June 5, 2009
In July 2007 the Securities and Exchange Commission suspended the uptick rule after years of pressure from the hedge fund community. Created in 1938 as a response to the market manipulation that lead to the market crash of 1929, in loose terms it prevents a firm from selling a stock short unless the price of the stock has “uicked up”!from the last trade price. Such an uptick is typically generated by a buyer entering the market. In theory, the rule was designed to prevent short sellers from repeatedly selling shares short in the absence of interested buyers.
Combined with the suspension of the uptick rule was lack of enforcement of naked shorting. In every stock shorting situation, whether the uptick rule is in place, the firm selling the stock short must borrow the shares they sell. The business of borrowing and lending shares has grown to a trillion dollar industry over the past 10 years with billions in profits generated by firms such as Goldman Sachs to JPMorgan Chase. Ironically, it was this business line at AIG that led to tens of billions in losses. What should have been a very conservative short-term investment, they invested the cash collateral of their hedge fund clients into subprime mortgages. Big oops.
Naked shorting occurs when a firm sells a stock short and then is unable to borrow the shares they just sold. Governed by the laws of supply and demand, the market for buying and selling of company shares are limited to the total number of shares the company has issued. But if a trader is able to sell shares without ever owning or borrowing them, the trader has in effect increased the number of company shares. In essence, naked shorters are able to issue their own shares solely for the purpose of driving down the stock price. Combined with the suspension of the uptick rule, this is a lethal combination.
According to one statistic reported by Bloomberg, on the Thursday just prior to Lehman Brothes collapse, 33 million shares of stock were sold as naked shorts. That was equivalent to all the shares of Lehman bought and sold on an average trading day. It was as if an entire group of investors from a parallel universe arrived and sold phantom shares for the entire day. It is no wonder the share price collapsed, irrespective of the underlying economics of the firm. Ultimately, the failure of Lehman lead to a far greater economic crisis as the financial system froze.
These are just two of many conditions that opened the financial markets to manipulation. From the undercapitalization of Fannie Mae to the unregulated market for Credit Default Swaps, we created an environment in which the financial markets could take control of our economic health. The motivation behind these actions has been the same for most of humanity —!personal gain. Whether it is AIG bonuses, hedge fund’t destructive trading strategies or political myopia, wve allowed our ambitions and me-first culture to derail the system that feeds us all.