Wall Street's Naked Swindle

http://www.rollingstone.com/politics/story/30481512/wall_streets_naked_swindle/print

by jasonlbaptiste • 17 years ago

162 95 17 years ago

rollingstone.com

wallflower• 17 years ago

Summary:

1) Hedge fund wants to short Bears Stearns

2) Hedge fund borrows 1M shares and sells them. Deposits its money with a Prime Broker.

3) Stock in Bears Stearns falls in price and hedge fund buys back the 1M shares it shorted (making a profit)

Now, where this gets insane is the shares the hedge fund borrows don't actually exist (it sells stock it does not have, delivering IOUs to the stock buyers and by dumping those non-existent shares it depresses the stock price)

> Instead, Wall Street now serves, in the words of one former investment executive, as "Lucy to America's Charlie Brown," endlessly creating new products to lure the great herd of unwitting investors into whatever tawdry greed-bubble is being spun at the moment

jacquesm3• 17 years ago

There was a ban on short selling financials for a while to stop this kind of stuff. Maybe they rescinded it too soon.

http://www.sec.gov/news/press/2008/2008-211.htm

yangyang5• 17 years ago

What this article is getting at is naked shorting. That ban included "normal" shorting (borrowing shares first).

gills2• 17 years ago

Good job, you read the first page.

The salient point of the article is calling out the obvious and rampant corruption that is strangling our economy; naked short-selling is an example to explain it.

NathanKP• 17 years ago

Wow. This article is very wordy, but it does a tremendous job of explaining how the stock market is basically completely corrupt. Its a wonder that our American economic system hasn't collapsed already.

brown9-23• 17 years ago

I guess it depends on your definiton of "collapsed".

gloob• 17 years ago

If you think "collapsed" is a legitimate description of the present state of the American economy, I tremble to contemplate the words you would use to describe, say, Zimbabwe's.

Edit: That, alone, is a tad too much snark with a tad too little data for me to leave it unadorned in good conscience. Here's a couple points of interest:

  1. In 2003, the Zimbabwean economy shrunk by 18 percent.
  2. In 2008, the estimated inflation rate in Zimbabwe was 231 000 000 percent.
  3. By late 2008, official statistics put that at 516 quintillion percent
  4. The Zimbabwean Dollar officially ceased to exist on 1 July, 2009
     (quoth Wikipedia; I'm not making this up).

America's doing just dandy, all things considered.

Edit again: On a non-economic front, it might be interesting to note that Zimbabwe's life expectancy is in the mid-30s for both sexes.

gills2• 17 years ago

We have collapsed. It's called denial.

gaius• 17 years ago

I must have missed the bread queue at the bakery this morning...

Seriously. There are still people alive who remember the Great Depression. Go find one and ask what it was like. We're not even close to that.

jsz0• 17 years ago

It's not all that bad. Shorting, credit default swaps and all these other ugly tricks are a comparatively small part of the overall system. The vast majority of the trading that happens everyday is completely legitimate old school business. The US economy is also freakishly resilient. We had an almost total collapse of our credit system last year and while we don't know the full long term ramifications yet it does appear we're going to make it through it without too much gloom & doom. It's somewhat of a miracle that we've only seen a doubling of the unemployment rate and very little (if any?) inflation or deflation due to all these external forces at work on the market. The end result for most of us is maybe we couldn't buy that new car we wanted or had to cancel a vacation.

euroclydon2• 17 years ago

That's naive my friend, were it not for the fact that central banks all over the world held more dollars than any other foreign currency (a fact that is rapidly changing) the two trillion we have printed out of thin air would have immediately caused drastic inflation.

I don't think a nation's economy, resilient of not, gets to print two trillion twice, and since we haven't yet fixed the fundamental issues that got us here: trade deficit and federal deficit, we'll need another bailout soon, but it will cost more, something like four trillion. The world knows it, and that's whey they're moving away from the dollar as fast as they can. There is not much in the US economy for the rest of the world any more. If we do the right thing and pay our debts off, that means drastic consumption cuts, and if we don't then we just continue to consume with credit. So you see, it's a lose-lose for the rest of the world.

nazgulnarsil• 17 years ago

the dollar lost a huge amount of purchasing power between 2005-present. prices just havn't caught up yet. expect CPI inflation to continue to suck for the next few years.

benreesman• 17 years ago

there have always been haves and have-nots, those are the facts of life. but these guys (read: gs) are laughing their asses off at us. and I'm pretty pissed off about it.

jacquesm3• 17 years ago

The problem is that our whole system is based around rewarding essentially detrimental behaviour.

We'll be forever wondering what the landscape would have looked like if those banks had been allowed to collapse.

I personally think that short term we'd have been much worse off, but longer term quite possibly much better.

brown9-23• 17 years ago

One thing I don't get about naked short selling: if I bought shares from a short seller and it turns out these shares don't actually exist, what happens to the money I paid to the short seller?

In other words, does the buyer of the phantom shares have no recourse?

alex_h• 17 years ago

It appears that at least some of the time, the shares are delivered many weeks after the transaction date instead of the required 3 days. This would give the seller of the stock time to wait until the price had fallen before acquiring the stock and giving it to you to settle the transaction. However, I'm not sure how this would work when the number of promised shares far exceeds the actual number that exist.

I would love to hear if anyone knows how this works.

michaelbuckbee5• 17 years ago

Shorts are really contracts to buy and sell shares at a future time, not actually shares themselves. So, at some future point money has to change hands, not actual shares.

Think of it like a bet. If next Friday the share price is over a $100, I'll pay you the difference between whatever the price on the open market is and if it's less than $100 you pay me the difference.

hristov4• 17 years ago

I dont know for sure, but there probably is some type of recourse. But the time that would elapse until you start suing people is plenty of time for a short seller to make his money and give you your shares.

If the short seller is blown up or cornered, in other words if the price of the shares has climbed so much that the short seller will lose money, then you might be trying to sue somebody who is already in bankruptcy.

So that is another problem of shortselling: it affects not only the companies but buyers as well, because buyers may end up holding stock that does not actually exist.

michaelbuckbee5• 17 years ago

The entity victimized here isn't the buyer who is going short it is the company that is "falsely" shorted.

An extremely contrived example:

Say a company has a 1000 shares of stock out in the market.

The broker buys 250 of the shares to sell to the person who wants to short the stock.

So if you were looking at this stock from the outside you'd think: "There are 750 shares where people think the price of the stock is going to go up (or why else would they have bought it) and there are 250 shares where people are betting that the price is going to go down (which is how you make money by going short)".

Note the 750 shares + 250 shorts = 1000 shares

So if someone wanted to short this company on 500 shares, the broker can't find the extra 250 on the open market so they sell the short positions even though they don't have a stock to associate against the last 250 (hence they are "naked").

So you have: 750 shares + 250 actual shorts + 250 naked shorts = 1250 positions in the market on a company that only has issued a 1000 shares.

So now you're an investor and you're trying to guess what the future share price of a company will be and you have:

Company A with legit shots which you can think of as 750 bets the stock will go up vs 250 bets the stock will go down.

and

Company B with naked shorts which you can think of as 750 bets the stock will go up vs 500 bets the stock will go down.

You'd look at the two of these and go: "Gee, there sure are more people in the world that think Company B's price is going to go down. I'm going to sell my Company B shares before they really tumble and buy up some of that good Company A."

So the naked shorts make Company B look less attractive which drives the price down further (making more money for the short positions).

nsrivast• 17 years ago

In this situation, there are more bets/people/indications/information that Company B's price will go down.

Yet Company B does not necessarily look less attractive - a high amount of short sales might mean a rise in the price when people cover (buy back) their shorts.

yangyang5• 17 years ago

> The broker buys 250 of the shares to sell to the person who wants to short the stock.

No. The entity that wants to short will locate (or get their PB to locate) shares to borrow that they will then sell, in order to short. They will pay interest on that borrow, and it can get quite expensive if that stock hard to borrow. They have to return the shares at some point - either when they decide to cover their short, or the lender recalls them.

Either way, the lender is still "betting" on the price going up, as they will get the shares back at some point in the future.

Xichekolas3• 17 years ago

> So the naked shorts make Company B look less attractive which drives the price down further

It's not even a matter of attractiveness (although false rumors would definitely fall in that category).

If you have more people trying to buy a stock than those willing to sell (at the current price), the price will rise until more people are willing to sell or fewer people are willing to buy.

Likewise, if more people are looking to sell (at the current price) than to buy, the price will go down until people are either no longer willing to sell, or more people want to buy.

Naked shorting creates excess supply. You suddenly have A LOT more 'shares' being sold, without a corresponding increase in buyers.

As such, the share price declines. Couple this with nasty rumors, and the declining share price doesn't entice any new buyers (which is normally the case when something gets cheap). As the price caves further, and the rumors persist, existing owners start to worry, and decide to get out before it gets worse. Now the downward spiral is in full force. Everyone wants off the sinking ship.

abalashov• 17 years ago

I claim no authority in the matter, but suspect that what happens is that from the buyer's point of view, the shares do exist - superficially. They are represented in some sort of "virtual" format by the seller and backed by some sort of obligation note from the Prime Broker to produce those shares on demand.

It's sort of like calling a revolving credit line; if the lender really needs the cash back, they can do it, but most of the time, they don't, and meanwhile, everything you've bought with it is real money for all practical purposes for anyone receiving it.

That's just a guess, but logic would suggest I am right. Who in their right mind would buy shares they know are phantom? I think the whole point is that the status of the shares is opaque to the buyer.

There are lots of these kinds of transactions in markets; there is some sort of virtual "advance" followed by some sort of belated follow-up/collection effort/call to actually settle the gap. The receiver doesn't know the difference. To some extent, these transactions support efficiency; it's just like if I borrow $1500 from my friend for 3 days to pay the mortgage due today while waiting for money to come in a few days later (an actual situation resembling what I face as a bootstrapped small business owner every month, minus the friend to borrow from!). But when it gets out of hand on this scale, it gets out of hand.

frig• 17 years ago

Can't see why you're being downmodded as you're quite close to the nitty-gritty mechanics.

Like most financial systems there's how people think it works and then you look at the actual mechanics and it's quite different; this often leads to semi-informed people thinking they know more than they do.

Read here:

http://www.law.cornell.edu/ucc/8/

...section 5 (pretty accessible as legal codes go) for the basics.

Essentially the laws are structured so that when you buy securities through an intermediary:

- "purchasing" shares through an intermediary doesn't instantly give you the shares; it immediately gives you a legal claim against the intermediary to produce those shares

- the type of claim you get is very standardized (in terms of delivery times and rules around it, etc.)

This makes complete sense if you think about the early years of the stock market. If you went into a brokerage in Chicago in 1940 and bought shares in General Motors, would it really be reasonable to get an actual share certificate instantly? Within an hour? What if it's not Chicago but Poughkeepsie?

So the fraud-minimizing solution is that: "purchasing shares" from an intermediary grants you an enforceable claim for those shares that you purchased, but doesn't instantly give you actual shares (it couldn't then, economically).

(Needless to say this pushes some of the risk onto intermediaries: since you are buying at whatever price the agent quotes if the stock price were to change then the agent can't ransom "your" shares to you for the post-agreement price change.)

A consequence of combining this general setup with the modern electronic infrastructure is that what is essentially fractional-reserve stockbroking becomes possible (if enough brokerages are in on it and if the regulators aren't vigilant enough).

The current claims about naked short selling basically reduce to a claim that certain aspects of the order-clearing system are being exploited for fraudulent profit (essentially unregulated fractional-reserve lending, but the specific dynamics are a little different due to the nature of the assets involved).

Part of the issue is that if the scam works as the naked-short-selling people think it does then it works best when the naked-shorted company goes out of business within a reasonable time period from when the scam commenced (due to the specific mechanics of how the claimed scam is supposed to work); this makes it hard to accurately assess the merits of many of the claims, since the companies supposedly targeted are usually long-since gone and whenever a company goes out of business there's usually plenty of reasons why it failed that don't involve stock market shenanigans.

mattchew• 17 years ago

"Wall Street has turned the economy into a giant asset-stripping scheme, one whose purpose is to suck the last bits of meat from the carcass of the middle class . . . an economic drought temporarily left the hyenas . . ."

I can't take this sort of writing seriously in an article like this. It's fine for an internet rant that is supposed to make me laugh. In an article that is pretending to be an economic analysis, well, I quit reading.

I did see something about naked short selling. Naked short selling sounds fraudulent to me, but I'd like to read a intelligent defense of it from supporters of the practice. Anyone know of one?

michaelbuckbee5• 17 years ago

Within the framework of current regulations, I'd consider naked short selling as a close cousin to something like insider trading. It's not so much fraudulent as it is both an indicator and piece of knowledge that the rest of the market doesn't have.

In general it's disallowed because people just betting on the price of stocks instead of owning them (at least in some derivative way) is considered a bad idea.

yangyang5• 17 years ago

It's disallowed because it can cause failures to deliver if a borrow can't be located. Lots of fails can lead to systemic problems.

anamax3• 17 years ago

Insider trading is actually a form of fraud against the entity that owns the information.

For example, Google is allowed to trade on the fact that it's doing biz with Intel. Google's employees are not.

Dilpil• 17 years ago

Not too many people will defend naked short selling, it is an illegal scam.

j2d22• 17 years ago

It's perfectly legal.

http://www.businessinsider.com/john-carney-why-matt-taibbi-i...

anamax3• 17 years ago

Does this judgement apply to all forms of getting paid in advance? If not, what makes stocks different?

yummyfajitas2• 17 years ago

It's not necessarily illegal. Nokia, Nintendo and Tesla all openly do naked short selling of their products. They call this a "preorder" -- you preorder a Wii/N900/whatever and they deliver it on or before a fixed date.

It's only illegal when you do it to manipulate a market or if you intend not to deliver the shares.

davidw• 17 years ago

> I can't take this sort of writing seriously in an article like this.

I flagged it - it doesn't seem very germane to hacker news, and comments like the one you cite seem to set people off in directions that meander ever further away from the topic. And that includes 'intellectual curiosity' as part of the topic; mine certainly isn't satisfied by politicized ranting.

Xichekolas3• 17 years ago

I'd agree that it starts out as rather polemic, but if you start reading from "The roots of short-selling date back to 1973...", it's quite an informative article.

It's also amazing that we have to turn to Rolling Stone for this kind of investigative reporting. Where is the rest of the Fourth Estate?

tibbon2• 17 years ago

I think it shows a rather interesting way of 'hacking the system' actually for a worldwide system- and getting away with it.

bayes• 17 years ago

Perhaps I'm stupid - certainly I'm no economist - but I don't see what's wrong with naked short selling.

For a market to work well you want liquidity, in order for the traded prices to reflect all the information known to market participants. One of the problems in the UK electricity market (which happens to be my day job) is that relatively few companies trade other than those who physically produce or use electricity, which hampers the effectiveness of the markets and (probably) increases the prices customers end up paying for their electricity.

So why are shares so different to any other market? Why should only people who physically own them be able to trade them?

Presumably the attraction of such a policy is that it allows share prices to remain artificially high. Even if many market participants believe that a price is too high, they won't necessarily be able to act on that belief, and the bubble will remain inflated. But is that such a good thing in the long run?

borism2• 17 years ago

The article is not pretending to be economic analysis! It is author's investigative piece on collapses of two huge firms and practices that contributed to them. Economy related, sure, but not an "analysis"!

Naked short selling sounds fraudulent to me, but I'd like to read a intelligent defense of it from supporters of the practice.

So you think it is illegal, but would like to know how would practitioners justify it? Kinda perverse, like asking rapist how would (s)he defend rape.

Here's standard Naked Shorts' defense: it provides liquidity and makes markets more efficient.

protomyth• 17 years ago

It is illegal to gamble on the stock price (check some historical articles about gambling halls that took such bets). I am having a very hard time seeing how any of the derivatives are not gambling.

michaelbuckbee5• 17 years ago

You're at the heart of the issue here. Naked Shorts (because they are NOT associated with an actual share someplace) are gambling.

tyn• 17 years ago

Hedging is one use of derivatives that is not gambling.

sielskr• 17 years ago

That dispassionate and nonpartisan authority on our financial system, Rolling Stone Magazine.

mattmcknight• 17 years ago

It's preposterous to suggest that naked shorts killed Bear and Lehman, as this article does in some places, despite providing the real reasons in others. The naked shorts may have profited from it unfairly and driven the share price down (via the share inflation concept), but the banks were killed by not having the collateral for their insane leverage (and not getting protection from the government). Just because the stock price of a company drops, it doesn't mean it's going out business. This article confuses the sketchy method used to profit from the collapse with actually causing the collapse in many places, usually by suggesting that the shorts are motivated to cause the collapse, but with scant evidence of any connection.

Seriously, Overstock.Com? They're still losing money. The shorts were right.

For the other side of the shorting story, look at what happened everyone shorting VW in 2008 when Porsche upped their stake to 75%. It briefly became the highest value company in the world, as every short seller had their lunch eaten trying to find the few remaining shares to deliver.

hristov4• 17 years ago

The article actually mentions the other reasons for collapse of those banks. But the article makes it clear I think that naked shorts did cause the collapse as it happened, otherwise it would have happened much slower.

Also naked shorts allowed many people to profit unfairly, by doing something that is illegal but it is not properly enforced.

Regarding the VW story, were naked shorts even involved in that? I don't think VW trades in US exchanges and I am not sure whether naked shorts are a factor in Germany. NAked shorting should be differentiated from ordinary legal shorting. Legal shorting is not that problematic because there is a natural limit to it. Theoretically naked shorts can crash any company because they can flood the market with an enormous amount of shares.

chrischen• 17 years ago

If there really are that many holes in the American economic system, then it's not unlikely that's where terrorists would strike next, since America is physically more robust than its other areas like the economy.

jmtame• 17 years ago

Overstock.com CEO:

"This really isn't about my company," Byrne says. "I mean, I've made my money. My initial concern, of course, was with Overstock. But the more I learned about this, the more my real worry became 'Jesus, what are the implications for the system?' And given what happened to Bear and Lehman last year, I think we ended up seeing what some of those implications are."

jongraehl2• 17 years ago

Byrne tried to deny his company's real problems by blaming naked shorts.

bluedanieru• 17 years ago

"How about bonds? "Naked short-selling of stocks is nothing compared to what goes on in the bond market," says Trimbath, the former DTC staffer. Indeed, the practice of selling bonds without delivering them is so rampant it has even infected the market for U.S. Treasury notes. That's right — Wall Street has actually been brazen enough to counterfeit the debt of the United States government right under the eyes of regulators, in the middle of a historic series of government bailouts! In fact, the amount of failed trades in Treasury bonds — the equivalent of "phantom" stocks — has doubled since 2007. In a single week last July, some $250 billion worth of U.S. Treasury bonds were sold and not delivered."

That passage is a little alarming. A run on US government debt could be triggered by American financial firms themselves.

jdbeast002• 17 years ago

What should the layperson read to learn more about the inner-workings of financial systems? Any good books?

tibbon2• 17 years ago

This article actually does a shockingly good job. I'm not an economist, but I understood everything that was happening there.

Speaking of economists, reading The Economist is a pretty good way to get your feet wet initially. It's a magazine, but its pretty in depth, but at the same time doesn't assume you're an expert on all parts of the system.

alttab• 17 years ago

My girlfriend is a tax specialist for one of the most respected Mutual Funds in the country that doesn't do any wishy-washy derivative trading, she works directly with the CFO and the Comptroller.

I read this entire article to her out loud and she was actually impressed with the accuracy of what is usually sensationalist writing from the Rolling Stone.

As programmers who like to make black and white or otherwise binary decisions about things, I'd say we'd be the least qualified to make bogus or unfounded statements.

ig1• 17 years ago

I normally recommend The Complete Guide to Capital Markets for Quantitative Professionals by Alex Kuznetsov (despite the title you don't have to be a mathmo to read it, anyone with a technical mindset should be fine).

I'd avoid relying upon articles like this one though, from my experience they're frequently wrong.

I've been a developer on the leading equities analytics software, was lead developer on the worlds largest credit derivative trade settlement platform, and now work in currency trading. I don't have a huge in-depth knowledge in these areas, but I know enough that I can tell most of these articles are written by people who are completely clueless.

jhancock• 17 years ago

Thanks for the book tip. Now, assuming this article is clueless. It is well written, but ok, lest say its factually inaccurate. Where is the article that is accessible and has enough facts right?

jdbeast002• 17 years ago

i bought it...thanks. hope its good

known• 17 years ago

http://www-rcf.usc.edu/%7Elharris/Trading/Book/Book-extract.... (PDF)

cynicalkane3• 17 years ago

It's not that the inner workings of financial systems are obscure, but rather that there is so much misinformation around. Ask a simple question like "how does money work" and you will hear responses, in very loud and belligerent voices, from the gold-standard crowd, the full-reserve banking crowd, the anti-Fed crowd, the Rolling Stone-influenced true believers, the hyperinflation fearmongers, the deflation fearmongers, Austrian economics true believers, Randists, socialists, And most of them are wrong. I don't really feel like addressing them all, or at all, but you should see most of them are wrong because most of them are mutually contradictory. About the only thing the have in common is an irrational fear of banks, as if banks are breaking into homes and stealing money from single mothers. The signal to noise ratio is very high.

I'm not aware of any book that describes all the major parts of finance in one go, but Warren Buffet's shareholder letters (which have been collected in book form) are a good place to start. He explains so clearly what business is and is not that I think it will arm one with a good signal-to-noise filter. I think the hacker feels that highs, lows, Jim Cramer's screaming, stock charts, naked shorts, uptrends/downtrends, and all that other stuff is a basket of canards, but is unable to articulate this; armed with the knowledge of how and why exactly public corporations work and what their stock is for, he should be ready to use the same patterns of knowledge to tackle the rest of finance.

jeromec4• 17 years ago

Warren Buffet himself said he doesn't understand economics.

jackfoxy• 17 years ago

There are too many powerful people who would have had near real-time knowledge of the March 11 meeting, the insight to connect the dots, and the means to cover their tracks. I'm guessing it was a consortium that made the bet on Bear, thus spreading around the protection. We'll never know.

tlb• 17 years ago

He seems to argue both that the fall of Bear Stearns was inevitable, and that it's impossible that a smart outsider could simply have figured that out and bet against them, therefore the naked short must be due to insider trading. You can't have both.

DTrejo2• 17 years ago

From what I understood, he said that insiders instigated the fall of Bear Stearns, and smart outsiders joined in to finish them off.

DTrejo2• 17 years ago

The new president for whom we all had such high hopes went and hired Michael Froman, a Citigroup executive who accepted a $2.2 million bonus after he joined the White House, to serve on his economic transition team — at the same time the government was giving Citigroup a massive bailout. Then, after promising to curb the influence of lobbyists, Obama hired a former Goldman Sachs lobbyist, Mark Patterson, as chief of staff at the Treasury. He hired another Goldmanite, Gary Gensler, to police the commodities markets. He handed control of the Treasury and Federal Reserve over to Geithner and Bernanke, a pair of stooges who spent their whole careers being bellhops for New York bankers. And on the first anniversary of the collapse of Lehman Brothers, when he finally came to Wall Street to promote "serious financial reform," his plan proved to be so completely absent of balls that the share prices of the major banks soared at the news.

haseman• 17 years ago

Not a bad article, but he attributed to some giant evil conspiracy by the banks something that was, in fact, simple economics.

Banks weren't out to swindle people with all those 'new' investment funds, they were reacting to overwhelming demand from the managers of 80-something trillion dollars. That overwhelming demand was driven, in part, by the fed holding the discount window open for so long.

If we remove the author's notion of 'evil' intent on the banks part, for which there is little to no evidence, and chalk it back to 'incompetence' instead, the author's article becomes a rehash basic economics and a lot of empty hyperbole.

For a more dispassionate recap of the debacle, I'd recommend This American Life's article, the Global Pool of Money.

http://www.npr.org/templates/story/story.php?storyId=9032768...

Wall Street's Naked Swindle

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