Friday, March 20, 2009

The Phantoms of the Stock Market

This post is about "phantom" shares - also known as "naked" short selling. What do naked short selling and CDSs, credit default swaps, have in common? Answer: DTCC. OK now you're thinking, what the heck is DTCC and why should I care? Well because it has a lot to do with the failures of both Bear Stearns and Lehman Brothers. And everyone agrees that those were the two critical events that precipitated the current financial crisis. And all this will lead into a discussion of the role of hedge funds in short selling.

So what qualifications do I have to talk about this stuff? Absolutely none. But I'll try to explain what I have found in the last few days of research on the internet. It's my belief that with an internet connection, Google, a strong obsession and a little bit of intelligence, anyone of us can become an "expert" on almost any topic one chooses. There are no secrets on the internet. Google knows all, you just have to ask the right questions.

My journey began innocently enough. I was looking to followup on a recent post about the incestuous relationship between AIG and Goldman Sachs. There was an article written by a New York Times reporter in September 2008 that was perhaps the best piece of journalism written on this subject. Somehow this reporter, Gretchen Morgenson, was able to piece together the story back then about the billions of dollars of CDSs that tied Goldman Sachs and AIG together in a dance of doom, even though much of this information was secret at the time. She should receive a Pulitzer for this article. GS representatives were so taken aback by this particular story that they took it upon themselves to publicly refute the facts presented by Ms. Morgenson. The problem is that the facts don't lie. But that didn't keep a GS spokesman from denying the truth and in the process mislead the American public as well as its own investors.
Lucas van Praag, a Goldman spokesman, on Sunday said the Times article was wrong to suggest that Goldman had reason to be concerned about AIG's problems.

"Although we have said many times on the record that our exposure to AIG was, and is, not material, the reporter chose to pursue a story line which suggests, by innuendo, that is not the case," he said in an e-mailed statement.

"For the avoidance of doubt, our exposure to AIG is offset by collateral and hedges and is not material to Goldman Sachs in any way," he continued. "The conclusions about our interests that readers of the New York Times article are invited to reach are seriously misleading."
I'll give GS credit for one thing - they are consistent. They keep repeating this same lie over and over again. As if by repeating it enough, that will somehow make it true.

So I was hoping that Ms. Morgenson would have some new insights given the recent revelations in this case. I was disappointed to see that her most recent articles were not up to the caliber that I expected from her. It almost made me wonder if they were being written by the same person. Perhaps powerful forces at Goldman Sachs had convinced her to tone down her writing.

But I read on, hoping that she had uncovered some golden nugget that the rest of the MSM had missed. What I found was this excerpt in an article titled, "At A.I.G., Good Luck Following the Money".
The government installed Edward M. Liddy as chief executive of A.I.G. when the company was bailed out. A former chief executive of Allstate, Mr. Liddy was also a director at Goldman Sachs before he joined A.I.G.

And in January, the Fed appointed three trustees to oversee the insurer. Their job is to maximize the company’s ability to repay amounts owed to the government and to ensure that A.I.G. is managed “in a manner that will not disrupt financial market conditions,” according to the Fed.

The trustees are Jill M. Considine, former chairman of the Depository Trust Company and a former director of the Federal Reserve Bank of New York; Chester B. Feldberg, a former New York Fed official who was chairman of Barclays Americas from 2000 to 2008; and Douglas L. Foshee, chief executive of the El Paso Corporation and chairman of the Houston branch of the Federal Reserve Bank of Dallas.

The trustees have already rankled a big A.I.G. shareholder. The American Federation of State, County and Municipal Employees pension plan, which owns 18,000 shares of A.I.G. common stock, had put forward a shareholder proposal on executive pay that it hoped would be put to a vote at the company’s annual meeting in May.

The proposal asked the company to adopt a policy requiring senior executives at A.I.G. to retain a significant percentage of the shares they received as compensation until two years after they left the company. Such a policy would help reward performance based on long-term value creation for shareholders, the pension plan said.
The article was nowhere near the masterpiece I was looking for, beginning with the title - "At A.I.G., Good Luck Following the Money". And the part describing Mr. Liddy's appointment to CEO of AIG only hinted at the fact that Liddy was sitting on the board of Goldman Sachs at the time he was appointed to takeover the CEO position at AIG. In fact he had to resign his GS board position in order to take the AIG position. This is very disturbing when you consider that Hank Paulson who hand picked him for the AIG position was the ex-CEO of Goldman Sachs, and as we now know AIG was used to secretly funnel government bailout funds to GS.

But the thing that caught my attention, because I hadn't seen it anywhere else, was the part about the three trustees. This might or might not be important, but it wasn't being reported anywhere else. And there was a hint that the trustees weren't doing a very good job at protecting the public's interest. Why would they oppose a shareholder proposal to force executives to hold on to shares for two years? This would create an incentive for the those in charge at AIG to take a longer term perspective. And wasn't the short term profit motive one of the main motivators that got the financial industry into the current dire situation?

I decided to look into the three AIG trustees and see what connections they might have with Goldman Sachs. I started with Jill M. Considine. I searched and searched, but couldn't find a connection with GS. So finally I looked up the Depository Trust Company. This company seemed to be involved in the most boring job on Wall Street. They basically are a back office that handles the stock trades for the stock exchanges. In today's computer driven world this should be a simple enough task. But surprisingly this is where things got interesting.

The Depository Trust Company, or DTC, is part of the DTCC, or Depository Trust & Clearing Corporation. What was interesting is a controversy involving DTCC with regards to naked short selling.
DTCC has been sued with regard to its alleged participation in naked short selling.
While there is no dispute that illegal naked shorting happens, there is a fight as to the extent to which DTCC is responsible. Some blame DTCC as the keeper of the system where it happens, and charge that DTCC turns a blind eye to the problem. DTCC has consistently noted that it has no authority over trading activities (which short selling is) and suggests that naked shorting is simply not widespread enough to be a major concern.
Well I'd heard of naked short selling, but I didn't understand how it worked. Usually short selling involves "borrowing" some stock shares, selling them, and then buying them back at a lower price at which time they are returned to their original owner. The idea is that the person who shorts the stocks is able to pocket the difference between the price they sell them at and the price they buy them back at. In this way an investor can make money when the price of a stock goes down. Of course if the stock happens to go up, the investor will lose money because they will have to pay the higher price when they buy back the stock. So basically this functions as a bet that the price of the stock will go down. OK. Got that?

"Naked" short selling I found out is the same thing, except the investor doesn't bother to "borrow" the stock that he is about to sell. Some people have compared this to counterfeiting. How can you sell shares that you don't own and you haven't even borrowed? Something doesn't sound right here.

As it turned out Bloomberg had just done a story titled, "Naked Short Sales Hint Fraud in Bringing Down Lehman".
The biggest bankruptcy in history might have been avoided if Wall Street had been prevented from practicing one of its darkest arts.

As Lehman Brothers Holdings Inc. struggled to survive last year, as many as 32.8 million shares in the company were sold and not delivered to buyers on time as of Sept. 11, according to data compiled by the Securities and Exchange Commission and Bloomberg. That was a more than 57-fold increase over the prior year’s peak of 567,518 failed trades on July 30.

The SEC has linked such so-called fails-to-deliver to naked short selling, a strategy that can be used to manipulate markets. A fail-to-deliver is a trade that doesn’t settle within three days.

“We had another word for this in Brooklyn,” said Harvey Pitt, a former SEC chairman. “The word was ‘fraud.’”
The article goes on to describe how naked short selling was used to cause the precipitous fall of Lehman Brothers. Granted that Lehman was on shaky ground anyway. But that doesn't explain how it could be worth billions one day and practically nothing a few days later. The inescapable conclusion is that Lehman was attacked and taken down by an organized effort of a small group of people that stood to profit from its fall.

The same thing had happened to Bear Stearns back in March. Lehman was targeted in September. But when Goldman Sachs was threatened by this same tactic of naked short selling, suddenly the SEC stepped in and temporarily banned the practice.

Now before you go feeling too sorry for Bear Stearns and Lehman, you should know that these big Wall Street firms were the ones that were enabling naked short selling in the first place. They took the orders and executed them. If one of their big hedge fund customers put in an order to short a stock and assured them that they had "borrowed" the necessary stocks to back up the transaction, then the Wall Street firms would put the order through and profit from the fees. They never required proof from their big customers that they actually had access to the stocks in question. And in many cases they didn't, but that didn't stop them from illegally putting in their sell orders.

This effectively flooded the market with sell orders and drove down the price of the stock. It's a simple matter of supply and demand - if there are more sell orders than buy orders then the price will go down. And this is exactly what happened in the cases of Bear Stearns and Lehman Brothers.

But big brothers Goldman Sachs and Morgan Stanley were saved by the SEC. Lucky them! I don't suppose that it hurt in the case of GS that ex-CEO Hank Paulson was the Treasury Secretary at the time. It's always good to have friends in high places.

I started this post by talking about DTCC. Remember they were the ones getting sued over a naked short selling issue. DTCC is able to detect and track naked short selling because they are the ones keeping the records of all stock transactions. And yet even when their records showed that massive fraud involving millions of "phantom" shares per day was taking place, they stood by and did nothing to try to stop it.

Why are they called "phantom" shares? Because they don't really exist. They are conjured up by the naked short sellers with the sole objective of driving down the stock price of their target victim. This is often accompanied by manufactured rumors that the company is about to fail which fuels the panic.

Think of it this way, the seller has to hand over the stock to the buyer. In the case of naked shorts, the seller doesn't have the stock to begin with. So he hands over an IOU instead. That IOU is supposed to be replaced by the real stock within three days. This is called settling the trade. If this doesn't happen then the trade has "failed to deliver". DTCC is the organization that handles the transfer of stock ownership. They keep track of stocks that have "failed to deliver". So they have full knowledge of how much naked short selling is going on, and who is doing it. You would think that when DTCC detects millions of shares a day in a particular stock that are failing to deliver, that they would sound the alert and report the guilty party to the authorities.

But in typical Wall St. fashion DTCC keeps this information secret from the public. And nobody, not even the SEC seems to have direct access to this information. Apparently DTCC is unregulated. The finance industry seems to like to use the word "opaque" to describe this lack of "transparency", but I prefer to just call it secretive. And here's the kicker. DTCC is a private corporation and the owners of DTCC are none other than the big Wall St. firms. As it turns out Wall Street is just one big incestuous cesspool.

At the beginning of this article I promised that there would be a tie in with CDSs, credit default swaps, as well. Once again it has to do with DTCC. Not only do they handle stock transactions, but they also handle CDS transactions. So they are the only ones who really know the size of the CDS market. Here's another article from Bloomberg titled, "DTCC May Raise Credit-Default Swap Disclosure Amid Criticism".
The Depository Trust and Clearing Corp., which operates a central registry for the $55 trillion credit- default swap market, may agree to disclose more data to counter criticism the derivatives amplified the financial crisis.

New York-based DTCC has discussed with banks, brokers and others that own the company ``whether or not there's any broader access to information we might provide,'' spokesman Stuart Goldstein said in an interview yesterday, declining to elaborate on what data may be published.

The DTCC earlier this month began releasing some information on trades in the registry to clear ``misconceptions'' about credit-default swaps following the bankruptcy of Lehman Brothers Holdings Inc., among the market's largest dealers.
So you can see who's running the show. It's like letting the lunatics run the insane asylum. And the regulators who are supposed to be protecting the public's interest seem to think that its their job to protect the interests of the Wall St. firms instead. And its all so secret. Sure because if people ever figure out exactly how this system works and how it benefits the insiders at the expense of the rest of us, then we'd all be really pissed off. We already have a taste of this with the huge bonuses that the Wall St. fatcats get. This has been going on for years and its only now because of the bailout that people are catching on to the amount of money that these parasites are paying themselves for sucking our blood.

I hope that made sense. I've tried to be as accurate as I can with a topic that I have absolutely no previous knowledge of. I end with a few videos that helped me make sense of this financial viper's nest. This is followed by some additional references on the topic of naked short selling.

Phantom Shares

Hedge Funds and the Global Economic Meltdown

The last video mentions some of the hedge fund operators that are suspected of having used naked short selling to cause the collapse of Bear Stearns and Lehman Brothers. They are Steve Cohen of SAC Capital, Jim Chanos of Kynikos Associates, and Dan Loeb of Third Point.

For more information on naked short selling visit the Deep Capture website which is dedicated to this topic. The article titled "The Naked Short Selling That Toppled Wall Street" gives an excellent detailed description of the collapse of Lehman Brothers. It covers much of the same information as the Bloomberg article but in even more detail, and yet it's easier to understand. In addition the Deep Capture website alleges that CNBC host David Faber spread false rumors generated by the hedge fund operators that fueled the panic selling which ended in the collapse of Bear Stearns.


Anonymous said...

Excellent article, Thank you for your reporting, the sheer level of fraud is staggering, I had no idea about the DTCC's role in monitoring the CDS market.

Frank Hope said...

Thanks for your comment. I hope you get a chance to watch the videos. The DTCC is part of the shadowy world of Wall Street. By maintaining this complex system, the Wall Street firms seek to dazzle and confuse the American public.

They do this to justify their exorbitant salaries. The system is so complex that we need to keep these "experts" around just to keep the system running. This is "job security" on a multi-billion dollar scale. Just look at the example of the AIG bonuses. They should all be fired instead and then bring in people to clean up the system so that it follows a rational and efficient process.

It is laughable in this day of blazing fast networks and computers that it normally takes 3 days for a stock trade to settle. The more I learn about the stock trading system, the more convinced I am that there are many layers of middle men (brokers) taking a cut. These are useless remnants of a pre-computer era.

If you think about it, naked short selling is flawed from the start. Allowing someone to make a trade and then come up with the stocks afterwards inherently introduces a "race condition" into the system. It leaves open the possibility that 2 people will make a trade and then go after the same share of stock to back it up.

If computer software was designed this way it would crash every five minutes. Maybe Microsoft hires ex-Wall Streeters to write its operating systems?

This financial crisis was a huge wasted opportunity. If these old dinosaurs had been allowed to go extinct (bankrupt), we might have finally freed ourselves from them and been able to create a 21st century financial system built on openness and fairness.

Instead our politicians chose to maintain the rigged system that has been used by the insiders to accumulate vast sums of wealth over the last century. And that wealth didn't just appear out of thin air. It was stolen from the productive sectors of the economy.

The people of the United States should demand a special prosecutor to look into the origins and the cause of the financial meltdown. Once all this abuse comes out in public, then it will become obvious where the changes in the system need to be made.

There is nothing wrong with capitalism as long as there is a level playing field. The level of corruption must be minimized and the guilty parties must be brought to justice. Otherwise America will become like a corrupt third world dictatorship.