Naked Shorting: An IM Exchange

March 19, 2009

I’ve been rude about Gary Matsumoto’s conspiracy theories in the past, and now he has a doozy of a new one: the bankruptcy of Lehman Brothers had very little to do with its management or its insolvency, and everything to do with naked shorting. Gary Weiss is one journalist who’s convinced that naked shorting is not a problem: I had this IM interview with him this morning.

Felix Salmon: So Gary Matsumoto is out with 2,685 words of conspiracy-mongering on the subject of naked shorting and Lehman Brothers
Which I know is a subject dear to your heart

Gary Weiss: Yes, following stock market conspiracy theories is one of my favorite hobbies.

Felix Salmon: So, in a nutshell, what’s the problem with this one?

Gary Weiss: Well, let’s start with the lead paragraph. It says, "The biggest bankruptcy in history might have been avoided if Wall Street had been prevented from practicing one of its darkest arts."
My reaction was, "Is he serious?"

Felix Salmon: Well, is he?

Gary Weiss: Yes, that is what I find remarkable. He provides not a shred of evidence for his hypothesis, except for some warmed-over "fails" trade data that proves nothing, a quote from a former SEC chairman who has a vested interest in the subject, and he ignores little things like what Lehman Brothers didto cause its own demise.

Felix Salmon: Why does the failed-trade data prove nothing?

Gary Weiss: Fails to deliver can be caused by any number of factors, of which naked short selling is just one.

Felix Salmon: As for Lehman Brothers causing its own demise, well, yes, obvs. But if short-sellers hadn’t driven Lehman stock down to the level at which the bank had to declare bankruptcy over the course of a fraught weekend, might not the authorities in the US and UK have managed to cobble together some kind of rescue package allowing Lehman to be sold to Barclays or Nomura or both?

Gary Weiss: You’re talking about ordinary short selling driving down the price of Lehman stock. What he is talking about is fails to deliver, which is another issue entirely.
I agree that the unwise abolition of the uptick rule left open the possibility that shorting could drive down stocks.

Felix Salmon: Is there any real empirical data on what proportion of fails are due to naked shorting?

Gary Weiss: There is absolutely none. In fact, as the SEC enforcement division just pointed out, there are no studies indicating that naked shorting has any impact on the market whatsoever.

Felix Salmon: In that case, is there any evidence that the kind of things which cause fails (and aren’t naked shorting) spiked around the time of the Lehman bankruptcy?
Matsumoto has one theory on the spike in fails: that it’s due to naked shorting. Do you have an alternative explanation?

Gary Weiss: The problem with fails data is that you can’t comb out fails that are unrelated to naked shorting. Since most fails are caused by things that aren’t naked shorting, and since SEC Chairman Christopher Cox said that there was no significant naked shorting of bank stocks, including Lehman, I’d suggest that factors other than naked shorting were at work in causing the fails.
Actually Cox’s exact words were that there has been no "unbridled" naked shorting of financial issues.

Felix Salmon: Matsumoto nods to this:
"The Federal Reserve Bank of New York lists several reasons for fails-to-deliver in securities trading besides naked shorting. They include misunderstandings between traders over details of transactions; computer glitches; and chain reactions, in which one failure to settle prevents delivery in a second trade."
Still, it seems like it’s more than just coincidence that spikes in fails have coincided exactly with periods when the stock in question fell dramatically.

Gary Weiss: Then I guess Cox was lying. Seriously. I am no fan of the man, but if there was no "unbridled naked shorting" of financial issues, and if there actually was significant naked shorting of financial issues, than he should be strung up from the nearest lamp post.
I would suggest that he was not lying and that, as has been the pattern over the years when naked shorting is raised, it is a red herring.

Felix Salmon: But how would he know? And why can’t we see the same evidence that he’s seeing?

Gary Weiss: I would love to see the SEC release all the evidence that it has on naked shorting. As a matter of fact, I think they should drop everything else that they are doing, stop investing actual stock frauds and Ponzi schemes, and devote themselves entirely to disproving a conspiracy theory.
He would know, by the way, because all trades leave a paper trail, and if a fail to deliver is caused by naked shorting I would think it would be fairly easy to ascertain if that were happening.
And if it were happening, I am sure, given the pressure whipped up over this, that he would have been more than happy to say it was happening.

Felix Salmon: It is worth pointing out (a) that Cox’s statement about unbridled naked shorting came in July, before Lehman collapsed. But also (b) the SEC has given no indication that it thinks there was a problem with naked shorts in Lehman’s collapse.

Gary Weiss: Yeah, that too. Getting back to the Bloomberg story, that was omitted entirely from the article.
(Unless it was buried somewhere after the quote from the superb former SEC chairman Harvey Pitt.)

Felix Salmon: The article did quote Susanna Trimbath as saying this:
"Failed trades correlate with drops in share value — enough to account for 30 to 70 percent of the declines in Bear Stearns, Lehman and other stocks last year, Trimbath said."

Gary Weiss: It may also correlate with the tides and the phases of the moon. The question is, where is the evidence of naked shorting actually taking place? The conspiracists’ case depends entirely on statistical data related to a phenomenon ("failed" trades) that is almost always not naked shorting.
Where are the SEC enforcement actions?
Why did Cox say it wasn’t a factor?

Felix Salmon: So what would constitute evidence of naked shorting actually taking place? Are we wholly reliant on the SEC to be able to see it and prosecute it?

Gary Weiss: We know that statistical evidence of "fails" data is meaningless, so yes, we have to rely on actual enforcement actions by the SEC and SROs. Heaven knows, they are motivated to find such things happening.

Felix Salmon: But the only evidence we have that fails spikes are meaningless is that there’s no correlation between fails spikes and subsequent SEC actions
I mean, I’m sympathetic to what you’re saying, but it is 100% reliant on the SEC.

Gary Weiss: And the SROs. Here’s an analogous situation:
Occasionally there is statistical evidence of pre-announcement runups in volume and share prices before takeovers.
That is indicative of insider trading and, sure enough there are prosecutions and enforcement actions. It is something actually happening.
Here we have "spikes on charts" and consultants to parties engaged in litigation against alleged named shorters (Ms. Trimbath) finding "correlations" and we have absolutely no regulatory actions whatsoever.
Either the SEC and the SROs are corrupted, as the conspiracists suggest, or it ain’t happening.

Felix Salmon: Still, if your argument that naked shorting isn’t a problem is entirely reliant on (lack of) SEC activity on this front, then it seems hard for you to attack the SEC itself for releasing a report taking the issue seriously. Aren’t they, by your lights, the exact institution which has to take such allegations seriously?

Gary Weiss: Absolutely not. If organized pressure groups and astroturf organizations are demanding disproportionate, unnecessary deployment of scarce SEC resources, the SEC has an obligation to reject those demands, and not pander to them.

Felix Salmon: What’s more, we’re in a bear market, and it can at times be hard to find a borrow (see eg Citigroup right now) and the temptation to engage in naked shorting must be high. You’d think that at the very least the SEC would have found some small-scale idiots who gave it a try.

Gary Weiss: As happens in all bear markets, there is historically enormous public and political pressure to target people profiting from share price declines.
That happened during the Great Depression, and it is happening now. That results in some good regulatory initiatives, such as the uptick rule, and it results in wastes of time, such as pandering to the naked shorting conspiracy theorists.
Remember: the SEC is often incompetent. I wrote a book in which that was one of the main themes. However, when it is reacting to a public problem, the SEC has the capacity to actually find things happening.
Here we have a campaign that has gone on for some years, backed by "statistical data" to "prove" that a problem called "naked shorting" exists. And the result: zip. Nothing.
My question is: when is the SEC going to have the guts to say, "Enough. It is not happening. We are not going to waste any more time on this."

Felix Salmon: So maybe we can agree about this:
The best-case scenario here is that the SEC should come out and say definitively that in the Bear and Lehman cases, there was no naked shorting going on.
It should make the data public, and explain how it came to that conclusion.
And if that’s convincing, then I think allegations of naked shorting elsewhere will dry up.

Gary Weiss: Yes. In my last Portfolio piece on Madoff, I took the idea one step further and suggested that a 9/11 style commission should investigate the entire financial crisis. That should include naked shorting. The only way to combat conspiracy theories of any kind is with facts–not that it matters to the conspiracists, who will always be with us.

Felix Salmon: But maybe they won’t get the opportunity to write long articles for Bloomberg.

Gary Weiss: There will always be conspiracists and there will always be bad journalism.

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