The biggest bankruptcy in history might have been avoided if Wall Street had been prevented from practicing one of its darkest arts. As Lehman Brothers Holdings Inc struggled to survive last year, as many as 32.8 million shares in the company were sold and not delivered to buyers on time as of September 11, according to data compiled by the Securities and Exchange Commission and Bloomberg. That was a more than 57-fold increase over the prior years peak of 567,518 failed trades on July 30. The SEC has linked such so-called fails-to-deliver to naked short selling, a strategy that can be used to manipulate markets. A fail-to-deliver is a trade that doesnt settle within three days. We had another word for this in Brooklyn, said Harvey Pitt, a former SEC chairman. The word was fraud.
While the commissions Enforcement Complaint Center received about 5,000 complaints about naked short-selling from January 2007 to June 2008, none led to enforcement actions, according to a report filed on Wednesday by David Kotz, the agencys inspector general. The way the SEC processes complaints hinders its ability to respond, the report said.
Twice last year, hundreds of thousands of failed trades coincided with widespread rumors about Lehman Brothers. Speculation that the company was being acquired at a discount and later that it was losing two trading partners both proved untrue. After the 158-year-old investment bank collapsed, listing $613 billion in debt, former CEO Richard Fuld told a congressional panel on that naked short sellers had midwifed his firms demise.
Gasoline on fire
Members of the House Committee on Government Oversight and Reform werent buying that explanation. If you havent discovered your role, youre the villain today, US Representative John Mica, a Florida Republican, told Fuld.
Yet, the trading pattern that emerges from 2008 SEC data shows naked shorts contributed to the fall of both Lehman Brothers and Bear Stearns Cos, which was acquired by JPMorgan Chase & Co in May.
Abusive short selling amounts to gasoline on the fire for distressed stocks and distressed markets, said US senator Ted Kaufman and one of the sponsors of a bill that would make the SEC restore the uptick rule. The regulation required traders to wait for a price increase in the stock they wanted to bet against; it prevented so-called bear raids, in which successive short sales forced prices down.
Driving down prices
Reinstating the rule would end the pattern of fails-to-deliver revealed in the SEC data, Kaufman said. These stories are disturbing and make a compelling case that the SEC must act now to end abusive short selling -- which is exactly what our bill, if enacted, would do, the senator said.
Short sellers arrange to borrow shares, then dispose of them in anticipation that they will fall. They later buy shares to replace those they borrowed, profiting if the price has dropped. Naked short sellers dont borrow before trading -- a practice that becomes evident once the stock isnt delivered. Such trades can generate unlimited sell orders, overwhelming buyers and driving down prices, said Susanne Trimbath, a trade-settlement expert and president of STP Advisory Services. The SEC last year started a probe into what it called possible market manipulation and banned short sales in financial stocks as the number of fails-to-deliver climbed.
The daily average value of fails-to-deliver surged to $7.4 billion in 2007 from $838.5 million in 1995, according to a study by Trimbath, who examined data from the annual reports of the National Securities Clearing Corp, a subsidiary of the Depository Trust & Clearing Corp.
Trade failures rose for Bear Stearns as well last year. They peaked at 1.2 million shares on March 17, the day after JPMorgan announced it would buy the investment bank for $2 a share. That was more than triple the prior-year peak of 364,171 on September 25. Fuld said naked short selling, coupled with unsubstantiated rumors, played a role in the demise of both his bank and Bear Stearns. The naked shorts and rumor mongers succeeded in bringing down Bear Stearns, Fuld said in prepared testimony to Congress in October. And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers.
Failed trades correlate with drops in share value enough to account for 30 to 70% of the declines in Bear Stearns, Lehman and other stocks last year, Trimbath said. While the correlation doesnt prove that naked shorting caused the lower prices, its a good first indicator of a statistical relationship between two variables, she said. Failing to deliver is like issuing new stock in a company without its permission, Trimbath said. You increase the number of shares circulating in the market, and that devalues a stock. The same thing happens to a currency when a government prints more of it. Trimbath attributes the almost ninefold growth in the value of failed trades from 1995 to 2007 to a rise in naked short sales. You cant have millions of shares fail to deliver and say, Oops, my dog ate my certificates, she said.
Online, the Federal Reserve Bank of New York lists several reasons for fails-to-deliver in securities trading besides naked shorting. They include misunderstandings between traders over details of transactions; computer glitches; and chain reactions, in which one failure to settle prevents delivery in a second trade. Failed trades in stocks that were easy to borrow, such as Lehman Brothers, constitute a red flag, said Richard H Baker, the president and CEO of the Washington-based Managed Funds Association. Suffice it to say that in a readily available stock that is traded frequently, there has to be an explanation to the appropriate regulator as to the circumstances surrounding the fail-to-deliver, said Baker.