that Goldman has fought in court to prevent the release of, only to have one of their own lawyers screw up by filing something not under seal.

EDIT: If you want to quote the actual emails, I've added most of the quotes from them below:

"Fuck the compliance area – procedures, schmecedures," chirps Peter Melz, former president of Merrill Lynch Professional Clearing Corp. (a.k.a. Merrill Pro), when a subordinate worries about the company failing to comply with the rules governing short sales.

"He should be someone we can work with, especially if he sees that cooperation results in resources, both data and funding," the lobbyist writes, "while resistance results in isolation."

“We are NOT borrowing negatives… I have made that clear from the beginning. Why would we want to borrow them? We want to fail them.”

“Two months ago 107% of the floating was short!”

“We have to be careful not to link locates to fails [because] we have told the regulators we can’t,” one executive is quoted as saying, in the document.

CUR10US2• 14 years ago

Has anyone read the motion (available from an economist.com server)? This what the Rolling Stone article is based on.

Is the issue whether and how GS makes money from the practice of naked short selling? Maybe the issue is that feeding the market with info about short sales that are never actually cleared (but which the market assumes will be cleared), can destroy the value of a company's stock.

Obviously if you can sell something without ever having to own or deliver it (is that really a sale?), you can do a lot of selling; and you can exert considerable influence on the market for a stock.

Maybe what happened here is a company, Overstock, believes they got screwed by naked short selling.

I need to read the motion to get a better idea of what happened.

krob• 14 years ago

This kind of aggressive shorting makes me start to wonder are these type of investors the real cancer behind the unemployment growth in this country? You read more and more about these kind of shenanigans and start to wonder what would happen if we actually started to lock-up/punish all of these crooks, what would be the aftermath? Would we see a slow growth in this countries GDP based on income growth from small & large businesses? Makes you wonder if we came swinging with large hammers and destroyed their worlds what kind of foundation would arise out of their financial destruction.

rottyguy• 14 years ago

I started reading Patrick Byrne's adventures in Naked Short Selling in the beginning but have since trailed off (this is like 10 years ago mind you). Perhaps his infamous "Miscreants Ball" diatribe kicked everything off which has been ridiculed since day one but begins to be prescient as more and more news of NSS surfaces. He now funds/participates in http://www.deepcapture.com/ which is fun reading from time to time. It's been quite a ride; I must give him kudos for his stamina but having read his speech from Pan-Mass http://www.pmc.org/articles.asp?ArticleID=110 regarding his life, one can't help but root for the guy.

Documents Show How Goldman et al Engaged in 'Naked Short Selling'

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