May 4, 2009
Naked Shorting of Stocks - The Simple, Literal Explanation
The St. Smallcap example conveyed the dynamics of the manipulation, but it was only a metaphor. This blog will provide an explanation whose truth is more literal.
You and I enter a stock trade. You buy a share of stock from me. You hand over your money, and I hand over the share of stock. That is called, settlement.
It may surprise you to learn that there are loopholes in our nations regulations that permit some people, when it comes time to settle, to hand over nothing but an IOU. By using one of these loopholes, when the time comes for settlement I can take your money but say, Im not delivering you any stock. Im just giving you an IOU for a share of stock that I will deliver later.
There are reasons these loopholes came into existence. If someone made a mistake by signing the wrong line on a form, for example, or mistakenly sold more shares than he really had, one would not want the entire system to vapor-lock as the mistake was rectified. So the system has been designed so that the gears do not get hung up on minor mistakes. The general idea is that, if someone sells shares it turns out he cannot deliver, he can create these IOUs and send them on as though they were real shares, giving himself time to clean up whatever error he is experiencing, and sending the real shares a couple days later.
There is no system in place to alert you to the fact that you sent me your money and received nothing but an IOU. The system treats these IOUs just as though they were real shares. Your brokerage statement will say that you got shares, even though I never sent anything but an IOU. You can sell them, and that IOU will pass on through the system into someone elses account.
The problem is, suppose I (having mastered these loopholes) start using the systems forgiveness strategically? Suppose I find a company that is likely to need capital to expand, or simply survive, in the near future? They plan on raising that capital by issuing shares of stock to the public (there is no crime in that: for example, lots of young pharmaceutical companies sip at the capital markets for years as they get going). Imagine that I target one of them, and deliberately go out selling that companys shares into the marketplace, yet instead of delivering stock, I deliver nothing but IOUs. I flood the market with them, always standing ready to sell more than anyone wants to buy. My IOUs are anything but temporary: they drift around in the market for weeks, months, and eventually years. If anyone gets mad and tells me that I have to deliver real shares against one of the IOUs I sold, I say, Sure, Ill deliver shares against that IOU, but what I deliver is just another IOU. Eventually I flood the market with so many IOUs that people end up reselling them, and they go and on until there are more share-IOUs bouncing around than there are actual shares.
What will the effect be on the price of those shares? If I have chosen a company like, for example, IBM, the effect will be negligible (just as in the example of the preceding blog, if the hedge funds brought their money machines to Paris and printed off 100 million temporary Euros to spend around France and Germany, it would not cause any real harm before they bought them all back as they departed).
But remember how the hedge fund managers destroyed the economy of St. Smallcap, so that the temporary currency they had issued could be paid off in the end for next-to-nothing? Similarly, if instead of choosing IBM I choose a tiny company, and I generate more IOUs than there are shares of stock in the company, then the market in those shares will crack just as surely as $100 million of fake currency would crack the tiny island economy of St. Smallcap. Once cracked, the stock becomes next-to-worthless. And if I manage to issue enough IOUs in my target companys stock that it cracks and becomes near-worthless, they become barely an obligation at all. Who cares about millions of IOUs, if those IOUs are for something with infinitesimal value?
I walk away with my winnings. The company, however, is in a fix: they planned on issuing stock to raise capital, but now their stock price has been destroyed through my manipulations, and they cannot raise capital. Maybe they run out of funds and disappear, or maybe they go into hibernation mode in order to nurse what capital they have. In either case, society is deprived of the output and the jobs that would have existed were it not for my villainy.
It may be hard to believe, but such loopholes really do exist (I will be explaining several of them in subsequent blogs). In reality, however, neither you (if you are like most Americans) nor I can actually use them. Only large hedge funds and broker-dealers can access these loopholes to create IOUs (just as, in the story of St. Smallcap, only hedge funds were allowed to own the currency machines with which to print off that temporary currency). As we will see in more detail, these hedge funds and broker-dealers have learned how to manipulate these loopholes in the stock settlement system so as to flood the market with over a billion IOUs (maybe many billion) in hundreds of companies. In doing so, they have disrupted the market for shares of companies that are researching cures for cancer and other illnesses, figuring out how to make blood substitutes to treat cases of acute blood loss, and building mine-resistant vehicles for troops in Iraq. Hundreds of such corporate St. Smallcaps have been damaged or destroyed. Thus, cancer patients are being deprived of treatments, accident victims are dying of acute blood loss, and soldiers in Iraq are dying from IEDs, so that some hedge fund ass-clowns can drive new Ferraris.
It really is that simple.