Thursday, July 17

Now the US Government Has A Problem With Short Sales?!?!?!

It is funny how all of a sudden the US Government takes an interest in something once it becomes liable for the cost.

Takes this news item:

US regulators will take emergency action to stop abusive short-selling in shares of financial institutions such as mortgage financiers Fannie Mae, Freddie Mac and Lehman Brothers.

Christopher Cox, Securities and Exchange Commission chairman, told legislators yesterday that the agency would issue an emergency rule to stop so-called "naked" short-selling of shares in significant financial entities. The SEC will also consider new rules to extend those trading limits to the rest of the market.

In "naked" short-selling, traders aim to profit from selling shares they do not own and have not borrowed. The emergency rule would require any person making a short sale to borrow the securities before the short sale is effected and deliver the securities on the settlement date. -
So now that the US Treasury might be dealing with the collapse of Fannie Mae and Freddie Mac stock, they have a problem with short sales of stock, especially in cases of naked shorting. Keep in mind that up to this point the Government and stock market regulators have basically dismissed ALL complaints about stock market short sale abuses.  But now, not only do they appear to admit that there is substantial naked shorting, but that there is also 'abusive' naking shorting as well.

Still, this is pretty damn short sided since it only applies to certain large companies specifically named in the order. I guess it is still ok to abusively short other stocks.  This limited order might oddly push abusive short sellers to other stocks increasing the effect on them of this abusive practice. Lets forget naked shorting for a minute and just concentrate on the shorting of stock.

A person ‘shorts’ a stock by borrowing it and then selling it. He then hopes to make a profit by buying the stock back at a lower price. Short selling is normally defined as an ‘accepted’ practice in the Stock Market.

Short selling:
An investor who sells stock short borrows shares from a brokerage house and sells them to another buyer. Proceeds from the sale go into the shorter's account. He must buy those shares back (cover) at some point in time and return them to the lender.
Shorting has the effect of increasing the total number of shares available. Imagine a company that has ten shares of stock. I own five of the shares and you own five. Your shares are borrowed by a broker who then sells them. The end result, I own five shares, you own five shares, buyer ‘x’ owns five shares. That totals fifteen shares. The way the professionals reason that this is ok is because somewhere there is shorter ‘y’ who owes fives shares. In this basic example, the total number of shares available was increased by 50%. However, there are plenty of stocks with five and even ten percent of the stock ‘float’ shorted. That increases the number of shares available by millions.

Not very fair is it?  Now this situation is with the shares being properly 'borrowed'.  I question the validity of being able to short a stock. Unfortunately for stockholders, shorting a stock has the result of increasing the amount of shares that are available for sale.

A result of short sales is an increase in the supply of shares available to be sold at every price level and reducing the pressure on the stock price to rise in order to meet a demand for the shares, even if all the stockholders have no intention of selling, since others are willing to take your shares and sell them (for you.) It is almost if the system is stacked to the side of selling.

Now imagine the increase in the available pool of shares when brokers start naked selling them.

Let’s say that none of a company's stockholders are interested in selling their stock and none are available to borrow to short, but a broker has a client (if not himself) who is just dying to short it. This brings us to the practice/abuse of ‘naked shorting.’

Naked shorting is when a stock is sold short but the ‘borrowed share’ is never delivered three days later at settlement time. Essentially, the broker sold the share without ever buying or borrowing it.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate", and it is a legal requirement that U.S. regulated broker-dealers not permit their customers to short securities without first obtaining a locate. Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security. The vast majority of stocks borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies (see list below). Sometimes, brokers are able to borrow stocks from their customers who own "long" positions. In these cases, if the customer has fully paid for the long position, the broker can not borrow the security without the express permission of the customer, and the broker must provide the customer with collateral and pay a fee to the customer. In cases where the customer has not fully paid for the long position (meaning, the customer borrowed money from the broker in order to finance the purchase of the security), the broker will not need to inform the customer that the long position is being used to effect delivery of another client's short sale. - Wikipedia
This is not an acceptable way to run a market. Not only that but the “locating” of these shares is deceptive. Take a look at how the regulators define locating stock to short:
Question 4.1: How should broker-dealers determine “reasonableness” to satisfy the locate requirement of Regulation SHO?

Answer: Rule 203(b)(1)(ii) permits a broker or dealer to accept a short sale order in an equity security if the broker-dealer has reasonable grounds to believe that the security can be borrowed so that it can be delivered on the settlement date. “Reasonableness” is determined based on the facts and circumstances of the particular transaction. What is reasonable in one context may not be reasonable in another context. The Commission provided some examples of reasonableness in the Adopting Release. (69 FR at 48014 and Footnotes 58, 61 and 62).
Why on earth is the settlement day for trades still three days later when we have electronic trading? How is it possible for a broker to sell shares of a stock that it does not have, without landing in jail? This is criminal behavior.  It only the regulations that permit this sort of behavior. How is it that a broker is permitted to sell short shares if he has a reasonable certainty that he will be able to locate shares to borrow? How is it that I cannot buy actual shares unless they are sure I have the funds in my account before I even place the order, let alone let me provide funds on the settlement date. The rule should be simple; you cannot short a stock unless you have the borrowed shares in-hand.

Better yet, they should do away with short selling of stock.  If you want to sell a stock, you should buy it first!

Previous Related Posts:
"the biggest global margin call in history"20 Aug 07
You should not be trading on Margin - 9 Jan 2006 (READ)
Congress Should Investigate Short Selling Records - 9 June 2006
Are Brokers 'Screwing' Stockholders through Short Selling? - 6 April 2006
Criminal Charges for Hedge Fund Over Naked Shorting - 9 Dec 2006
Morgan Stanley fined $2.9 Million for Rogue Trading - 26 Oct 2006
Do You Know If You Have A Margin Account? - 2 May 2007


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