Last year was certainly a turbulent one for investors. Not only did good assets and companies sell off with bad, but the very integrity of the U.S. markets was brought into question. Financial firms spend millions of dollars convincing the average citizen that investing in stocks is necessary and prudent, yet the playing field is far from level. Fraud, naked shorting and other forms of manipulation are now endemic to the American markets. As Overstock's lawyer, John O'Quinn points out, “You have more chance to be treated fairly in a casino in Vegas.” How can you invest if you can't trust the system?
Jim Puplava, Mike Schneider and a few other journalists have exposed the prevalence of naked shorting on Wall Street. While selling short is a legitimate activity, naked shorting occurs when parties sell shares they don't own and don't intend to borrow, causing more shares to be traded than actually exist. Approximately 7.5% of the trades reported by the DTCC fail to deliver each day, and this agency is private and not at all transparent. Furthermore, 96% of all stock transactions are completed outside the official system and are totally unregulated.
Regulation SHO was enacted in 2005 by the Securities and Exchange Commission (SEC) to supposedly eliminate chronic settlement failures by forcing brokers to close out positions after thirteen consecutive trading days. However the regulation doesn't cover small and micro cap companies, or failures to deliver (FTDs) that are below a certain numerical threshold. Market makers were exempt from this regulation until last fall, and old FTDs were allowed to remain open. Some corporations remained on the threshold list for over a year consecutively with no relief from the SEC.
Chairman Cox admitted in July 2006 that there were many large loopholes in Regulation SHO which allowed predatory shorting to continue. Few firms were investigated, and even those brokers who were caught paid minimal fines. Almost nothing was done until naked shorting threatened “the stability of financial institutions,” according to Cox. In July 2008, the SEC banned naked shorting of 19 select financial firms. With this rule and the subsequent emergency order banning all short selling in 799 financial institutions, Cox admitted that naked shorting was a serious problem, but the SEC would only enforce the rules for certain institutions that deserved the effort.
The Commission has demonstrated where its real allegiance lies, and it’s not with the small investor. For years, hedge funds, brokerages, and investment banks soaked up fat profits by naked shorting promising companies to death. These shorts never have to be covered if the company is delisted and goes bankrupt, so it’s a very lucrative criminal practice. When some of these same corporations that preyed on small cap stocks suffered share price drops due to their hideous balance sheets, the SEC moved in to give them special protection.
Even with some of the loopholes closed, market manipulation still goes on. As Allan Young points out on his website, naked shorting is in effect another derivative like credit default swaps or mortgage backed securities. Predatory brokers can sell more shares than exist, as if they are buying a put (a bet that prices will go down). Sell enough shares and you can ensure your bet is correct. These brokers can later close out their naked shorts and avoid censure from the SEC.
Although the most egregious violations of the naked short rules have been eliminated, with corporations like Overstock now off the naked short list, much of the damage has already been done. Many solid businesses have been naked shorted out of existence, leading to unemployment and destruction of wealth for millions of taxpayers. U.S. citizens are angry and scared as they watch their stock portfolios shrink, and see their pensions in jeopardy.
This begs the question as to why the U.S. government would prop the markets up on one hand using the Plunge Protection Team, while allowing naked shorting on the other which pushes the share prices down. I can only conclude that the system is designed to redistribute wealth from small investors to elite bankers and hedge fund managers. Perhaps the stock markets were allowed to decline so the politically connected shorts could cover profitably. With the close relationship between Wall Street, regulators, Congress, and the Treasury Department full of former Goldman Sachs executives, it's clear that the average worker with retirement money invested in the market is at an extreme disadvantage.
The SEC suffered another embarassment with the revelation that Bernard Madoff ran a US$50 billion Ponzi scheme disguised as a hedge fund for several years. Only a tip from Madoff's sons to the FBI unraveled the scheme. In fact, the SEC investigated Madoff's company eight times over more than a decade and failed to find any fraud. A former SEC attorney is now married to Madoff's niece, raising doubts about his objectivity in examining Madoff's books. Even when Harry Markopoulos, a private whistleblower, produced evidence that Madoff's trading results could not be replicated, no one at the SEC took him seriously.
Congress has been quick to blame Commissioner Cox, a former colleague for the Madoff scandal. However, missteps and inadequate enforcement predate Cox, who has only run the SEC since August 2005.
Obama's pick to replace Cox, Mary Schapiro has many flaws of her own. She previously appointed one of Madoff's sons to a disciplinary board, making her judgement look very poor. Schapiro is currently chief of the Financial Industry Regulatory Authority, a self regulating body which has been even less willing than usual to crack down on Wall Street abuses during her tenure. She ran the Commodity Futures Trading Commission (CFTC) under President Clinton, an agency that has been unable or unwilling to perceive the manipulation in the precious metals markets while pursuing collusion in other commodities. Schapiro stated she was inspired to pursue a regulatory career by watching the Hunt brothers' silver moves, so we know where her biases lie.
As an analyst, I spend hours each week poring over balance sheets, and reading financial statements of companies I may want to recommend to my subscribers. My task is made very difficult by the widespread financial fraud. While Madoff's results were too good to be true, other forms of deception are extremely hard to detect. Satyam is the latest scandal to hit Wall Street. Although the corporation is headquartered in India, Satyam has Fortune 500 clients in the U.S. and is listed on the NYSE. It has to comply with Sarbanes-Oxley regulations just like any American company, rules that are supposed to enforce honesty and transparency. Satyam – which is Sanskrit for truth - was awarded the Golden Peacock award for corporate governance just three months ago, in an amazing bit of irony.
With all these scandals, no wonder Merrill Lynch reports that rich customers are demanding gold coins and bars instead of shares in “paper gold” like ETFs. Credible stories indicate that the COMEX warehouses are experiencing record activity as receipt holders seek delivery of their gold. Brokers are apparently attempting to discourage this activity to squelch metal demand. When trust is eroded, people naturally seek safety in an asset without counterparty risk like gold.
If you are a stock investor despite all these perils, how to you separate the wheat from the chaff? First you have to find industries with impeccable fundamentals. While commodities suffered greatly in 2008, I believe they will see a strong rebound in 2009.
Second, check the track record of management and look for any hints of impropriety. Third, read the financial statements and look for unnecessarily complicated structures or conflicts of interest: these are red flags. Fourth, if results seem unbelievably excellent, they may be fictional. Fifth, while you can no longer take delivery of shares in the United States, you can contact the companies you invest in to determine if you are on the list of legitimate shareholders or a victim of naked shorting. Sixth, diversify into several different companies so if one is fraudulent you don't lose all your money. With the danger inherent in stocks, I recommend only investing capital you can afford to lose.
Copyright © 2009 Jennifer Barry
