| | |  Editorials | Issues | October 2009 
Wall Street's Naked Swindle - 6
 Matt Taibbi - Rollingstone.com
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October 25, 2009
So the Fed — on whose New York board sits JPMorgan chief Jamie Dimon — immediately agreed to accommodate the new buyers, forking over $29 billion in public funds to buy up the yucky parts of Bear. Paulson, meanwhile, took care of the bargain issue, putting the government's gun to Schwartz's head and telling him he had to sell low. Really low.
On Saturday night, March 15th, Schwartz and Dimon had discussed a deal for JPMorgan to buy Bear at $8 to $12 a share. By Sunday afternoon, however, Geithner reported that the price had plunged even further. "Shareholders are going to get between $3 and $5 a share," he told Paulson.
But Paulson pissed on even that price from a great height. "I can't see why they're getting anything," he told Dimon that afternoon from Washington, via speakerphone. "I could see something nominal, like $1 or $2 per share."
Just like that, with a slight nod of Paulson's big shiny head, Bear was vaporized. This, remember, all took place while Bear's stock was still selling at $30. By knocking the share price down 28 bucks, Paulson ensured that the manipulators who were illegally counterfeiting Bear's shares would make an awesome fortune.
Although we don't know who was behind the naked short-selling that targeted Bear — short-traders aren't required to reveal their stake in a company — the scam wasn't just a fetish crime for small-time financial swindlers. On the contrary, the widespread selling of shares without delivering them translated into an enormously profitable business for the biggest companies on Wall Street, fueling the growth of a booming sector in the financial-services industry called Prime Brokerage.
As with other Wall Street abuses, the lucrative business in counterfeiting stock got its start with a semisecret surrender of regulatory authority by the government. In 1989, a group of prominent Wall Street broker-dealers — led, ironically, by Bear Stearns — asked the SEC for permission to manage the accounts of hedge funds engaged in short-selling, assuming responsibility for locating, lending and transferring shares of stock. In 1994, federal regulators agreed, allowing the nation's biggest investment banks to serve as Prime Brokers. Think of them as the house in a casino: They provide a gambler with markers to play and to manage his winnings.
Under the original concept, a hedge fund that wanted to short a stock like Bear Stearns would first "locate" the stock with his Prime Broker, then would do the trade with a so-called Executing Broker. But as time passed, Prime Brokers increasingly allowed their hedge-fund customers to use automated systems and "locate" the stock themselves. Now the conversation went something like this:
Evil Hedge Fund: I just sold a million shares of Bear Stearns. Here, hold this shitload of money for me.
Prime Broker: Awesome! Where did you borrow the shares from?
Evil Hedge Fund: Oh, from Corrupt Broker. You know, Vinnie.
Prime Broker: Oh, OK. Is he sure he can find those shares? Because, you know, there are rules.
Evil Hedge Fund: Oh, yeah. You know Vinnie. He's good for it.
Prime Broker: Sweet!
Following the SEC's approval of this cozy relationship, Prime Brokers boomed. Indeed, with the rise of discount brokers online and the collapse of IPOs and corporate mergers, Prime Brokerage — in essence, the service end of the short- selling business — is now one of the most profitable sectors that big Wall Street firms have left. Last year, Goldman Sachs netted $3.4 billion providing "securities services" — the lion's share of it from Prime Brokerage.
When one considers how easy it is for short-sellers to sell stock without delivering, it's not hard to see how this can be such a profitable business for Prime Brokers. It's really a license to print money, almost in the literal sense. As such, Prime Brokers have tended to be lax about making sure that their customers actually possess, or can even realistically find, the stock they've sold. That point is made abundantly clear by tapes obtained by Rolling Stone of recent meetings held by the compliance officers for big Prime Brokers like Goldman Sachs, Morgan Stanley and Deutsche Bank. Compliance officers are supposed to make sure that traders at their firms follow the rules — but in the tapes, they talk about how they routinely greenlight transactions they know are dicey.
In a conference held at the JW Marriott Desert Ridge Resort in Phoenix in May 2008 — just over a month after Bear collapsed — a compliance officer for Goldman Sachs named Jonathan Breckenridge talks with his colleagues about how the firm's customers use an automated program to report where they borrowed their stock from. The problem, he says, is the system allows short-sellers to enter anything they want in the text field, no matter how nonsensical — or even leave the field blank. "You can enter ABC, you can enter Go, you can enter Locate Goldman, you can enter whatever you want," he says. "Three dots — I've actually seen that."
The room erupts with laughter.
After making this admission, Breckenridge asks officials from the Securities Industry and Financial Markets Association, the trade group representing Wall Street broker-dealers, for guidance in how to make this appear less blatantly improper. "How do you have in place a process," he wonders, "and make sure that it looks legit?"
The funny thing is that Prime Brokers didn't even need to fudge the rules. They could counterfeit stocks legally, thanks to yet another loophole — this one involving key players known as "market makers." When a customer wants to buy options and no one is lining up to sell them, the market maker steps in and sells those options out of his own portfolio. In market terms, he "provides liquidity," making sure you can always buy or sell the options you want.
Under what became known as the "options market maker exception," the SEC permitted a market maker to sell shares whether or not he had them or could find them right away. In theory, this made sense, since delaying the market maker from selling to offset a big buy order could dry up liquidity and slow down trading. But it also created a loophole for naked short-sellers to kill stocks easily — and legally. Take Bear Stearns, for example. Say the stock is trading at $62, as it was on March 11th, and someone buys put options from the market maker to sell $1.7 million in Bear stock nine days later at $30. To offset that big trade, the market maker might try to keep his own portfolio balanced by selling off shares in the company, whether or not he can locate them.
But here's the catch: The market maker often sells those phantom shares to the same person who bought the put options. That buyer, after all, would love to snap up a bunch of counterfeit Bear stock, since he can drive the company's price down by reselling those fake shares. In fact, the shares you buy from a market maker via the SEC-sanctioned loophole are sometimes called "bullets," because when you pump these counterfeit IOUs into the market, it's like firing bullets into the company — it kills the price, just like printing more Island Rubles kills a currency.
Which, it appears, is exactly what happened to Bear Stearns. Someone bought a shitload of puts in Bear, and then someone sold a shitload of Bear shares that never got delivered. Bear then staggered forward, bleeding from every internal organ, and fell on its face. "It looks to me like Bear Stearns got riddled with bullets," John Welborn, an economist with an investment firm called the Haverford Group, later observed.
So who conducted the naked short- selling against Bear? We don't know — but we do know that, thanks to the free pass the SEC gave them, Prime Brokers stood to profit from the transactions. And the confidential meeting at the Fed on March 11th included all the major Prime Brokers on Wall Street — as well as many of the biggest hedge funds, who also happen to be some of the biggest short-sellers on Wall Street.
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