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Taibbi writes: "It doesn't happen often, but sometimes God smiles on us. Last week, he smiled on investigative reporters everywhere, when the lawyers for Goldman Sachs slipped on one whopper of a legal banana peel, inadvertently delivering some of the bank's darker secrets into the hands of the public."

Matt Taibbi at Skylight Studio in New York, 10/27/10. (photo: Neilson Barnard/Getty Images)
Matt Taibbi at Skylight Studio in New York, 10/27/10. (photo: Neilson Barnard/Getty Images)

'Naked Short Selling'

By Matt Taibbi, Rolling Stone

16 May 12


t doesn’t happen often, but sometimes God smiles on us. Last week, he smiled on investigative reporters everywhere, when the lawyers for Goldman, Sachs slipped on one whopper of a legal banana peel, inadvertently delivering some of the bank’s darker secrets into the hands of the public.

The lawyers for Goldman and Bank of America/Merrill Lynch have been involved in a legal battle for some time – primarily with the retail giant, but also with Rolling Stone, the Economist, Bloomberg, and the New York Times. The banks have been fighting us to keep sealed certain documents that surfaced in the discovery process of an ultimately unsuccessful lawsuit filed by Overstock against the banks.

Last week, in response to an motion to unseal certain documents, the banks’ lawyers, apparently accidentally, filed an unredacted version of Overstock’s motion as an exhibit in their declaration of opposition to that motion. In doing so, they inadvertently entered into the public record a sort of greatest-hits selection of the very material they’ve been fighting for years to keep sealed.

I contacted Morgan Lewis, the firm that represents Goldman in this matter, earlier today, but they haven’t commented as of yet. I wonder if the poor lawyer who FUBARred this thing has already had his organs harvested; his panic is almost palpable in the air. It is both terrible and hilarious to contemplate. The bank has spent a fortune in legal fees trying to keep this material out of the public eye, and here one of their own lawyers goes and dumps it out on the street.

The lawsuit between Overstock and the banks concerned a phenomenon called naked short-selling, a kind of high-finance counterfeiting that, especially prior to the introduction of new regulations in 2008, short-sellers could use to artificially depress the value of the stocks they’ve bet against. The subject of naked short-selling is a) highly technical, and b) very controversial on Wall Street, with many pundits in the financial press for years treating the phenomenon as the stuff of myths and conspiracy theories.

Now, however, through the magic of this unredacted document, the public will be able to see for itself what the banks’ attitudes are not just toward the “mythical” practice of naked short selling (hint: they volubly confess to the activity, in writing), but toward regulations and laws in general.

“Fuck the compliance area – procedures, schmecedures,” chirps Peter Melz, former president of Merrill Lynch Professional Clearing Corp. (a.k.a. Merrill Pro), when a subordinate worries about the company failing to comply with the rules governing short sales.

We also find out here how Wall Street professionals manipulated public opinion by buying off and/or intimidating experts in their respective fields. In one email made public in this document, a lobbyist for SIFMA, the Securities Industry and Financial Markets Association, tells a Goldman executive how to engage an expert who otherwise would go work for “our more powerful enemies,” i.e. would work with Overstock on the company’s lawsuit.

“He should be someone we can work with, especially if he sees that cooperation results in resources, both data and funding,” the lobbyist writes, “while resistance results in isolation.”

There are even more troubling passages, some of which should raise a few eyebrows, in light of former Goldman executive Greg Smith's recent public resignation, in which he complained that the firm routinely screwed its own clients and denigrated them (by calling them "Muppets," among other things).

Here, the plaintiff’s motion refers to an “exhibit 96,” which refers to “an email from [Goldman executive] John Masterson that sends nonpublic data concerning customer short positions in Overstock and four other hard-to-borrow stocks to Maverick Capital, a large hedge fund that sells stocks short.”

Was Goldman really disclosing “nonpublic data concerning customer short positions” to its big hedge fund clients? That would be something its smaller, “Muppet” customers would probably want to hear about.

When I contacted Goldman and asked if it was true that Masterson had shared nonpublic customer information with a big hedge fund client, their spokesperson Michael Duvally offered this explanation:

Among other services it provides, Securities Lending at Goldman provides market color information to clients regarding various activity in the securities lending marketplace on a security specific or sector specific basis.  In accordance with the group's guidelines concerning the provision of market color, Mr. Masterson provided a client with certain aggregate information regarding short balances in certain securities.  The information did not contain reference to any particular clients' short positions.

You can draw your own conclusions from that answer, but it's safe to say we'd like to hear more about these practices.

Anyway, the document is full of other interesting disclosures. Among the more compelling is the specter of executives from numerous companies admitting openly to engaging in naked short selling, a practice that, again, was often dismissed as mythical or unimportant.

A quick primer on what naked short selling is. First of all, short selling, which is a completely legal and often beneficial activity, is when an investor bets that the value of a stock will decline. You do this by first borrowing and then selling the stock at its current price, then returning the stock to your original lender after the price has gone down. You then earn a profit on the difference between the original price and the new, lower price.

What matters here is the technical issue of how you borrow the stock. Typically, if you’re a hedge fund and you want to short a company, you go to some big-shot investment bank like Goldman or Morgan Stanley and place the order. They then go out into the world, find the shares of the stock you want to short, borrow them for you, then physically settle the trade later.

But sometimes it’s not easy to find those shares to borrow. Sometimes the shares are controlled by investors who might have no interest in lending them out. Sometimes there’s such scarcity of borrowable shares that banks/brokers like Goldman have to pay a fee just to borrow the stock.

These hard-to-borrow stocks, stocks that cost money to borrow, are called negative rebate stocks. In some cases, these negative rebate stocks cost so much just to borrow that a short-seller would need to see a real price drop of 35 percent in the stock just to break even. So how do you short a stock when you can’t find shares to borrow? Well, one solution is, you don’t even bother to borrow them. And then, when the trade is done, you don’t bother to deliver them. You just do the trade anyway without physically locating the stock.

Thus in this document we have another former Merrill Pro president, Thomas Tranfaglia, saying in a 2005 email: “We are NOT borrowing negatives… I have made that clear from the beginning. Why would we want to borrow them? We want to fail them.”

Trafaglia, in other words, didn’t want to bother paying the high cost of borrowing “negative rebate” stocks. Instead, he preferred to just sell stock he didn’t actually possess. That is what is meant by, “We want to fail them.” Trafaglia was talking about creating “fails” or “failed trades,” which is what happens when you don’t actually locate and borrow the stock within the time the law allows for trades to be settled.

If this sounds complicated, just focus on this: naked short selling, in essence, is selling stock you do not have. If you don’t have to actually locate and borrow stock before you short it, you’re creating an artificial supply of stock shares.

In this case, that resulted in absurdities like the following disclosure in this document, in which a Goldman executive admits in a 2006 email that just a little bit too much trading in Overstock was going on: “Two months ago 107% of the floating was short!”

In other words, 107% of all Overstock shares available for trade were short – a physical impossibility, unless someone was somehow creating artificial supply in the stock.

Goldman clearly knew there was a discrepancy between what it was telling regulators, and what it was actually doing. “We have to be careful not to link locates to fails [because] we have told the regulators we can’t,” one executive is quoted as saying, in the document.

One of the companies Goldman used to facilitate these trades was called SBA Trading, whose chief, Scott Arenstein, was fined $3.6 million in 2007 by the former American Stock Exchange for naked short selling.

The process of how banks circumvented federal clearing regulations is highly technical and incredibly difficult to follow. These companies were using obscure loopholes in regulations that allowed them to short companies by trading in shadows, or echoes, of real shares in their stock. They manipulated rules to avoid having to disclose these “failed” trades to regulators.

The import of this is that it made it cheaper and easier to bet down the value of a stock, while simultaneously devaluing the same stock by adding fake supply. This makes it easier to make money by destroying value, and is another example of how the over-financialization of the economy makes real, job-creating growth more difficult.

In any case, this document all by itself shows numerous executives from companies like Goldman Sachs Execution and Clearing (GSEC) and Merrill Pro talking about a conscious strategy of “failing” trades – in other words, not bothering to locate, borrow, and deliver stock within the time alotted for legal settlement. For instance, in one email, GSEC tells a client, Wolverine Trading, “We will let you fail.”

More damning is an email from a Goldman, Sachs hedge fund client, who remarked that when wanting to “short an impossible name and fully expecting not to receive it” he would then be “shocked to learn that [Goldman’s representative] could get it for us.”

Meaning: when an experienced hedge funder wanted to trade a very hard-to-find stock, he was continually surprised to find that Goldman, magically, could locate the stock. Obviously, it is not hard to locate a stock if you’re just saying you located it, without really doing it.

As a hilarious side-note: when I contacted Goldman about this story, they couldn't resist using their usual P.R. playbook. In this case, Goldman hastened to point out that Overstock lost this lawsuit (it was dismissed because of a jurisdictional issue), and then had this to say about Overstock:

Overstock pursued the lawsuit as part of its longstanding self-described "Jihad" designed to distract attention from its own failure to meet its projected growth and profitability goals and the resulting sharp drop in its stock price during the 2005-2006 period.

Good old Goldman - they can't answer any criticism without describing their critics as losers, conspiracy theorists, or, most frequently, both. Incidentally, Overstock rebounded from the  2005-2006 short attack to become a profitable company again, during the same period when Goldman was needing hundreds of billions of dollars in emergency Fed lending and federal bailouts to stave off extinction.

Anyway, this galactic screwup by usually-slick banker lawyers gives us a rare peek into the internal mindset of these companies, and their attitude toward regulations, the markets, even their own clients. The fact that they wanted to keep all of this information sealed is not surprising, since it’s incredibly embarrassing stuff, if you understand the context.

More to come: until then, here’s the motion, and pay particular attention to pages 14-19.

UPDATE: Well, I guess I shouldn't feel too badly for the lawyer who stepped on this land mine. For Morgan Lewis counsel Joe Floren, karma, it seems, really is a bitch. your social media marketing partner


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+93 # jmizialko 2012-05-16 11:21
It's time to get serious about prosecuting these arrogant slime-buckets!
Matt Taibbi fits the "real" definition of a patriot and should win a Pullizer for all of his brilliant, investigative reporting.
+10 # B. Traven 2012-05-17 22:14
It's been time to prosecute "them" for years and Taibbi has been writing about it for years. Maybe the problem is not "them" but "us" for allowing it to continue.
+63 # Buddha 2012-05-16 11:31
99% of America has no clue what Wall St. is really doing, so they don't put up effective pressue on Congress to stop these practices. Heck, many just parrot the FAUXNews-WallSt talking points like "excessive regulation" is the problem, providing the footsoldier cannon fodder for defending Wall St.'s egregious and risky behavior. We are going to have to go to a true Great Depression (I'm thinking in 2013 it will happen), with soup lines and "Hooverville" tent cities before Americans really wake up.
+17 # JSRaleigh 2012-05-16 13:14
Quoting Buddha:
99% of America has no clue what Wall St. is really doing, so they don't put up effective pressue on Congress to stop these practices.

Easy enough to figure out. Dictionaries are on-line now.

fraud [frawd] noun

1. deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage.

2. a particular instance of such deceit or trickery: mail fraud; election frauds.

3. any deception, trickery, or humbug: That diet book is a fraud and a waste of time.

4. a person who makes deceitful pretenses; sham; poseur.
+43 # Gevurah 2012-05-16 11:50

you de man!

this sweet little old lady reads Rolling Stone (not my universe!!) JUST for your investigative reports!
0 # B. Traven 2012-05-19 19:27
The lady doth protest too much, methinks.
+60 # Maverick 2012-05-16 12:02
I'm so grateful for people like Matt. Without him (and other investigative journalists worthy of the title), these criminals would be plotting our financial demise in broad daylight, and the vast majority of us would not have a clue. These transactions are complicated -- certainly THAT is no accident -- and it requires supreme diligence and attention to mind-numbing detail to ferret out the ferrets. Unfortunately -- and most often -- by the time they are caught, they've amassed millions (if not billions) and can easily afford the best legal counsel on the planet . . . financed by their ill-gotten gain.
+38 # Archie1954 2012-05-16 12:06
Now I know why the Wall Street bankers are described as criminals.
+22 # paulrevere 2012-05-16 12:06
As usual Matt, your reporting be stellar!

This entire tale were it not so powerful a hosing of the American people has a decided scent of the Keystone Kops vs Snidely Whiplash...Mast er Thieves of the Universe.

Per harvested banker organs??? are you nuts?? not a body on earth could survive that transplant!
+41 # William LeGro 2012-05-16 12:16
This hurts my brain. In naked short selling, you basically invent - counterfeit - shares of a stock out of thin air. I understand that that alone drives down the price of the stock. But you're shorting those counterfeited shares by selling them at a high price. No borrowing, nobody to return the shares to at a lower price.

My question is: Who's buying those counterfeit shares? Isn't it like buying the Brooklyn Bridge or swampland in Florida? I mean, there's nothing there - you're buying nothing. Do you later check your portfolio and find out the shares you thought you were buying aren't there?

How is this short selling at all? It's just pure crime. I can't understand why the FBI or somebody isn't pursuing this enormous crime with a vengeance.
+17 # jack406 2012-05-16 18:56
Great question. If I buy a stock, I don't know that it is a naked short. How does the naked-short-sel ler have stock that he doesn't own and hasn't borrowed delivered to my brokerage account.
Sounds like Grand Theft to me!
+12 # Dumbledorf 2012-05-16 12:29
We have a problem with this statement: "First of all, short selling, which is a completely legal and often beneficial activity, is when an investor bets that the value of a stock will decline. You do this by first borrowing and then selling the stock at its current price, then returning the stock to your original lender after the price has gone down."
If you've already sold the stock at its "current price" how do you "return the stock" to you original lender????
+16 # dkonstruction 2012-05-16 14:08
Dumbledorf, if i understand the process correctly, essentially, after you have borrowed and sold the stock (short) at the market price at the time, you then have to repurchase the same number of shares in order to return them to the person you borrowed. If the stock has gone down in value you pocket the difference (i.e., you make money); if the stock has gone up in value during the time you were shorting it, you have to pay that difference (you lose money).
+3 # RLF 2012-05-17 06:05
There is probably a tax advantage...or some such cause people to loan stocks.
+14 # cordleycoit 2012-05-16 12:36
This is an example of how and why capitalism has failed and needs to exit the river of history as a failed and corrupt practice. Rotten and perverted why would decent people want to associated with Wall Street? Or our the reformers slime in training?
+19 # tuandon 2012-05-16 12:49
Their naked dishonesty, and naked disregard for regulations, should leave them working on a rock pile in some federal prison somewhere -- naked. These people are beneath contempt, and I am further disgusted by the way the Republicans kiss their asses. May they all rot in Hell.
+13 # drush 2012-05-16 13:27
These banks basically print there own money,
fake stocks more of the same. First they were allowed to use "securely" saved money for there own gain then that just wasn't enough.
It is time to turn to government banking.
Mistrust of government is at least healthy.
Corporations could care less.
Most likely nothing will come from this. Just some Lawyer will be ruined (saved actually).
+19 # tshette 2012-05-16 13:42
Rarely has there been a time in our history when we needed banking regulation more than we do now...YET...the Repulsives are saying that any regulation is too much for the banks. If we don't get Dodd- Frank in place and ENFORCED soon we are going to see another meltdown of the banking system. Bankers cannot police themselves. Just this week this article by Matt and the 2 billion lost by JP Dimon Chase in illegal derivatives sooner had Dimon testified that he would never do such a thing than the story breaks that he actually did.
+12 # JetpackAngel 2012-05-16 14:56
If I was the leak, I would immediately run to the nearest Occupy encampment and beg for shelter under the guise of pretending that the accidental leak was really some sort of whistle-blowing heroics. It might be the only way he survives this (literally). Poor bastard, his career is over and I wouldn't put it past today's Wall Street to end his life either.
+15 # humanmancalvin 2012-05-16 15:24
The Radical Right Insurgency AKA the Republican party of NO promote that these Wall Street thieves police themselves. We don't need no stinkin' regulation. Thieves protecting thieves in a naked power move to control yet more of Americas wealth held by but a few.
It has been said repeatedly by myself & others on RSN but it bears repeating: Never, ever, never vote Republican. Period.
+9 # byard pidgeon 2012-05-16 15:29
Presently, there are no real penalties severe enough to prevent this gang of thieves from continuing to operate.
Firing squads, just a few, would probably serve to keep them in line.
+9 # Howard T. Lewis III 2012-05-16 15:54
It is good fun to watch greedy little coked up Wall Street boys at the deregulation trout farm trying to catch the big one only to be pulled in by the justice fish hidden by the stirred up the muck of the American CFRtv government. The genius of invention and free enterprise is attacked by a regiment of unrepentant shoplifters and bled dry. Timmy Geithner used to ride with Richard Perle. I wonder who Jaime 'Jaime 's Cryin' Dimon sold his soul to. He is a slower learner than Timmy, or closer to the top.
+4 # Howard T. Lewis III 2012-05-16 16:19
The whole mess will have to be swamped out for the subject to be worthy of note.
+4 # too-small-to-fail 2012-05-16 20:19
Makes me sick to my stomach.
+2 # walt 2012-05-16 21:17
Is there any doubt that all these Wall Street dealers are crooks who deserve prosecution? And we saw $2 billion just disappear yesterday with no consequences.

Where is the Obama administration? Is the White House so in bed with Wall Street that they will do nothing?
+7 # soularddave 2012-05-16 22:43
Thanks, as always, for bringing us up to speed on another of their shameless schemes. You do it well, by educating us with definitions, examples, and explanations. I know you repeat a bit from article to article, but at least *I* need that to learn what I don't even want to know.
Keep up the great work, but also keep safe. I could imagine there being a price on your head from those monsters which you reveal to be the scum of the earth.
+7 # sandyclaws 2012-05-17 06:05
It's time these people receive what's coming to them! All the monies they have collected through these illegal means should be considered viral and any money or property that it has been co-mingled with should also be considered illegal and therefore should confiscated in addition to serious prison time. Then we can start paying back our debt and stop the crime on Wall Street! If a person commits a crime, and there are no consequences, do you really think that he will stop?
+4 # hammermann 2012-05-17 20:22
In way of explanation- shorting is basicly betting that stock is going down; and having to borrow it (supposedly) from someone is a way of limiting and slowing what can be destabilizing bet. But it is useful in stopping crazy rises or balancing out pressures. In reality, nobody ever takes possession of these "borrowed" stocks- it's all done on paper. It was almost impossible to even find out anything about shorting when I did trading at height of Internet bubble 99-2000; I'd call Datek and get 4 different answers on when there would be a margin call (demand for more money)- nobody knew. It's actually much easier to make money on shorts than rises- if there is some bad news for an industry or general collapse, weakest players are guaranteed to drop. Problem is A. you have to pay interest on the borrowed stock so don't want to hold it for very long periods; B. you can lose many times the money you have if you are wrong and stock quadruples.

Sometimes the trade wouldn't go through in the 30 seconds or so, cause the system couldn't find the stock to borrow, but if you tried 3-4 times, it always would. I really don't understand naked shorts- if they never borrowed the stock, it seems they were committing to pay out themselves, and it's just naked fraud. 107% of stock in Overstock was overstocked shorts??? Huh- that's a bit of a sign that the SEC shoulda caught- if they weren't asleep and gutted.
+2 # George Baggett 2012-05-18 10:06
In my opinion, it seems likely that short sellers are often the source of "bad news" stories and applaud one-sided reporting noting bad while failing to mention stability. Take the battery and electric vehicle folks who have been having their problems of late as a good example. Killing progressive activities not controlled by the large conglomerates seems like fish food for short sellers and old money competitors. Somewhere along the line (i.e. JP Morgan)the short or long manipulators will get it wrong, and it couldn't happen to a bunch of nicer guys!
+2 # B. Traven 2012-05-19 21:28
The thing that really strikes me about the article--and most of Taibbi's stuff--is the contempt the financial industry execs seem to feel(and probably express in private)for the regulators even as they commit blatantly criminal acts. Doubtless Bernie Madoff and Ken Lay felt the same way.

They all know that the "He who sells what isn't his'n..." ditty is nothing more than a nursery rhyme for public consumption, with no more substance than the Jabberwocky. Frumious Bandersnatch indeed!

And why do they feel this contempt?

Is it because they know the regulators--the SEC, CFTC, etc.--are underfunded and understaffed by poorly paid and demoralized bureaucrats trying their best to enforce impossibly complex rules?

Perhaps it's because they all, industry execs and regulators alike, know that the rules are more loophole than law and that they've been written by agents of the very people being regulated.

And why is this so? Well, we all know why, the real question is what can be done to change it? "Get the money out of politics" is too simple. HOW? And is it too late, do the Goliath donors already own the state and federal legislative branches and now we're just haggling over price like Churchill's apocryphal whore?

I'm gettin' a headache... think I'll go read Atlas Shrugged, see can I make some sense of all this.

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