Matt Taibbi <i>"Wall Street's Naked Swindle"</i>

By John Ballard

This video opens with a reference to Goldman Alchemy: Turning a crisis into Billions, a NY Times article by Graham Bowley and Jenny Anderson about Goldman-Sachs. The focus of this post is neither Goldman-Sachs nor Matt Taibbi, but both are important to understanding yesterday's tepid but courageous attempt on the part of President Obama to get some of his biggest cash cows to go along with something they want nothing to do with: better controls over the big financial universe.
(�So if there are members of the financial industry in the audience today,� Mr. Obama said, drawing some ooohs and chuckles from the well-heeled crowd. �I would ask that you join us in passing what are necessary reforms. Don�t fight them.�)
The notion is very much like persuading bulls to submit to becoming steers. (For those without an agricultural background, that means castration.)
I also wanted to see for myself what Matt Taibbi looks like.

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Matt Taibbi,  (not to be confused with his dad,  NBC's Mike Taibbi) spells out chapter and verse of techniques used by financial big shots to create assets out of air by manipulating options on the stock market.
"Wall Street's Naked Swindle" in Rolling Stone (H/T Kat for the tip) has the tawdry details.

...when Bear and Lehman made their final leap off the cliff of history, both undeniably got a push � especially in the form of a flat-out counterfeiting scheme called naked short-selling.

That this particular scam played such a prominent role in the demise of the two firms was supremely ironic. After all, the boom that had ballooned both companies to fantastic heights was basically a counterfeit economy, a mountain of paste that Wall Street had built to replace the legitimate business it no longer had. By the middle of the Bush years, the great investment banks like Bear and Lehman no longer made their money financing real businesses and creating jobs. Instead, Wall Street now serves, in the words of one former investment executive, as "Lucy to America's Charlie Brown," endlessly creating new products to lure the great herd of unwitting investors into whatever tawdry greed-bubble is being spun at the moment: Come kick the football again, only this time we'll call it the Internet, real estate, oil futures. Wall Street has turned the economy into a giant asset-stripping scheme, one whose purpose is to suck the last bits of meat from the carcass of the middle class.

What really happened to Bear and Lehman is that an economic drought temporarily left the hyenas without any more middle-class victims � and so they started eating each other, using the exact same schemes they had been using for years to fleece the rest of the country. And in the forensic footprint left by those kills, we can see for the first time exactly how the scam worked � and how completely even the government regulators who are supposed to protect us have given up trying to stop it.

This is a long article and the typical reader will not understand some of the vocabulary.

I'm not an expert, but I learned enough about common stocks years ago to keep out of individual stocks, unless the money invested there was not a big part of my total assets. Unless an investor can afford to lose everything, he should keep most of his assets in a portfolio of funds, CD's or well-rated bonds. Individual stocks and gold are more glamorous but those zones should be regarded as places where if the money vanishes, like money budgeted for gambling, you'll never miss it. 

The term naked short-selling highlighted above is one of those easy to miss terms that a reader not familiar with investing is likely to overlook. We all do it, more now than at any other time, skipping over words or phrases (or acronyms or text abbreviations) presuming to catch the gist of the message from the context. But figuring out exactly what is going on requires looking more closely. And Matt Taibbi does a great job of explaining naked short-selling.

Once someone understands the concept of short selling to make money if the market price of a stock goes down, the next step is realizing how easy it is to lose money if the stock increases. It's easy to know how much can be made if the stock goes to zero (100% return, less commissions) but it is easy to overlook how much might be lost if the stock price increases instead. In that case, the sky's the limit, because there is no upside to a stock's potential value. That's why "bubbles" are so dangerous. Bubbles typically fail for the same reason that short sales work: borrowed assets. If you borrow money and use it for an investment that returns a better rate than you pay for the borrowed money, you win. Otherwise you lose.

The most common form of borrowed money used for an investment has been the home mortgage, the most common tax-advantaged investment for ordinary people. By borrowing enough money in the form of a mortgage, an ordinary person expects to live in the house and perhaps make something on that investment because the rate of interest on the borrowed money should not be as great as (a) the rate of inflation and/or (b) the value of real estate in the market where the home is located. Either or both of these variables should make the home mortgage a good risk. (Lately we have learned the hard way how "adjustable rates" together with unrealistic expectations of the market are ticking investment bombs, but that is another story.)

The "naked" part of naked short-selling refers to the fact that the principles in the transaction do not actually own the underlying assets. Those assets are not only borrowed, but they are borrowed with borrowed money -- a kind of two-dimensional borrowing. It's like someone in a poker game who runs out of money and wants to get credit from others in the game, but none of the others wants to extend it to him because he's done this kind of thing before and they know he isn't good for it. So the guy goes to someone not at the table and puts the finger on him for more borrowed money. 

Does this sound anything like a Ponzi scheme?
Does the name Madoff ring a bell?
What about Raj Rajaratnam?

Back to other big shots. In the world of investment banking short selling is taken to an industrial extreme. Unlike individual investors whose assets and liabilities are closely monitored by the institutions with which they deal, the really big players have no real institutional oversight.

It's important to point out that not only is normal short-selling completely legal, it can also be socially beneficial. By incentivizing Wall Street players to sniff out inefficient or corrupt companies and bet against them, short-selling acts as a sort of policing system; legal short- sellers have been instrumental in helping expose firms like Enron and WorldCom. The problem is, the new paperless system instituted by the DTC opened up a giant loophole for those eager to game the market. Under the old system, would-be short-sellers had to physically borrow actual paper shares before they could execute a short sale. In other words, you had to actually have stock before you could sell it. But under the new system, a short-seller only had to make a good-faith effort to "locate" the stock he wanted to borrow, which usually amounts to little more than a conversation with a broker:

Evil Hedge Fund: I want to short IBM. Do you have a million shares I can borrow?

Corrupt Broker [not checking, playing Tetris]: Uh, yeah, whatever. Go ahead and sell.

There was nothing to prevent that broker � let's say he has only a million shares of IBM total � from making the same promise to five different hedge funds. And not only could brokers lend stocks they never had, another loophole in the system allowed hedge funds to sell those stocks and deliver a kind of IOU instead of the actual share to the buyer. When a share of stock is sold but never delivered, it's called a "fail" or a "fail to deliver" � and there was no law or regulation in place that prevented it. It's exactly what it sounds like: a loophole legalizing the counterfeiting of stock. In place of real stock, the system could become infected with "fails" � phantom IOU shares � instead of real assets.

If you own stock that pays a dividend, you can even look at your dividend check to see if your shares are real. If you see a line that says "PIL" � meaning "Payment in Lieu" of dividends � your shares were never actually delivered to you when you bought the stock. The mere fact that you're even getting this money is evidence of the crime: This counterfeiting scheme is so profitable for the hedge funds, banks and brokers involved that they are willing to pay "dividends" for shares that do not exist. "They're making the payments without complaint," says Susanne Trimbath, an economist who worked at the Depository Trust Company. "So they're making the money somewhere else."

For the newbie this piece in Rolling Stone is a great introduction to why and how the financial crisis came about and how the same dynamics responsible for last year's crippling meltdown remain in place.

The real lesson is not that we have been bitten by a venomous snake but luckily we have been treated and seem to be responding well to the antivenin serum.

The real lesson is that the snake is still out there, coiled and getting ready for another strike.
And next time we may not be so lucky.

One way to drive home a point is to repeat it using different language. Toward the end of the piece Taibbi does that with this great illustration.

Here's how naked short-selling works: Imagine you travel to a small foreign island on vacation. Instead of going to an exchange office in your hotel to turn your dollars into Island Rubles, the country instead gives you a small printing press and makes you a deal: Print as many Island Rubles as you like, then on the way out of the country you can settle your account. So you take your printing press, print out gigantic quantities of Rubles and start buying goods and services. Before long, the cash you've churned out floods the market, and the currency's value plummets. Do this long enough and you'll crack the currency entirely; the loaf of bread that cost the equivalent of one American dollar the day you arrived now costs less than a cent.

With prices completely depressed, you keep printing money and buy everything of value � homes, cars, priceless works of art. You then load it all into a cargo ship and head home. On the way out of the country, you have to settle your account with the currency office. But the Island Rubles you printed are now worthless, so it takes just a handful of U.S. dollars to settle your debt. Arriving home with your cargo ship, you sell all the island riches you bought at a discount and make a fortune.

This is the basic outline for how to seize the assets of a publicly traded company using counterfeit stock. What naked short-sellers do is sell large quantities of stock they don't actually have, flooding the market with "phantom" shares that, just like those Island Rubles, depress a company's share price by making the shares less scarce and therefore less valuable.

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It should be mentioned that the investment banking community is not taking Taibbi's piece lying down. A quick search for "naked Short-selling matt taibbi" returns a spate of complaints, retorts and insults.Looks like the guy really hit a nerve.

As I said before, I'm no expert, but l have learned enough to know that big-time financial manipulations are a product of Wall Street, not Hollywood. It is true that short sales, options trading and other elaborate investment techniques are regulated at the street level. But it is abundantly clear that last September something really shitty went down, no regulatory mechanisms kicked in to avert it and millions of people have been paying the price ever since.