Naked shortselling: Is it real?

I got curious when, during last week’s Congressional testimony by Hank Paulson and SEC Chairman Chris Cox about Fannie Mae and Freddie Mac, Cox decided to focus his testimony on the presence of naked shortselling, and the ways that the SEC was using to battle it.

What is naked shortselling? And how is it possible that it could be the reason for the spectacular collapse of some stocks in the market? As I myself have no direct experience in shortselling, the legal or the naked kind, it would be worthwhile for me to start with everybody’s definition of shortselling. This from wikipedia:

Short selling is a form of speculation that allows a trader to sell securities that he does not own, effectively taking a "negative position". They do this when they expect the value of the securities to decrease in the market, allowing them to sell securities at today's price and then buy the securities back when they decrease in value. With a large enough move in the price, the trader can purchase the securities, "covering" their position, for less money than they received for selling them earlier. The opposite case can also occur; if the price increases they will be forced to cover at a higher cost, a money-losing trade.

In order to make the initial sale, the regular method is first to "borrow" securities from a current shareholder, typically a bank or prime broker, agreeing to return them at some future date. The trader then delivers these borrowed shares to the buyer, a third party. The lender generally charges an interest fee on the share value during the time when the position is being held by the trader. When the trader wants to "unwind" the position, he buys back the shares in the market and return those to the lender. This short/borrow system ensures the trader has shares to deliver to his buyer, and the lender makes some money on a position that he was not actively trading.

Seems very straightforward to me. The way I understand how shortselling is supposed to be done, it will only work if the shorter can locate three counterparties: the person who lends him the stock, a buyer for the stock at current market price, and lastly, a seller who will sell the stock to him at a lower price later on. In short, many consenting investors should allow for the shortseller to, in a way, “test” or prove his hypothesis, that a particular stock price is supposed to be lower, or will go lower. If any one of the other parties are not available, and particularly, the seller who will sell to him at a lower price than is currently at a later date, he won’t be able to do the short, or worse, lose out on the trade.

In a nutshell, my view is that there should only be a certain amount short transactions before eventually, the shorter runs out of willing buyers (if the price is really going down), willing future sellers (if the price has already gone down too far), or even stock lenders (who would probably start selling as well, if the price is now expected to come down further). So how can shortselling be so rampant and overblown, as the SEC’s actions seem to imply? Well, there’s such a thing, apparently, as naked shortselling. Turning back to wikipedia, it’s defined as:

Naked short selling, or naked shorting, is the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed.

A trader selling shares that he has not borrowed? What happens during settlement then? Certainly, the shortseller will not have any shares for the buyer then. There will be settlement failure. Fools.com explains:

What exactly are settlement failures? In a legitimate short sale, shares must be delivered within three days of the transaction. If they are not, this is called (excuse the tortured syntax) "fails to deliver." Failure to deliver -- that is, a settlement failure -- could be the result of a bureaucratic snafu or clerical oversight. But consistent failure in large volume would seem to indicate something more nefarious, or at the very least, a major bureaucratic breakdown in desperate need of repair. Failures on the scale experienced by some companies go beyond any innocent explanation.

So has there be a lot of these failures lately?

An official of the SEC said that "While there may be instances of abusive short selling, 99% of all trades in dollar value settle on time without incident." Of all those that do not, 85% are resolved within 10 business days and 90% within 20…………

.....Legal naked shorting would normally be invisible in a liquid market, as long as the short sale is eventually delivered to the buyer. However, if the covers are impossible to find, the trades fail. A sudden rise in the number of fail reports will alert the SEC that something irregular is going on. In some recent cases, it was claimed that the daily activity was larger than all of the available shares, which would normally be unlikely.

So there is a common sense way to know if someone is selling bogus stock then. Once they fail to deliver on settlement, they’re caught. But consider this testimony, as reported by Fools.com, provided by. Sen. Robert Bennett in a US Senate Banking Committee hearing:

Summarizing how abusive practices might continue under Reg SHO, Bennett said: "I'm told that the way it works is that one brokerage house sells short, has 13 days under your rule under which to acquire the shares, and in that 13-day period hands the whole transaction off to another brokerage house. They just keep moving it around and nobody ever has to settle."

The Reg SHO being talked about is this: The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities. It states that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold. The rule has the following exemptions:
1. Broker or dealer accepting a short sale order from another registered broker or dealer
2. Bona-fide market making
3. Broker-dealer effecting a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200 through no fault of the customer or the broker-dealer.

The market maker exemption to the rules governing the practice is intended to allow market makers to naked short sell on a very temporary basis, in order to increase liquidity and stabilize markets.

Fools. Com article explains this further: Under the new rules, if shares haven't been delivered for 13 days after the transaction, the broker must buy them back -- with money it presumably would collect from the client who shorted the stock in the first place. So a bad actor can break the law a little bit, but if he breaks it a lot, he has to cover the short -- which he was going to have to do anyway and, since he's been manipulating the price by illegal activity, can probably be done at a bargain price. Now that's showing the bad guys! Moreover, as Sen. Bennett noted, brokers working together could get around even this restriction by passing the transaction among each other, starting the 13-day clock over again.

Now, it would seem to me that the process of covering a short negates the effects of the short. So if the stock price went down as a result of the short, covering should have the opposite effect, right? But the last part of Sen. Bennett’s testimony is bothersome. Brokers pass the transaction among each other? The Fools.com article further explains:

It is the market-making exemption that still seems to me like a source of potential trouble. Market makers don't have to locate shares before executing short sales in most circumstances. Their role is to keep an inventory of readily available stock, to smooth volatility, and to manage their own risk, and this sometimes requires them to short shares. A prime example of why this is sometimes a valuable function and even protects investors can occasionally be seen with companies emerging from bankruptcy.

When US Airways was planning to re-emerge from bankruptcy in 2003, for instance, its old common stock, trading on the OTC BB, rallied -- apparently because some investors mistakenly thought the news was somehow good for shareholders in the old common stock. But the plan called for the issuance of new stock, and the old shares were to become worthless. Market makers, by shorting the old common shares, could burst a speculative mini-bubble in the making and stop more ill-informed investors from losing their shirts. (Of course, one wonders why stocks are allowed to trade at all in these situations, but that's another matter). In any case, this is an extreme example of one function legitimate market makers serve by shorting stock and why they are given an exemption to the rules.

The potential problem is that unscrupulous folks could potentially register as market makers to take advantage of the exemptions.

So in short, a consortium of “market makers” can trade the short positions among each other? But over time, you’d probably notice this suspicious trend, if only a certain group is passing a position around, right? Otherwise, at a certain price level, there could already be demand for the shares from investors outside of the consortium, won’t there?

This gets more complicated. I mean, think about it. If the short position is naked in the first place, and there are no actual stocks backing the short, what happens then once there are now legitimate investors willing to buy out the position? That should bring us back to the case of settlement failures, right? Or otherwise, lead to the creation of bogus share certificates, or “phantom” stocks, which the SEC denies is possible.

So what’s the deal with naked shortselling? Is it real? Is it done rampantly? Perhaps it is, or the SEC would not be clamping down on it. But I’m very curious as to how it's actually being done.

Update: Similar-themed post here.