Studies have shown that shortsellers have been blamed for market declines since the inception of the stock market. New theories of how to “cure” this alleged problem surface every few years. Five years ago the cry was to call in your certificates. A couple of years ago it was to abolish the DTC and return to paper certificates. Now, thanks to people like Bob O’Brien, abolishing naked short selling is the medicine of choice.

Simple, logical analysis shows how misguided the anti naked shorting crowd is. For example, here are a few *myths* exposed:

1. We Need to Eliminate Naked Short Selling to Level the Playing Field

The risk of going long is finite in that a stock will only fall to a value of 0, thus limiting your liability to the amount invested. As a stock may rise indefinitely, the money necessary to cover a short is theoretically unlimited. Obviously, the playing field is not just un-level, it is tilted to create a slippery slope for short sellers.

Furthermore, one can buy a stock whether the price is going up or down. The “Uptick Rule” prevents shorting a stock whose price is on the decline.

Next time someone tries to soft peddle their opposition to naked short selling as “I just want to make sure both sides play by the same rules,” ask them if they are in favor of capping risk on short selling and abolishing the Uptick Rule.

2. Naked Short Selling Destroys Innocent Thinly Traded Companies

According to a study of market manipulation cases brought by the SEC between January 1990 to October 2001, entitled “Stock Market Manipulation – Theory and Evidence”, “84.51% of manipulation cases involve the inflation of stock prices while less than 1% of cases involve the deflation of stock prices. Stabilization accounts for 2%. For about 13% of cases we do not have enough information to classify the type of manipulation.” [1]

Another study, entitled “The Long and Short of Hedge Funds: Effects of Strategies for Managing Market Risk”, analyzed the performance of companies that complained about excessive shorting of their stock: “Firms don’t like it when someone shorts their stock, and some firms try to impede short selling using legal threats, investigations, lawsuits, and various technical actions. Consistent with the hypothesis that short sale constraints allow stocks to be overpriced, firms taking these anti-shorting actions have in the subsequent year very low abnormal returns of about -24 percent per year. The negative returns continue for up to three years. What appears to be happening is that these companies are overpriced, either because of excessively optimistic investor expectations, faulty products or business plans, or just plain fraud on the part of management.” [2]

Conclusion

Given the inherent risk in going short a stock vs. going long, any argument in favor of further constraining short sellers in order to level the playing field is fallacious. It’s precisely this added risk that makes it much more likely a heavily shorted stock indicates a less desirable investment in general. With frauds of massive proportion like Enron, Worldcom, and Tyco — not to mention absurd abuses by mutual funds, investment houses, and even media talking heads — the SEC, and presumably Mark Cuban, should have a much higher agenda than wasting time battling the latest fad excuse for why someone like Bob O’Brien’s pet stock is not making him rich.

Sources (highly recommended for further reading):
[1] http://www.sec.gov/rules/proposed/s72303/ger010504.htm
[2] http://financialservices.house.gov/media/pdf/052203ol.pdf

For a chronicle of investment chatboard related lawsuits, maintained by the author, see:
http://www.siliconinvestor.com/subject.aspx?subjectid=28509

bovine

Refs:
http://www.unm.edu/~boni/Fails_paper_Nov2004.doc
http://marketrac.nyse.com/ot/ot.html

It seems that Bob agrees in principal that a company with strong fundamentals will not be hurt by a short selling. They’ll sell their widgets, and the people will continue to buy them.

He excludes REITs from this due to their need for constant capitalization. There is an interesting implication here that the health of REITs are directly, not indirectly or marginally, but directly related to how well they are able to maintain their stock price.

Here’s the problem: Knowing this, why wouldn’t everyone short REITs since this would create a cycle of depressing the stock price, making the company less healthy, depressing the stock price further, making the stock even more unhealthy, etc. etc. What Bob is really saying, unless I’m missing something, is that REITs are extremely vulnerable to short selling, legal or otherwise.

This isn’t exactly an endorsement of the entire REIT business model.

You are not getting the full import of my observations. I am saying that REITs are more vulnerable because of their requirements for secondaries, but that all companies are vulnerable at their core. The SEC recognized that when they made their comments in the Reg SHO invitation for discussion, available at their website at SEC.gov – http://www.sec.gov/rules/proposed/34-48709.htm#II :

“Although short selling serves useful market purposes, it also may be used to illegally manipulate stock prices.23 One example is the “bear raid” where an equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest.24 Further, unrestricted short selling can exacerbate a declining market in a security by increasing pressure from the sell-side, eliminating bids, and causing a further reduction in the price of a security by creating an appearance that the security price is falling for fundamental reasons.

Short selling was one of the central issues studied by Congress before enacting the Exchange Act, but Congress did not directly prohibit short selling.25 Instead, Congress gave the Commission broad authority to regulate short sales in order to stop short selling abuses.”

There’s more, but to cut to the chase, the SEC recognizes that unrestricted and illegal naked short selling can destroy a company’s market cap. They get it. And yet they pardoned all the past instances – my hunch is because the fallout is so large it would cripple the Wall Street crony network, and they don’t want to hurt their buddies who were busy raping the system on their watch in the first place.

Here’s another piece that lifts the corner of the curtain so you can see just how ugly this is – the Elgindy case. It has it all. Saudi arms dealers, bad federal agents, scamming, networks of predatory hedge funds. I can’t make this shit up. And it speaks to why I would want to keep my identity anonymous.

http://www.faulkingtruth.com/Articles/Investing101/1014.html

In short (no pun intended) illegal naked shorting is not just a nuisance that a stiff upper lip and a positive attitude will rectify. It is an illegal part of a criminal scheme to harm targeted companies using whatever means are at the predator’s disposal. Just running your company honestly and hoping for the best is not effective – any more than being law abiding is an effective deterrent to bank robbers or rapists or counterfeiters. This has to be viewed as uniquely different than legal short selling, which I don’t have a problem with. Folks that try to blur the distinction are in my opinion either badly mistaken or deliberately disingenuous.

Mark: I think its wrong to raise money in a 2ndary to pay a dividend. Either you have money to pay the div or you don’t. 2ndaries dilute ownership and create a bigger obligation for future dividends. That’s a slippery slope, IMHO

Bob: Every MREIT on the planet does secondaries every few months to raise capital to invest in growing the business. NFI has and always has had the money to pay their dividend – the portfolio earns almost 90% of it. The problem, which again, ALL MREITs have, is that if you are paying out 90 or 100% of the Taxable Income as a dividend, there’s no money left over to invest in growing. That why they ALL do regular secondaries. Alternatively you can believe that all MREITs are some sort of Ponzi scheme. Depends upon your ignorance of accounting and REIT rules, I suppose. The company actually addressed this, as did I in debunking the Gradient Analytics report at the http://www.NFI-Info.net website’s news page under the 2.20 date.

MARK: Missing your numbers because of rising short term interest rates when it’s pretty obvious that short term rates were going to go up. Suggests there is a failure to communicate between them and the analysts.

Bob: There is a failure, but it isn’t in the company’s communications. Again, speaks to ignorance of the specifics. The GAAP numbers weren’t “missed” due to short-term rates going up. They took an Impairment due to the forward yield curve spiking – a forecasting mechanism for future rates that spiked in the last few weeks of December. That causes the value of the newer securities they hold to go down in value, and some older securities they hold to go up in value. The problem is that GAAP won’t let you revalue those older securities up or recognize the increase in value of the hedges even though in the real world they did increase in value (I know, I know, that’s not fair, but it’s the way GAAP in its wisdom works), only to write DOWN the newer securities, hence an impairment on the GAAP number – note that there is NO impairment on Taxable Income, which is what the dividend is paid off of.

So nothing to do with short term rates going up in Q4, everything to do with a change in the forward curve (again, which has nothing whatsoever to do with interest rates in December – rates could have gone down then and if the curve had gone up it still would have caused the same impairment.)

So the facts actually get you to a different conclusion than Mr. Cuban arrived at, if you dig in deep and look at all the facts.

Funny, that.

Although I do like talking specifics. Specifics are your friend. If you are accurately assessing the data. Which I try to do.

Overall, short-selling is beneficial to the market; however it’s not without its warts. Certainly more could done in terms of reporting (see previous comments), enforcement, and penalties. I mean, before the mutual fund scandal surfaced whodda thunk there was a problem?

ps – Charter’s at the river tonight…it’s not too late to break-out the green-eye shade and do some pre-grame analysis…

And the company not asking me to change the name of the site is a reason to want to short it? You realize there are windows-sucks.com, mi-crosoft.com, microsoftsucks.com, and a f*ckmicrosoft.com? Should we all short microsoft as they didn’t have them change their names?

Seems a little specious. Actually a lot specious. Although it is reassuring that none of the reasons you have given so far are legitimate reasons to short the company.

No disrespect intended. But they aren’t.

In other words, Marky the Donald Trump wannabe is a coward and he knows he’s outclassed. Way to weasel out Marky. Marky wants to call BS, which is all Marky has: no reasons, no facts, no analysis. He can’t tell a mbs-reit from his own ass. Good luck with that hedge fund for gambling, Marky. One of the stupidest ideas I’ve ever heard.

And oh by the way, why was your television show canceled? Loser.

He goes further, rightfully so imho, and states that it is actually GOOD that someone would short a strong company. This provides an opportunity for a company to perhaps buy back its stock at a significant discount (among other benefits). Can you imagine that…the short sellers are providing a company with the ability to RAISE shareholder value?

I feel like I’m paraphrasing Mark, but it seems like it needs to be reiterated for some people: If a company needs to rely on its stock price to stay in business, it probably isn’t in a very healthy position in the first place.

And Willie, can I call you Willie? Please close your pie hole. What is your list of accomplishments? If you have nothing better to do than disparage on of the greatest lessons in TV recently, then you seriously consider taking the next step in advancing your career in organ donation.