"Tuesday, June 16, 2009
In defence of naked short selling – or why the crackdown on a phoney problem is costing taxpayers at least a billion dollars
Brief synopsis: a misguided government policy driven by fraudsters in the stock market is making the market less efficient at a cost to taxpayers of at least a billion dollars.
This post has two start points – a start point for people unfamiliar with the basic operation of short selling and risk arbitrage – and a start point for most my readership (who seem to be hedge fund managers).
Start point for readers without a financial market background
There are readers that do not know what short selling is – and what naked short selling (allegedly) is. So to help readers out – imagine I think for some reason a particular stock will go down – and I want to bet that it goes down. Then there is a mechanism by which I can make that bet. I can “borrow” the shares (say some shares in Citigroup). Then I sell those shares in the market (selling what I do not own – and have only borrowed). If the shares go down I can buy identical shares back in the market and return the identical shares. Rather than aim to “buy low and sell high” I
When I buy back the shares (either at a profit or loss) I close out the transaction by returning them to the person I have borrowed them from. At all times my account is collateralised so the risk to my broker is minimal. [The risk to me unfortunately is not.]
Naked short selling is a much promoted – but in my view almost entirely fictional problem – whereby people do the short selling but without actually borrowing a share first. When they do so they will inevitably fail to deliver the shares to the exchange on the due date. The existence of fails is – at least according to the proponents of the “naked short selling hypothesis” proof that there is a ma
Still some people have argued that a collateralised fail-to-deliver in a financial market has the ability through price manipulation of a stock to bring a business to its knees. Sorry – but generally the business does not care who owns the stock or what is going on the stock market unless the business is weak and needs capital. [This is the corollary of the old Wall Street truism: “the stock doesn’t know you own it”.]
Most short selling is mere speculation – but sometimes it involves arbitrage. Arbitrage is kind of useful and goes on all the time in financial markets. For instance if Company A agrees to buy Company B for stock the price should converge – over time – on the agreed stock swap deal. But if for some reason it does not arbitragers could buy company B’s stock and shortsell company A. When the Company B stock converts into company A shares they could
Start Point for people with decent financial market knowledge
“Naked short selling issue” was a phoney issue – promoted by flim flams, stock promoters and other market slime-bags invented a problem which did not exist but helped them to promote their stock or
The story was that selling stock you did not own was producing “counterfeit shares”. I have yet to see mischievous naked short selling of any real business – though I have seen some fails-to-deliver (that is not actually being able to borrow the stock on the delivery date) remedied a few days later and with all obligations to the exchange cash collateralised over the interim period. There were plenty of “fails” but no real naked short selling “problem”. Hard to borrow stocks did fail regularly – but I assure you – and I have been doing this for years – when there were fails to deliver my broker called my short back and hey – presto – a few days later I had settled. If there was a “counterfeit share” it was cash collateralised and it was cancelled a few days later (in exchange for the cash collateral). The person who purchased the share from me got all the economic benefit of owning that share – and a full voting share was delivered to them within a modest time.
Fails to deliver now are – with electronic settlement – a far lesser and far quicker remedied problem than they were in the days of paper certificates. And with the speed at which they are settled – and the ability to demand cash collateral when a party fails to deliver they cause no economic problem at all.
Nonetheless the SEC took the slime-bag stock promoters seriously – at one stage issuing subpoenas to
Nonetheless in response to the well-promoted bogus threat of “naked short selling” the SEC radically tightened the delivery rules for stock. Now you have to locate a borrow before you actually short the stock (rather than having to locate a borrow before you deliver the stock) and if you can’t maintain a borrow you must cover the stock immediately – rather than fail (and pay fail-fees) for a couple of days.
Well and good you might say – but you would be wrong.
At the moment there is a well publicised arbitrage in Citigroup stock. There are four classes of Citigroup Preferred Shares which – on tendering to Citigroup – convert to common equity. And – surprise – you can buy Citigroup cheaper if you buy those preferred shares rather than buy the common. As of last night it was 18% cheaper to buy the Citigroup preferred than the common. So – with seemingly free money on the table we at Bronte Capital decided to short sell Citigroup common and buy the preferreds. An 18% return over about a month looks pretty darn good for a pure arbitrage. (So good it should not exist… its billion dollar bills on the sidewalk.)
But alas there is a problem. This deal is large - $20 billion – and as a result Citigroup common has become modestly difficult to borrow. You can’t short-sell the Citigroup common with certainty because you might not be able to borrow the shares and hence you might be forced to buy it in. And if you buy it in before you get the new (and identical) shares from tendering your preferred you could get “squeezed”. You will be forced to buy back your Citigroup stock at the same time as the other arbitragers (who have also been called on their borrowed stock) and you will pay a high price.
After paying a high price to borrow the stock you will receive your (now unhedged) new Citigroup shares at the same time as the other arbitragers (most of whom will be sellers) and – inevitably you will sell the shares then too as your plan was not to “own” Citibank. You will sell at the same time as the other arbitragers (presumably at a low price).
In the old days it would be easy. You would simply fail to deliver your Citigroup common for a few days whilst the new shares were delivered to you – and then you would deliver the new shares.
What was a perfect arbitrage has become an imperfect one.
So what you say – why should arbitragers like us at Bronte Capital be given a free ride? Well – hey we were not being given any ride – but now we are. Currently we are earning 18% on face value in a month for taking this risk – in the old days the price would have equilibrated almost instantly and people like me would not be making that money.
And that money comes from somewhere. Largely the difficulty in equilibrating the price through arbitrage makes it harder for Citigroup to raise the capital it wants. It has thus made that capital more expensive (by the bulk of our expected profits on the arbitrage).
Alas – even if you do not own any Citigroup you should be worried by this. The government is and remains the biggest holder of Citigroup stock – and when Citigroup has to pay more to raise private sector equity capital that “more” is effectively “less” for the existing shareholders. That is less for you the taxpayer.
So – in pursuing the bogus issue of naked short selling not only has the SEC diverted resources from its real
But – I should not complain. It has put a reasonable risk arbitrage our way – and I hope to report back that – thanks to the SEC crackdown on a bogus issue our clients are
Nonetheless I will know a commentator who really gets it when they defend modest levels of cash collateralised fails to deliver as a normal part of a normally functioning financial market. Naked short selling is good for markets, good for taxpayers and good for capitalism.
Quantifying the loss to taxpayers
Consider who bears this loss? There is 18% discount for buying the common over the preferred. To anyone who swaps preferred for common there is an 18% profit. As this is a 20 billion deal this profit is 18% of 20 billion or $3.6 billion.
The market is a zero sum game – that $3.6 billion is paid by someone. Well that someone is two groups. The first group is the existing preferred shareholders who should have got more for their shares. The other someone is Citigroup who get a less good price for the shares they are issuing. The incidence is hard to determine but given the recent history of squeezing shorts on preferred conversions is obvious enough that Citigroup bears at least half of the incidence.
As half of the loss is born by Citigroup who gets to issue the shares at a price that is too low. That is the loss is borne by Citigroup shareholders.
The cost to the taxpayer – well 18% of 20 billion raised is 3.6 billion. Just over half of Citigroup is owned by the taxpayer – and more than a half of that arbitrage profit comes from the issuing company (Citigroup). The cost to the taxpayer – a neat gift to hedge fund operators – is at least a billion dollar.
These days I guess that is small change. Either way – as a recipient of this gift I wish to thank the slime-bag proponents of the naked short selling hogwash.
Correction. I have been emailed to say that Joe Nocera did not get a subpoena.