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Getting naked in short selling
The practice of short selling has been blamed for the collapse of several major companies' shares during the financial crisis. What is short selling? Marketplace Senior Editor Paddy Hirsch explains.
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Given the extent of the crisis, why aren't banks willing modify mortgages, reducing the amount owed by borrowers? Sure, banks will make less money, but don't they stand to lose a lot more money if these at-risk mortgages are foreclosured instead?
Good explanation of naked shorting, but you've missed one key point: when hedge funds engage in this practice, they do it in such high volume that the market becomes warped beyond all recognition. A good example of this is Lehman Brothers. On 9/17/2008, the total volume in LEH was about 215-million shares, of which 50-million were naked shorts. Such extreme, artificial swelling of supply can only have one result: plummeting price. That day, LEH closed down 70% (13 cents), and indeed, the price freefall observed during Lehman's final week is accompanied by an unprecedented surge in naked short selling.
The same is true of Bear Stearns.
I have long wondered how short selling worked and the simple line drawing and story was very illustrative in how the process works and how seductive it is for the greedy and the high risk takers. It is gambling with other people's money, trust and confidence in the markets?
To Tony and Carlos,
Although I'm no expert, I believe the reason why naked short selling can bring down the value of a stock is because (as from the example) when Sam doesnt have any shares to give to Caitlin because nobody is willing to lend/sell it to him, it creates an impression that the stock is very hard to borrow - which sends negative vibes about the company and its stock - hence driving the share price down. Also this is good for the short sellers as the more the price falls, the more the profit they can pocket - and this thus becomes a spiralling downfall.
Please correct me if someone has a better explanation.
I love this, Paddy you should be a professor.
Tony when you make a naked short sale and you fail to deliver like Paddy was explaining, because electronic trading allows for an electronic receipt for the buyer (eventually, the actually delivery of the stock is resolved with time), there's that extra supply of stock that should have already been bought. So in effect it's like you have a sell order that didn't get taken out and adds more supply of shares of the company on the market and voila...downward pressure.
Dunno if that makes all the sense in the world but this article could help (read under 'Phantom Stock'): http://online.wsj.com/public/article/SB118359867562957720-5Yb1Y_mpcl9a2n...
I have the same question Carlos Martinez had...according to your explanation how does naked short selling affect the market price when no shares (real or imagined) are being sold?
To me, one person just seems to owe another person 100 shares.
The drink comment and the pen throwing is like Paddy Hirsch's signature now!
For some reason, throwing stuff brings back fond memories of the Swedish chef from muppets
http://www.youtube.com/watch?v=CAsYwW7pt7o&feature=related
Excellent videos, I must say.
my wife and I enjoyed the videos,and appreciate the visual explanation style but got lost at the end of the "naked short selling" lesson. why would short selling drive down market values? the transactions themselves don't seem to have much impact on the share prices.
Also...
Could you explain the carry trade currency phenomenon with the yen ?
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