The SEC and Naked Shorting

Yesterday on Money for Breakfast, Paul Atkins, one of the commissioners of the SEC, whose tenure expires this Friday, joined me to discuss the SEC's temporary naked short sale progress. By my measure, since the day that the SEC announced the emergency rule change on Tuesday July 15th, the SEC has seen its plan manifest itself in a big move to the upside in the stocks that were given access to the discount window. Take a look at the percentage gains on some of the names on the list since it was announced. Note I did the math the old-fashioned way: on a piece of paper. Hopefully my second grade math is decent. What would we do without calculators?

FNM up almost 65%
FRE up almost 60%
LEH up almost 30%
BAC up almost 60%
C up almost 30%
JPM up almost 27%
Dow in that same period rose from 10,962 to 11,370 or roughly 3%
WM up 23 cents according to Friday’s close or 6% (Not covered under the rule)
WB up almost 60% (Not covered under the rule)

There you have it. Now as you and I both know there are a lot more names on the list and almost all of them have fared very well. I didn't list performance based on when the rules went into effect because once it was announced the short covering started. Also of note is that some of these companies reported in the past couple of weeks and pure fundamentals have clearly played a role in their performance. Also check out Wachovia Bank which was not on the list but has fared better than one might have expected. Will the SEC take into account the performance of financial institutions not on the list to see if the temporary change needs to be extended to all banks or financial institutions? Absolutely! The decision to extend the naked short selling rule will be decided this evening.

For whether this rule should extend beyond these nineteen institutions or whether short sales should be reported and disclosed, take a look at the Commissioner's response.

In the second part of my discussion about the SEC's progress, Overstock.com CEO Patrick Byrne joined me to discuss what he likes and dislikes about the temporary rule changes. If you don't know him or haven't seen him interviewed, he has been a big proponent of change at the SEC and DTCC. His number one concern has been the lack of transparency at the DTCC (Depository Trust & Clearing Corporation) and the increase in the failures-to-deliver or FTD's, as they're commonly referred to. He notes that the number of FTD's has increased precipitously and that no one is policing them. That suggests that naked short sellers have been running amuck with no supervision and that no one has been clamping down on the borrowers or institutions that facilitate that borrowing, to deliver stock or get a locate. In essence, people can do phantom trading above the float of the stock. Look at the email that he sent me before our interview.

I employ a team of economists and database managers outside of Overstock to research the issue of Failures-To-Deliver (FTD’s). Over the last two years we have spent countless hours on FOIA requests regarding FTD’s. In recent months, some of the information we seek has been coming out automatically, but one quarter stale.

In any case, this is what DTCC CNS fails look like up to the end of Q1:

* denotes date through March 31

Take-aways:

1)So there was a day this year in Q1 when FTD’s almost reached $14 billion (they ended Q1 at $8.5 billion).

2) And the average daily FTD’s has just climbed and climbed for the last few years.

Some other talking points:

1) More shocking yet (and I can send the back-up data on this) is that on an average day, 72% of the FTD’s are in stocks that are on the Reg SHO list. Some protection.

2) How bad a problem is this?

a.You understand that $1 million of toxic waste does not cost $1 million to clean up: it may cost much more. Similarly, a broker holding a 10 million share FTD in a $1 stock may carry it as a $10 million liability, but if he has to clean up his fail, and buy-in 10 million shares in a stock trading 50,000 shares/day… it may cost him $10 million, but it could just as easily cost $100 million.

b. Put that together with the $8.5 billion number above. Cleaning it up will not cost $8.5 billion. It could cost $18.5 billion, or $80 billion… No one has any idea.

c. The CNS failures are just one part of the equation. There is also broker-level “pre-netting”, fails resolved by the DTCC Stock Borrow Program, ex-clearing, and failures coming in from off-shore clearing systems. Everybody who will talk from within the system says that collectively, these are a far bigger (the estimates from within the system are $30 - $190 billion, depending upon who is speaking).

Patrick Byrne has been talking about naked short selling for years and is not opposed to short selling as a whole but feels that his company and others have been unfairly penalized.