| | |  Editorials | Issues | October 2009 
Wall Street's Naked Swindle - 5
 Matt Taibbi - Rollingstone.com
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October 25, 2009
In 2005, complaints from investors about naked short-selling finally prompted the SEC to try to curb the scam. A new rule called Regulation SHO, known as "Reg SHO" for short, established a series of guidelines designed, in theory, to prevent traders from selling stock and then failing to deliver it to the buyer. "Intentionally failing to deliver stock," then-SEC chief Christopher Cox noted, "is market manipulation that is clearly violative of the federal securities laws." But thanks to lobbying by hedge funds and brokers, the new rule included no financial penalties for violators and no real enforcement mechanism. Instead, it merely created a thing called the "threshold list," requiring short-sellers to close out their positions in any company where the amount of "fails to deliver" exceeded 10,000 shares for more than 13 days. In other words, if counterfeiters got caught selling a chunk of phantom shares in a firm for two straight weeks, they were no longer allowed to counterfeit the stock.
A nice, if timid idea — except that it's completely meaningless. Not only has there been virtually no enforcement of the rule, but the SEC doesn't even bother to track who is targeting companies with failed trades. As a result, many stocks attacked by naked short-sellers spent years on the threshold list, including Krispy Kreme, Martha Stewart and Overstock.com.
"We were actually on it for 668 consecutive days," says Patrick Byrne, the CEO of Overstock, who became a much-ridiculed pariah on Wall Street for his lobbying against naked short-selling. At one point, investors claimed ownership of nearly 42 million shares in Overstock — even though fewer than 24 million shares in the company had actually been issued.
Byrne is not an easy person for anyone with any kind of achievement neuroses to like. He is young, good-looking, has shitloads of money, speaks fluent Chinese, holds a doctorate in philosophy and spent his youth playing hooky from high school and getting business tips from the likes of Warren Buffett. But because of his fight against naked short-selling, he has been turbofragged by the mainstream media as a tinfoil-hat lunatic; one story in the New York Post featured a picture of Byrne with a flying saucer coming out of his head.
Nonetheless, Byrne's howlings about naked short-selling look extremely prescient in light of what happened to Bear and Lehman. Over the past four years, Byrne has outlined the parameters of a naked-shorting scam that always includes some combination of the following elements: negative rumors planted in the financial press, the flooding of the market with enormous quantities of undelivered shares, absurdly high trading volumes and the prolonged appearance of the targeted company on the Reg SHO list.
In January 2005 — at the exact moment Reg SHO was launched — Byrne's own company was trading above $65 a share, and the number of failed trades in circulation was virtually nil. By March 2006, however, Overstock was down to $28 a share, and Reg SHO data indicated an explosion of failed trades — nearly 4 million undelivered shares on some days. At those moments, in other words, nearly a fifth of all Overstock shares were fake.
"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."
Watch Matt Taibbi break down short-selling vs. naked short-selling on his blog, Taibblog.
Bear Stearns wasn't the kind of company that had a problem with naked short-selling. Before March 11th, 2008, there had never been a period in which significant quantities of Bear stock had been sold and then not delivered, and the company had never shown up on the Reg SHO list. But beginning on March 12th — the day after the Fed meeting that failed to include Bear, and the mysterious purchase of the options betting on the firm's imminent collapse — the number of counterfeit shares in Bear skyrocketed.
The best way to grasp what happened is to look at the data: On Tuesday, March 11th, there were 201,768 shares of Bear that had failed to deliver. The very next day, the number of phantom shares leaped to 1.2 million. By the close of trading that Friday, the number passed 2 million — and when the market reopened the following Monday, it soared to 13.7 million. In less than a week, the number of counterfeit shares in Bear had jumped nearly seventyfold.
The giant numbers of undelivered shares over the course of that week amounted to one of the most blatant cases of stock manipulation in Wall Street history. "There is not a doubt in my mind, not a single doubt" that naked short-selling helped destroy Bear, says Sen. Ted Kaufman, a Democrat from Delaware who has introduced legislation to curb such financial fraud. Asked to rate how obvious a case of naked short-selling Bear is, on a scale of one to 10, former SEC counsel Brent Baker doesn't hesitate. "Easily a 10," he says.
At the same time that naked short- sellers were counterfeiting Bear's stock, the firm was being hit by another classic tactic of bear raids: negative rumors in the media. Tipped off by a source, CNBC reporter David Faber reported on March 12th that Goldman Sachs had held up a trade with Bear because it was worried about the firm's creditworthiness. Faber noted that the hold was temporary — the deal had gone through that morning. But the damage was done; inside Bear, Faber's report was blamed for much of the subsequent panic.
"I like Faber, he's a good guy," a Bear executive later said. "But I wonder if he ever asked himself, 'Why is someone telling me this?' There was a reason this was leaked, and the reason is simple: Someone wanted us to go down, and go down hard."
At first, the full-blown speculative attack on Bear seemed to be working. Thanks to the media-fueled rumors and the mounting anxiety over the company's ability to make its payments, Bear's share price plummeted seven percent on March 13th, to $57. It still had a ways to go for the mysterious short-seller to make a profit on his bet against the firm, but it was headed in the right direction. But then, early on the morning of Friday, March 14th, Bear's CEO, Alan Schwartz, struck a deal with the Fed and JPMorgan to provide an emergency loan to keep the company's doors open. When the news hit the street that morning, Bear's stock rallied, gaining more than nine percent and climbing back to $62.
The sudden and unexpected rally prompted celebrations inside Bear's offices. "We're alive!" someone on the company's trading floor reportedly shouted, and employees greeted the news by high-fiving each other. Many gleefully believed that the short-sellers targeting the firm would get "squeezed" — in other words, if the share price kept going up, the bets against Bear would blow up in the attackers' faces.
The rally proved short-lived — Bear ended the day at $30 — but it suggested that all was not lost. Then a strange thing happened. As Bear understood it, the emergency credit line that the Fed had arranged was originally supposed to last for 28 days. But that Friday, despite the rally, Geithner and then-Treasury secretary Hank Paulson — the former head of Goldman Sachs, one of the firms rumored to be shorting Bear — had a sudden change of heart. When the market closed for the weekend, Paulson called Schwartz and told him that the rescue timeline had to be accelerated. Paulson wouldn't stay up another night worrying about Bear Stearns, he reportedly told Schwartz. Bear had until Sunday night to find a buyer or it could go fuck itself.
Bear was out of options. Over the course of that weekend, the firm opened its books to JPMorgan, the only realistic potential buyer. But upon seeing all the "shit" on Bear's books, as one source privy to the negotiations put it — including great gobs of toxic investments in the subprime markets — JPMorgan hedged. It wouldn't do the deal, it announced, unless it got two things: a huge bargain on the sale price, and a lot of public money to wipe out the "shit."
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