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Marketplace Scratch Pad

Getting Naked

Scott Jagow Sep 30, 2009

Just wanted to make sure you were paying attention because this is an important topic. What’s the likelihood that public companies are being destroyed by millions of shares of stock that don’t exist?

Today, the SEC held a hearing about short-selling, which is essentially betting that a company’s shares are overvalued.

Georgetown finance professor James Angel explained the benefits on the Marketplace Morning Report:

AMY SCOTT: Angel says short-sellers provide a service. They identify stocks that are overpriced, and that keeps prices fair for everyone. He says think about the people who make band-aids.

JAMES ANGEL: The only time you need a band-aid is when you get a cut. So the people who make band-aids are really profiting from the misfortune of others. But I’m really glad they’re doing that, because, you know, I’ve got a band-aid when I need it.

But there’s a difference between legitimate short-selling and naked short-selling, which involves investors selling shares they don’t have. It’s illegal to drive down the price of stocks with naked shorting, but many people say it happens regularly.

Clusterstock doesn’t believe it exists. It’s dreamed up by companies that get clobbered in the market:

Naked short-selling is a popular mythical beast promoted by the execs at those failed companies, as well as guys like Patrick Byrne at Overstock.com, but it’s rubbish. It’s really no different than regular old short-selling, which also happens to be villified by the media, and by executives at struggling companies.

We’ll get to Patrick Byrne in a minute. Clusterstock is on the attack against blogger Matt Taibbi, famous for his Rolling Stone “Goldman is a vampire squid” story. In Taibbi’s latest column, he goes off on naked short-selling (“counterfeiting”) and the lengths investment banks will go to protect it:

Last Friday I got a call from a Senate staffer who said that Goldman had just been in his boss’s office, lobbying against restrictions on naked short-selling. The aide said Goldman had passed out a fact sheet about the issue that was so ridiculous that one of the other staffers immediately thought to send it to me. When I went to actually get the document, though, the aide had had a change of heart.

Which was weird, and I thought the matter had ended there. But the exact same situation then repeated itself with another congressional staffer, who then actually passed me Goldman’s fact sheet.

Now, the mere fact that two different congressional aides were so disgusted by Goldman’s performance that they both called me on the same day — and I don’t have a relationship with either of these people — tells you how nauseated they were.

But is naked short-selling a “mythical beast”?

Deep Capture tells the story of Overstock.com CEO Patrick Byrne. He claims there’s a conspiracy among short- sellers and certain people in the financial media to destroy public companies that have been heavily shorted:

… some short-sellers do not play by the rules. A small group of powerful hedge fund managers stop at nothing to annihilate the companies they sell short. Their tactics include: blackmail, smear campaigns, espionage, fraud, harassment, extortion, bribery, rumor-mongering, sabotage, off-shore money laundering, political cronyism, frivolous lawsuits, witness tampering, biased financial research, false identities, bogus credit ratings, bribery, libelous blogs, bad science, forgery, wiretapping, counterfeiting, collusion, lying, cheating, threats and theft.

Their most egregious trick is to sell “phantom stock.” By exploiting a glitch in Wall Street’s computerized trading system, and a loophole in federal regulations, some hedge funds sell virtually unlimited amounts of stock that they have not yet borrowed or purchased. This is often referred to as “naked short selling.” Hedge funds use this tactic to flood the market with supply and drive down prices – which is blatantly illegal.

When you have some time (it’s long), read the whole story and see what you think. The guy is either delusional, a fantastic Hollywood screenwriter or he’s telling a truth that needs to be told.

Read it.

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