Mother of All Short Squeezes?

by: Matt Blackman posted on: July 20, 2008 | about stocks: AZ / BAC / BCS / C / CS / DB / FNM / FRE / GS / HBC / JPM / LEH / MDTL / MER / MFG / MS / RBS / UBS    

Tuesday’s action by the SEC in amending Regulation Short Sales (RegSHO) listed 19 banks and financial companies for which naked shorting was effectively banned for 30 days. Such a limit was long overdue but why limit the restriction to just 19 companies and just 30 days?  

Naked short selling (selling shares short that are not first borrowed, which is required to execute a legal short) is endemic and the SEC has turned a blind eye to it since the agency was created. This recent action is a knee-jerk reaction but a clear example of too little way too late.  The question is will they have the stomach to do what it necessary and give all stocks the same naked short protection? But like anything else, the devil is in the detail.

As you can see from the chart below, the ban and rally created one mother of a short squeeze this week with the 17 companies trading on the NYSE rallying nearly 20% in just three days. However, since May 1, 2008 this group is still down 24.8%. (Before this past week’s rocket ride, the group was down 37.2%.)

Not surprisingly given the government bailout plan announced this week, Fannie Mae (FNM) and Freddie Mac (FRE) enjoyed the biggest lift jumping 89.5% and 74.5% between July 15 and July 18. But as of the July 18 close, they were still down 61% and 72% in the last four months (since March 20). 

In their monthly Short Interest Report on July 16, Bespoke Investment Group updated their short interest numbers showing that short interest as a percentage of the float continued to increase during the second half of June with the average short interest hitting 6% for the S&P 500. Over the last year, short interest has increased 48% for the 500 stocks. Bespoke also found that the 10 percent of stocks in the S&P 1500 with the highest short interest (150 stocks) gained 15.1% in the two day period ending July 17, 2008 compared to just 2.2% for the 150 stocks with the lowest short interest. Now that’s a short squeeze rally!

click to enlarge

Image

Figure 2 – Chart showing three-day stock performance for 17 of the 19 stocks that the SEC identified in its naked-short prohibition order amendment to the Regulation Short Sale (RegSHO) rules Tuesday. Two of the companies trade on the pink sheets so we graphed the other 17 that trade on the NYSE. As a group, these stocks jumped nearly 20% in the recent three-day period! Chart by VectorVest.com.

We checked Buyins.net, a website that tracks naked short selling statistics that became available as the result of RegSHO that became law on January 1, 2005. Buyins.net has to contend with a regular barrage of hack attacks presumably from short sellers who don’t like what they are doing.

We looked at their list of stocks that are fail to delivers [FTDs] (stocks shorted without first having to borrow the same number of shares, which is what you and I have to do before executing a short sale).

At the top of the list is Medis Technologies (MDTL), which has remained on the SEC’s fail to deliver threshold list for 742 days. In other words, it has been the target of naked short attacks and these shorts have not had to deliver shares that they have shorted for a total of 742 days! We counted a total of 244 stocks that have stocks that are classified as fail to delivers in excess of the maximum supposedly allowed by the SEC of 13 days.

Brokers, market makers and some other big players have found ways around this inconvenient rule. Brokers and money-makers should have some time to deliver borrows, but 742 days?!  There is something seriously wrong in stock regulation/enforcement land and as long as it is allowed to continue, stock markets will experience increased short-driven volatility.

Disclosure: None

This article has 20 comments! Add yours below...

Matt Blackman

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This article has 20 comments:

  •  
    stockjockey2
    5
    Jul 20 06:33 PM
    Unless the SEC understands and addresses the "Berlin Stock Exchange" connection with naked short selling and hedge fund broker dealer subsidiaries the abuses will not end. Many companies are unknowingly listed on this exchange and "arbitrage" naked short selling is permitted. This is a bogus excuse for sidestepping an outlawed practice. The consequences are that capital hungry small companies are shorted into oblivion by an abject manipulation.
  •  
    quetzalcoatl
    Jul 20 06:53 PM
    I'm not an expert in these matters, but it seems from what I have been reading lately that the SEC ought to enforce their rules, and do so vigorously.
  •  
    glassbox
    Jul 20 09:22 PM
    you know why there is such a big resistance to short selling especially on sites like SA and coming from many fund managers, esp hedge fund managers.... Because if rationality and logic has its way, running a hedge fund is going to less profitable, market makers will no longer be able to make as much markets and brokers cannot earn twice on their margin business (first from lending you money and then lending your shares).
  •  
    The Dark
    Knight 77
    Jul 20 09:50 PM
    Very refreshing views on the financial crisis, regulation can help but the gaps will always be present so closing these gray areas in the stock market will help the stability of the financial sector
  •  
    MauiTrader
    Jul 20 10:08 PM
    Stop regulating free markets and just use common sense laws.

    Like naked shorting should be legal in the first place.

    KISS everyone. More regulations = less 2003 markets and more 2001-2002 market environments. What we need to really grow is tax cuts. Study tax cuts and market gains and it is clear when you lower taxes, the markets rally. When you raise them.....DUH. ;)
  •  
    sharp10
    Jul 20 10:14 PM
    How convenient that the SEC decides to come out with this right before most banks are due to report.

    And why other companies like WB, or NCC on that list?
    Should I assume that a company like Morgan Stanley or Goldman are more vulnerable to naked short selling than a WB, or WM?
    Please...
  •  
    sharp10
    Jul 20 10:15 PM
    I left out the NOT on that list...sorry


    On Jul 20 10:14 PM sharp10 wrote:

    > How convenient that the SEC decides to come out with this right before
    > most banks are due to report.
    >
    > And why other companies like WB, or NCC on that list?
    > Should I assume that a company like Morgan Stanley or Goldman are
    > more vulnerable to naked short selling than a WB, or WM?
    > Please...
  •  
    Cruiseguy
    Jul 20 10:29 PM
    My Website
    All I know is the Financials were easy money this week...DUG is looking good for the next couple of months!!!
  •  
    Cruiseguy
    Jul 20 10:31 PM
    My Website
    Are they going to ban naked shorting on Homebuilders? I am surprised Beazer or one of the other builders have not BKed....

    Pulling for a good report from CTX...but it is doubtful...you never though banks surprised this week....a couple of the better homebuilders next?
  •  
    Medici
    Jul 20 10:45 PM
    My Website
    Naked shorting Legal?? What? Crazzzyyy....It has nothing to do with the "free markets", essentially people could sell short more shares in a company than actually exsist...Thats not good for anyone in the "free markets". shorting is a good, naked shorting = bad.
  •  
    bm1087
    Jul 20 11:19 PM
    If you been around Wall Street any length of time you will come to realize there is no such animal as a "free market". Wall Street is a well-oiled machine controlled by very few players. You and I ride on those coattails for good or for bad.
  •  
    gaucho
    Jul 20 11:39 PM
    My Website
    I remmber when the SEC said that Naked shorting was just some BS story made up by losers.

    They they said it exists but had no impact.

    Then the implemented reg SHO

    Now they are saying it is destroying the banks.

    Now we have a huge rally.

    SOO now the king has no cloths. Hw re they ever going back to the past when Naked Shorting does not exist.

    Remember after the short squeeze then the bottom will fall out like a rock
  •  
    pelican
    Jul 20 11:56 PM
    Great article, Matt. Lots of interesting responses from people too.
  •  
    friend
    Jul 21 12:45 AM
    Yes , why does the unlawful naked short selling being allowed openly by SEC ?

    Even at emergency , SEC offers policing to only 19 investment banks for 30 days .

    How about the regional banks where they have already been hurt by naked short sellings .

    The naked short sellers can short sell unlimited quantity of shares of any bank by not having to borrow the same .

    Such short sellers then have the " privilege " to command an unlimited supply of shares .

    Such short sellers are naturally invincible since they have been well fed financially in expense of the economy of USA .

    Yet , SEC would only police for 19 investment banks .

    Why does the lawmakers tolerate such notorious violation of the law ?

    Further , banks are often required to shore up their balance sheet forcing them to sell newly issued stocks at depleted pricing .

    An article indicated that the same short sellers who depleted the banks' pricing would buy the newly issued stocks for covering their position .

    Magic ! short selling " nothing " at a high price and buying back the tremendous quantity of new issues at a dirt cheap price .

    A small group of short sellers make huge profit on the misery of a very large number of innocent people .

    Is this vicious cycle of selling phantom stocks at high prices while covering the position with cheap new issues , really happening under the eyes of lawmakers ?

    Just in case , Banks should have a grace time to shore up their balance sheet until the naked short selling is limited .

  •  
    Stephjen
    Jul 21 12:53 AM
    My Website
    i think the actual "ban" is just for one week, with the option to extend for 30 calender days.
  •  
    Bob Gary
    Jul 21 01:31 AM
    The Fed along with the Government did everything they could to engender capitulation last week. As far as the the whole short-selling debacle goes, where do you draw the line. I was reading this piece over the weekend wondering what happens next?

    www.greenfaucet.com/th...
  •  
    User 118015
    Jul 21 02:15 AM
    Its obvious the banking crisis is way overdone...stocks like Banner Bank in Seattle for example has had less problems and is profitable and the stock took a great hit for no reason...by the way the dividend is over 8 percent and probably will remain so...take that in your pipe and smoke it..
  •  
    thoroughbred
    Jul 21 02:46 AM
    Not that I am a big fan of his, but didn't the CEO of Overstock.com complain about this ad nauseum and all he got was ridiculed, maybe he was right?
  •  
    tagthatstock
    Jul 21 07:11 AM
    excellent writing! been saying its only a matter of time before the berlin boys find the bigboy stocks far more liquid and profitable on naked shorting. and with the reg sho factor, it shows the fed/sec only cares when it impacts their stock options lmao. we are gonna get to witness a market without shorts waiting for bull exhaustion to wipe out down the road. next the berlin boys will just move to other sectors,,,,,our fed/sec can not control 'the global markets',,, oil has proven that.

  •  
    SYA
    Jul 21 05:33 PM
    It has always mystified me that the SEC will let naked shorting occur as this would be defined as selling of unregistered and unissued shares which is illegal and forbidden under the Securities Act of 1933. A technicality--I don't think so. Until these shares are borrowed or covered the company's capitalization increases.
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