Dr. Patrick Byrne on naked short-selling

Dr. Patrick Byrne, CEO of Overstock has had more than his fair share of naked shorting. But this is not a guy who lays down and takes it, he fights back, started the excellent deepcapture.com website, the best background information on naked shorting on the web. Here, the story of an editorial he wrote years ago, but the Newspaper backed out in publishing it at the time (just as he predicted). Now, Forbes has published it, you can find it below as well.  In essence, it’s another regulation problem, or lack of it.

The Simple Truth About Naked Short Selling – A Bit Late
September 24th, 2008 by Mark Mitchell

More than two years ago, Patrick Byrne, the future Deep Capture reporter, had dinner with an editor of one of the nation’s most important newspapers. The editor said, “I know the media has not been fair to you on the naked short selling issue. Would you like to write an editorial?”

Patrick said, “Sure, but it won’t get published.”

The editor said, “I decide what gets published.”

Patrick wrote the editorial. A day after he submitted it, the editor, known to be a gentleman, called Patrick and said, “I am terribly embarrassed to have to tell you this, but it appears that I will not be able to publish your editorial – or, for that matter, anything else written by you.”

Other publications seemed to have a similar attitude, so Patrick put his editorial in a drawer.

But he didn’t shut up about naked short selling. He said that this problem would eventually crash the financial system. He lambasted the media for failing to cover it.

The media did not listen. Influential journalists, I am embarrassed to tell you, went out of their way to silence or ridicule people who said naked short selling was a problem.

Well, now that Wall Street has suffered the biggest calamity since the Great Depression, almost everyone agrees that naked short selling is a problem. John McCain, Hillary Clinton, the Chairman of the SEC, the Secretary of the Treasury, and the CEOs of some of the very investment banks that have long participated in naked short selling – they all said last week that this crime must be stopped, or the financial system is toast.

So, just for kicks, Patrick dusted off his editorial.

This time, it was published – by Forbes.com

Too late now, perhaps. But, please, read this editorial. Read it because it is so simple. Read it because you will see what some of our most sophisticated financial journalists failed, or refused, to grasp.

Read it because the media could not, or would not, and this says something very important about the quality of our public discourse.

[Below, the article as published by Forbes recently]

Naked In Wonderland
Patrick Byrne 09.23.08, 12:50 PM ET

Recent concerns about short-selling have culminated in a regulatory flurry of emergency orders and amendments. What should be of concern, however, is not short-selling per se: As its devotees frequently remind us, short-selling is a vital and legitimate market activity. What should be of concern are specific types of stock manipulation that cloak themselves within legitimate activities such as shorting, and which, in one way or another, rely upon loopholes in our nation’s system of stock settlement.

Settlement” is the moment in a stock trade when the seller receives money and the buyer receives stock. Our settlement system has gaping loopholes that allow sellers to sell shares but fail to deliver them. In such cases, the system creates IOUs for shares, and lets those “stock IOUs” circulate in the expectation the seller will soon correct his error. This is harmless–as long as the IOUs are inadvertent, temporary and few.

Manipulators are exploiting these loopholes, however, selling stock they do not intend to deliver. This is often referred to as “naked short-selling” (short-selling because they feign selling borrowed shares; naked because they don’t really borrow shares, but instead deliberately rely on loopholes to generate and hide stock IOUs).

However, naked short-selling is just one form this manipulation takes. Other forms include failed long-sales, abuse of the option-market-maker exception, failed offshore deliveries and ex-clearing abuses. The common denominator of these manipulations is that they flood the system with stock IOUs that are deliberate, persistent and massive.

By whatever name, these actions create small, medium and large problems.

The small problem is that stock IOUs corrupt corporate democracy because the system has trouble distinguishing real stock with real votes from stock IOUs with fake votes. In 2006, Bloomberg Markets wrote, “A robust market for stock loans puts into circulation billions of borrowed shares that can create multiple votes that corrupt corporate elections.”

Bloomberg quoted Registrar & Transfer CEO Thomas Montrone: “It is an abomination. … A lot of the time, we have no idea who’s entitled to vote and who isn’t. It’s nothing short of criminal.” Bloomberg suggested arbitrageurs are exploiting this, and concluded that until it is fixed, “double and triple voting on one share will continue to make a mockery of shareholder democracy.”

The medium problem is that manipulators selling millions of stock IOUs drive down share prices: If they choose the right target (e.g., a large financial firm already weakened by exposure to the mortgage crisis, or a small biotech company sipping at capital as it develops drugs), this can crash the firm.

According to former Undersecretary of Commerce for Economics Dr. Robert Shapiro, “There is considerable evidence that market manipulation through the use of naked short-sales has been much more common than almost anyone has suspected, and certainly more widespread than most investors believe.”

His research turned up at least 200 companies that were destroyed, for “a combined market loss of more than $105 billion.” Shapiro added, “we believe that this type of stock manipulation has occurred in many hundreds and perhaps thousands of cases over the last decade. … Illicit short-sales on such a scale or anything approaching it point to grave inadequacies in the current regulatory regime.”

The large problem is that unsettled stock trades create systemic risk. Imagine that a hedge fund generates IOUs on 5 million shares of a $1 stock and carries this as a $5 million liability. To settle these IOUs, the fund must obtain stock. However, the act of buying 5 million shares of a thinly traded stock forces its price up (i.e., a “squeeze”). The fund must pay more than $1 per share, so the $5 million liability balloons.

The Securities and Exchange Commission has revealed that, during the second quarter of 2008, there were $14.9 billion in stock IOUs at just the tip of the non-settlement iceberg. The commission refuses to reveal (and, in fact, may not know) the size of the whole iceberg. Public data suggests the entire bucket may be over $150 billion; settling it would cost more than $150 billion, but perhaps far, far more.

Our settlement system lies within a black-box called the Depository Trust & Clearance Corporation. The DTCC is essentially unregulated, but is owned by those who benefit from seeing these activities continue–investment banks, which in return for prime brokerage fees, enable manipulative hedge funds.

When these loopholes began to be exposed this winter, Wall Street started to eat its own. In a moment of Shakespearean irony, Bear Stearns–with its legendary willingness to provide cover to manipulative hedge funds–became the target. Stock IOUs in Bear Stearns spiked, as they subsequently did in Lehman Brothers (nyse: LEH – news – people ), Merrill Lynch (nyse: MER – news – people ), Fannie Mae (nyse: FNM – news – people ) and Freddie Mac (nyse: FRE – news – people ).

In an absurdity worthy of Lewis Carroll, the SEC promulgated a temporary (and now expired) emergency order against doing to these and 16 other firms what has been illegal for seven decades: selling non-existent stock and deliberately relying upon stock IOUs. That the 19 companies protected included prime brokers widely thought to be enabling naked shorting against other firms may only be described as “Kafkaesque.”

Since its Aug. 12 expiration, four of the 19 firms have been lost. The rest of the financial market balances on a precipice as the SEC temporizes, adopting half-measures with Nerf penalties, draconian measures (such as forbidding all shorting in financial stocks), contradictory measures (re-opening the option-market-maker exception for financial stocks), and “don’t ask, don’t tell” measures (such as yesterday’s, requiring option-market makers not to sell puts to someone they think is increasing a net short position in a financial stock).

While the SEC performs its best headless chicken imitation, we must not be distracted from the fundamental problem: Our system is rife with unsettled trades that are deliberate, persistent and massive.

Commenting on this last year, Warren Buffett’s partner, Charles Munger, said, “Those delays in delivering sometimes reflect tremendous slop in the clearance process. It is not good for a civilization to have huge slop. Sort of like how it isn’t good to have a lot of slop in nuclear power plants.” Charlie Munger is known for many things, but careless word choice is not one of them.