(Mr. Ben Mah, author of America and China, America and the World, America in the Age of Neoliberalism, Financial Tsunami and Economic Crisis – The End of American Hegemony, and the forthcoming China in the Global Crisis of Capitalism, is a frequent contributor to this website.)
In the wake of the collapse of Lehman Brothers in 2008, which was the biggest bankruptcy in history, it was revealed that as many as over 32 million of the company’s shares were sold on the market but not delivered to the buyers. This number of fails-to-deliver transactions represents a more than 57-fold increase over the peak of the prior year. The practice of fails-to-deliver is linked by the Securities Commission to naked short sales, a strategy of market manipulation. Similar short sales also happened with the near-collapse of Bear Stearns, 6 months earlier.1.
Traditionally, short sellers sell stocks by borrowing them from the brokers with the hope that they can buy them back at a lower price and pocket the difference. However, “naked short sellers don’t borrow before trading – a practice that becomes evident once the stock isn’t delivered. Such trades can generate unlimited sell orders, overwhelming buyers and drive down prices.”1.
In fact, short selling is regarded as a form of counterfeiting, a fraud. The price of the stock is supposed to respond to supply and demand in the financial market, but with unlimited sell orders, there are no “free market forces.” When two or more shareholders own the same share, the price of the shares will fall. Generally, “price will continue to fall as long as supply continues to expand beyond demand. Furthermore, price decline is not a linear function of supply expansion. At some point, if supply continues to expand beyond demand, the ‘bottom will fall out of the market,’ and prices will plunge.”2.
In 2004, the questionable actions of the naked short sellers came to light with the launch of lawsuits called “Stockgate”, which alleged that there is collusion between the hedge fund managers, stockbrokers and market markers exploiting small and medium-sized American public companies. C. Austin Burrell, the lawyer acting for the plaintiffs alleged that “illegal Naked Short Selling has stripped hundreds of billions, if not trillions, of dollars from American investors.” He stated that for a six-year period before 2004, over 7,000 public companies have been “shorted out of existence.” Burrell declared that over 1,200 hedge funds have been involved in these kinds of dealings, and “as much as $1 trillion to $3 trillion may have been lost to naked short selling.”3.
Depository Trust Company (DTC) is the official agency responsible for stock clearing, and is a private concern owned by broker-dealers and banks. The lawsuits “allege that the DTC has an enormous pecuniary interest in the short selling scheme, because it gets a fee each time a journal entry is made in the ‘Stock Borrow Program’.”3.The situation became quite serious, as the Investors Business Daily reported that: “The scandal has embroiled hundreds of companies and dozens of brokers and market makers, in a web of international intrigue, manipulative short-selling and cross-border actions and denials.”3. However, complaints and lawsuits seem to have no bearing with the issue as the SEC imposed only small penalties and has little deterrent effect on the offenders. The SEC even refused to disclose the amount of naked short sales, or the name of the sellers.3.
Indeed, SEC seems powerless to enforce basic security rules, as “fail to deliver” is clearly in defiance of orderly trade as a short seller is required to borrow replacement stocks within three days. The situation of regulation and enforcement of rules became worse in the age of financial innovation, which introduced products such as mortgage-backed securities, CDOs and derivative instruments. In fact, “Regulations did not keep up with the explosion of financially innovative products, which created a loophole for a new, more sophisticated type of ‘bear raid’ that coincided to [with] the big financial crisis of 2008.”4.
The financial crisis of 2008 began with the collapse of the leverage funds sponsored by investment bank Bear Stearns. Bear Stearns’ “High-Grade Structure Credit Strategic Enhanced Leverage Fund” with capital of $600 million, “borrowed another $6 billion, then made about $16 billion in bets.” 5. Bear Stearn’s fund was an active participant in the subprime mortgage market and, as a result of loan defaults, which started in 2006, the fund was unable to meet the debt obligations and declared bankruptcy.
The bankruptcy of Bear Stearns’ High-Grade fund set off a storm of panic in the financial community, as Wall Street investment bankers were supposedly magicians who can turn subprime mortgages into collateralized debt obligations, or CDOs. These financial products were often stamped with AA to AAA by the credit agencies. These securities were promoted as sound investments and sold to institutional investors at home and abroad.
However, Wall Street bankers have long recognized the inherent risk of structured finance and have come up with another money-making scheme; the development of credit default swap derivatives to insure the value of the securities. But as with any derivatives trading, this requires a counter-party, which is another financial speculator, who will risk bankruptcy in the case of major loan defaults. More importantly, one should realize that a credit default swap, an instrument with no underlying assets, is merely a bet. Not surprisingly, in this Wall Street casino, betting is growing at a much faster rate than the loans themselves. In fact, the derivative market is many times the size of the market for bonds, stocks and other instruments.
Consequently, Wall Street, where derivatives trading were running rampant, became a global casino. This is the inevitable outcome of financial liberalization, low interest rates and easy credit, as global capital was looking for high returns. In this kind of environment, traditionally conservative, risk-averse financial institutions such as banks and insurance companies have changed into risk-taking enterprises. Unfortunately, investment banks, as peddlers of toxic subprime mortgages, have to “warehouse” loans, sometimes for a few months. In other words, they have to take the mortgage-backed securities and CDOs into their balance sheet, and become the owners of toxic assets.
Toxic assets such as mortgage-backed securities and collateralized debt obligations (CDOs) usually consisted of 10 to 30 year mortgages, and that created a mismatch on the bank’s balance sheet, which is short-term funding. This was obvious with the case of Bear Stearns, which financed its daily requirement to the tune of $50 billion a day on the repos market.
Repos is the repurchase agreement market where borrowers sell their securities to lenders for cash and agree to buy back the securities for more cash one day later. Under this kind of financial arrangement, any rumors regarding a firm’s financial health or credit downgrading by a rating agency would cause a free fall in that company’s stock and shake the confidence on the part of repos lenders. This was exactly what happened to Bear Stearns providing a good opportunity for bear raiders to attack the company.
At first, the bear raiders bid up the price of the credit default swaps of the bonds, which caused the price of CDOs and the mortgage backed securities to drop. On the morning of March 8th, 2008, Moody’s dropped a bombshell on the financial market by downgrading Bears Stearns bonds. Bears Stearns' stock fell sharply following the downgrade despite the fact that it was already down more than 50% from a high of $172 a share in 2007.6.
Subsequently, Bear Stearns was rescued from bankruptcy by the Fed; as it worked out a deal with JPMorgan Chase to buy the company at $2 a share with the Fed undertaking a security guarantee to the purchaser to the tune of $30 billion. The collapse of Bear Stearns, according to its CEO, Mr. Alan Schwartz, “was a pre-mediated attack orchestrated by market speculators who stood to profit from its demise. Those unnamed speculators, employed a complex scheme to force a handful of major Wall Street firms to hold up trade with Bear, and then leaked the news to the media, creating an artificial panic.”6.
On September 11, 2008, the seventh anniversary of 9/11, Lehman Brothers, another Wall Street investment bank, was under speculative attack, as it was bombed with short selling. The Lehman trading shares registered the biggest one-day drop with highest trading volume. The company suffered a bear raid and filed for bankruptcy on Monday, September 14, 2008.
No sooner had Lehman Brothers gone bankrupt than attention in the financial community turned to AIG, the world’s largest insurance company based in New York with global operations. Similarly, AIG suffered the same fate as Bear Stearns and Lehman Brothers with a credit downgrade and speculative selling of its stock.
Consequently, the U.S. was in the midst of economic crisis, as George Soros, the head of the gigantic hedge fund stated: “After the bankruptcy of Lehman Brothers on September 15, the financial system really ceased to function. It had to be put on artificial life support. At the same time, the financial shock had a tremendous effect on the real economy, and the real economy went into a free fall, and that was global.”7.
A few months after the bailout of AIG and the the demise of Lehman Brothers, George Soros offered his view on the sudden collapse of Wall Street firms:
“It is clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination.”8.
While admitting that “CDS are toxic instruments whose use ought to be strictly regulated,” and “only those who own the underlying bonds ought to be allowed to buy them,” George Soros thinks by doing this it would stop bear raids. Unfortunately, as an active participant of derivative trading, Mr. Soros only wishes to maintain the present dysfunctional financial system with a slight modification. Notwithstanding that this financial system brought American economy to the brink of disaster, Mr. Soros still does not see the need for fundamental changes. But these changes are necessary to get out of the present economic quagmire. More importantly, “short selling is the modern version of counterfeiting,” and speculators like Mr. Soros and his colleagues have earned tens of billions of dollars of profit from pure speculation. When Mr. Soros is short selling currencies, whether they are the British pound, Italian lia, Thai baht, Malaysian ringgit or Hong Kong dollar, Mr. Soros is in fact diluting the local currencies of those countries with a flood of paper money, and this has bought unemployment, economic chaos and misery and untold suffering to those local populations.
Well-versed in sophisticated trading strategy and derivatives, speculators such as Mr. Soros can “manipulate markets, cause massive currency devaluations, and force small vulnerable countries to do their bidding. Derivatives have been used to destroy the value of the national currencies of competitor countries, allowing national assets to be picked up at fire sale prices, just as the assets of the American public were snatched up by wealthy insiders after the crash of 1929.”9. During the Asian financial crisis, defenders of the global economic order such as Paul Krugman blamed targeted countries for their “crony capitalism”, but “the fault actually lies in a monetary scheme that opens their currencies to manipulation by foreign speculators who have access to a flood of ‘phantom money’ borrowed into existence from foreign banks.”9.
Based on the above, one should not expect speculators like Mr. Soros to offer any useful insights to solve the current economic problem, as that would require fundamental changes to the way of doing business in the financial market. After all, Mr. Soros earned himself the local nickname of “crocodile” for the tactics he employed to undermine the local currencies and stock markets during the Asia financial crisis and in Hong Kong in 1998.
Notes:
1. Matsumoto, Gary: “Naked Short Sales Hint Fraud in Bringing Down Lehman”, March 19, 2009 Bloomberg.com
2. Brown, Ellen: “Web of Debt”, P 181 Third Millennium Press 2008
3. Brown, Ellen: “Web of Debt”, PP 185-186 Third Millennium Press 2008
4. Dailystocks.com: “How Does a Bear Raid Work?” 1997-2009
5. Hoefle, John: “Wall Street's Toxic Waste” June 29, 2007 Executive Intelligence Review
6. Burrough, Bryan: "Bringing Down Bear Stearns”, August 2008, Vanity Fair
7. Globaleconomicwarfare.com: “What Caused the 2008 Market Collapse?"
8. Soros, George: “One Way to Stop Bear Raids”, March 24, 2009 Wall Street Journal
9. Brown, Ellen: “Web of Debt”, P 187 Third Millennium Press 2008
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