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Naked Short Selling: Cause of Lehman’s End?

March 20, 2009 05:40 PM
by Anne Szustek
The SEC suggests that sales of Lehman Brothers stock that failed to deliver constitute naked short selling; others are skeptical.

Naked Short Selling and Lehman Brothers: Connection?

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According to an article published on Bloomberg’s Web site on Thursday, the Securities and Exchange Commission released data showing that as of Sept. 11, 2008, “as many as 32.8 million shares in [Lehman Brothers] were sold and not delivered to buyers on time.”

“That was a more than 57-fold increase over the prior year’s peak of 567,518 failed trades on July 30,” Bloomberg continued.

This could be a sign of naked short selling, an illegal act of market manipulation, in which stock is sold that might not exist. In a report filed Thursday by SEC inspector general David Kotz, from January 2007 to June 2008, the SEC’s Enforcement Complaint Center received approximately 5,000 complaints about alleged naked short selling. According to the report, however, no action was taken.

Longtime investment banking stalwart Lehman Brothers went bankrupt on Sept. 15, one of the first major financial upsets in a week that nearly saw the world financial system come to a halt.

Former Lehman CEO Richard Fuld told a panel of members of Congress on Oct. 6 that naked short sellers had played a significant role in the 158-year-old investment bank’s downfall.

Naked short selling can harm a company by driving down its stock price.  The price action can lend credibility to market rumors about the company's financial condition.  When the company is a financial institution like Lehman whose existence depends on the faith and trust of customers and trading partners, the combination of plunging share price and market rumors can become a self-fulfilling prophesy.

But others remain unconvinced. House Committee on Government Oversight and Reform member Rep. John Mica, R-Fla., was quoted by Bloomber as saying to Fuld, “If you haven’t discovered your role, you’re the villain today.”
Another skeptic of the naked shorting and Lehman hypothesis is financial journalist Gary Weiss. In an IM interview with Condé Nast Portfolio, he rips the Bloomberg article, saying it is tantamount to “stock market conspiracy theories.” He continues, “Fails to deliver can be caused by any number of factors, of which naked short selling is just one.”

Weiss does admit, however, that during times of economic distress, those who seek to make money off of decreasing prices per share become the target of unwelcome attention.

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Reference: Short selling and naked shorting

Short selling is when sellers sell a security, such as a stock or bond, which they do not own, “or any sale that is completed by the delivery of a security borrowed by the seller,” writes Investopedia. The sellers then try to buy back the stock later at a cheaper price, turning a profit in the process.

Generally traders need to confirm that they can borrow shares before short selling. But selling shares that “have not been affirmatively determined to exist,” known as naked short selling, is illegal, as it can cause manipulation of the market. Investopedia writes, “While no exact system of measurement exists, most point to the level of trades that fail to deliver from the seller to the buyer within the mandatory three-day stock settlement period as evidence of naked shorting. Naked shorts may represent a major portion of these failed trades.”

Background: The demise of Merrill Lynch, Lehman Brothers and Bear Stearns

In September 2008, Merrill Lynch and Lehman Brothers became the second and third major investment banks to fall by the financial wayside. Bank of America bought Merrill in a stock for stock transaction, and Lehman Brothers filed for bankruptcy, reporting more than $613 billion in debts. 

Last March, another erstwhile investment banking titan, Bear Stearns, was rolled into JPMorgan after its stock collapsed.  Many believe Bear Stearns’ downfall came at the hands of short sellers betting on a bearish outlook on the bank.

Related Topic: Congressman believes short selling uptick rule is to be reinstituted

On March 10, House of Representatives Financial Services Chair Barney Frank, D-Mass., said that he believes that the uptick rule on short selling of stocks will be put back in place in roughly a month. The uptick rule prevents traders from short selling unless the sale price is higher than the previous sale price, helping to slow the stock’s decline. It was rolled back in 2007 by the SEC over concerns that changes in trading tactics had rendered it ineffective.
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