Is Naked Shorting Really as Benign as Mom and Apple Pie?

I found myself pondering this after reading Matt Taibbi's latest screed called Wall Street's Naked Swindle. Taibbi comes down hard on the practice, but then I wandered over to Clusterstock where John Carney says, in so many words, "Wrong, wrong, wrong, Taibbi -- naked shorting isn't a villain."

There are several comments I was going to make on Taibbi's piece, but I'll keep this entry manageable by looking only at naked short-selling of shares. For those already shaking their heads -- the phrase does sound indecent, on the very face of it -- this refers to a variation on the practice of short selling.

Short-selling stock is what you do when you think the price is going to drop. Let's say IBM is at $30 a share. You borrow 100 shares, sell them, wait until IBM falls to $10, then buy 100 shares on the market to replace those that you borrowed. Sweet payday: $30 x 100 - $10 x 100 = $2,000 in your pocket, ignoring transaction and borrowing costs.

Naked short selling is all of the above except -- you don't borrow the shares in the first place for whatever reason. Say trading in the stock is relatively illiquid and the shares are simply hard to find. Or you just can't be bothered. Or ... (there could be a nefarious reason, as we'll soon see).

Now, if you tried to sell a car you didn't own -- and that you hadn't even bothered to contractually borrow from someone else -- the outcome would be rather predictable. Some guy in a blue uniform would show up on your doorstep and put a pair of hard-metal bracelets around your wrists and take you for a little ride to the county courthouse. But let's let that go for the moment. Because, after all, just the act of buying a stock is a pretty complex transaction, once you get behind the scenes, as Carney does in his glibly titled Everything You Always Wanted to Know About Naked Shorting but Were Afraid to Ask. (On another day, when the winds of time are favorably at my back, I'd like to deconstruct his little 23-part lesson, as I think he loses the forest for the trees in his explanation in a way that sheds light on why we're in such a financial mess.)

So, for the moment, let's ignore the felonious-seeming nature of naked shorting (and the racy naughtiness suggested by its very name). Let's get right down to mathematical brass tacks and see what there might be to worry about.

Okay, this is an extreme case I'll paint below, but it's an extension of the principles, and sometimes when you extend the principles, you can get a sense of what's right or wrong to begin with. Let's imagine a world where naked shorting is embraced with the same vigor that say a naked Jessica Alba would be (Naked Shorts Gone Very Wild?).

In this world Fusty's Freezers is an oh-so-small public company. It has 100 shares that trade at $100 each. That gives it a "market capitalization" of $10,000.

In this world the naked shorts decide that tiny Fusty's is ripe for some manipulation. Now, if they had to sell shares short the regular way, they'd have to borrow them. So, for instance, if they sold short 100 shares, they'd have to borrow those 100 first. Supply wise, nothing would change in trading of Fusty's Freezers stock. Even though there are new owners of the 100 shares, the existing owners (who have lent their stock to the short sellers), can't go ahead and lend their stock again or sell it. It's already spoken for, tied up, frozen. (Theoretically anyway.)

Now suppose the naked shorts decide to sell shares they don't own ... and that they haven't borrowed either. A LOT of shares. Let's take an extreme case and say that they sell another 900 shares of Fusty's Freezers into the market.

What would you expect with 1,000 shares of a $10,000 market cap company in circulation? Easy: the price would fall to $10 (actually it wouldn't be quite $10, but that's a complicated tangent that we don't need to chase here). So in other words, the act of naked shorting would drive the stock's price down about 90 percent. (One other note: I'm disregarding momentum effects too, which arguably would drive the price down even more.)

Wow. Even though this is an extreme example, I think a skeptical reader's sniffers should activate. Hmm, something doesn't smell right here. And a couple of interesting questions pop up: (1) Those short sellers made a lot of money. Was it deserved? They made it simply because of the math of what occurred and the laws of supply and demand; there was no underlying weakness in the company that would prompt the share price drop, in my example. (2) Now the SEC, in this rather longish document (just do a search at the top of the page on "counterfeit" and you'll find the relevant section), says naked shorting doesn't actually produce "counterfeit" shares (as Taibbi mistakenly says). But that raises a second question: So could an acquirer swoop in now and grab a $10,000 company (remember Fusty's Freezers is still worth $10,000) for $1,000, as its 100 shares now sell for $10 each?

So imagine Joe Naked Short working in tandem with Vulture Vic. Joe Naked drives down the share price, then Vulture Vic swoops in and snatches up the company for a song. Cool! ... unless you're one of the poor shareholders who got screwed. Remember, no value is being added anywhere here. What Joe Naked and Vulture Vic make, some other shmuck loses.

Now this is an extreme example, granted. Carney does protest that "the overwhelming amount of naked shorting takes place when companies announce abnormally positive results and contrarian traders scramble to fight the tape." In other words, the naked shorters are just really smart, motivated short sellers who can't get their fingers on the shares they need, at that very second, and every second counts.

Okay, maybe true (I haven't researched it). Still, if naked shorting has the potential for massive manipulation, and even if it's done for that purpose only 1 percent of the time, that could be the life or death of a particular small company. So the rare outlier events here could be pretty darn big.

Anyone care to defend naked shorting? I admit to not knowing a whole lot about it. But from what I've seen, I'm pretty skeptical. Instead of trying to preserve naked shorting, I think we'd be better off trying to shore up the legitimate and quite valuable practice of regular short selling. Why not just spend our energy on trying to make ordinary shorting work better so that it's more responsive to a rapidly changing market?