the audit

Bloomberg’s Naked-Short Story Shows Stretch Marks

March 19, 2009

If you want to get a controversy going on Web business sites, bring up naked shorting. So what will happen when a mainstream business outlet like Bloomberg News says naked shorts brought down Lehman Brothers, the failure of which, recall, turned a disaster into a catastrophe last September?

If it’s right it’s a blockbuster—and a devastating blow for a financial press that has pooh-poohed the naked-shorting issue. But this story is problematic and its case seems very thin.

First a brief explainer from me on naked shorting:

Short-selling is when investors bet that a company’s stock will go down. They do this by borrowing the company’s shares from someone, selling them and promising to replace those shares at a future date. If the stock price goes down, they replace them with cheaper shares and pocket the difference. Investors often hate shorts because they don’t play the “game”—the one where everybody wins if stocks go up, up, up. But shorting is a legitimate activity that helps bring efficiency to stock markets. They counteract the bubblicious pressures of “longs” and, since they have an incentive to, often spot problems at a company before others.

Naked short-selling is when someone shorts without actually borrowing the stock. That’s not illegal—the rules say you have to reasonably expect you’ll be able to borrow the stock within a brief period after your trade. It is illegal to do this if you don’t expect to actually borrow the shares.

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Bloomberg has some interesting stuff in its piece today, but it’s ultimately unconvincing. And it certainly doesn’t justify dropping the word “fraud” in a news-story headline (“Naked Short Sales Hint Fraud in Bringing Down Lehman”) or using this lede:

The biggest bankruptcy in history might have been avoided if Wall Street had been prevented from practicing one of its darkest arts.

The piece’s peg is a report issued yesterday by the SEC Inspector General that criticized how the agency has handled the naked-shorting issue. Here’s the nut of Bloomberg’s evidence:

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 Sept. 11, according to data compiled by the Securities and Exchange Commission and Bloomberg. That was a more than 57-fold increase over the prior year’s peak of 567,518 failed trades on July 30.

Now, I don’t have a dog in the naked-shorts fight. I can’t tell you if this is being done illegally on a large-scale and having a real impact on companies. I just don’t know.

But one of the first things that comes to mind here is—wouldn’t you expect fails-to-deliver to soar for a company teetering on the brink of bankruptcy under an avalanche of bad news? I’d expect there would be a rush to short a stock like Lehman, which was about to collapse anyway. So, people who usually could expect to borrow shares to short might have found that they couldn’t because everybody else was doing the same thing.

Now, Bloomberg does quote a hedge-fund industry representative saying such a thing happening in a liquid stock like Lehman is a “red flag”:

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, the hedge fund industry’s biggest lobbying group.

“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, who served in the U.S. House of Representatives as a Republican from Louisiana from 1986 to February 2008.

The graph preceding those is the only one where reporter Gary Matsumoto concedes there might be legitimate explanations for fails-to-deliver:

On its Web site, 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.

But even if all 33 million fails-to-deliver on September 11 were illegal naked shorts, Bloomberg writes that Lehman’s public float (the total amount of outstanding shares) was 688 million. Would illegally shorting an additional 5% of the stock cause it to go under? I don’t know for sure it wouldn’t. I’m just asking.

More important, Matsumoto and Bloomberg give short shrift to the idea that Lehman, you know, was a dead man walking anyway. The company was levered to the hilt with dog assets. Has anyone besides Dick Fuld said the company wasn’t? If Citigroup or GM goes down are we going to blame short-selling, naked or otherwise?

And the Bloomberg piece leans on sources whose credibility is questionable. Harvey Pitt, the former SEC chairman for one. Not many people think he was good in that position—to say the least—but he now runs a company that relies on the threat of short-selling rules and prosecutions to get business. Bloomberg calls it “a Web-based service that locates stock to help sellers comply with short-selling rules.”

Another key source, Susanne Trimbath, says this:

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.

But couldn’t that be explained by the increased volume of trading in the same period? I went back and looked at average daily volume on the Dow Jones Industrial Average. In 2007, it was about 3.5 billion shares per day. In 1995, it was about 350 million. If trading volume has increased by ten times in that span why is it suspicious that fails-to-deliver have increased by less than that?

Again, I’m not close to being an expert on this issue, but some of this stuff just raises obvious questions.

I don’t want to discourage the press from looking into this issue. Far from it. But it can do much better than this.


See this interesting Felix Salmon interview of his Portfolio colleague Gary Weiss, who’s one of the most vehement critics of those who push the nefarious naked-short-sellers theory, about this story. It’s worth a read.

I feel about like Salmon does here: The story was way overwrought, but there’s enough smoke here that it needs to be explained.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR’s business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.