pecora-ferdinand.thumbnail.jpgOne of the great "evils" identified by the Pecora Commission was "short selling," well, actually all margin trading. In many instances, when you open a brokerage account with a major firm, there is a clause in your client agreement which allows the firm to "borrow" stocks and other securities from your account. The firm then lends your stock to another customer who "sells" your stock to a third person.

In this transaction (scroll down in the link to the block quotes about "securities lending" and "hypothecation") the borrower/seller of your stock has X number of days to replace the borrowed stock. In order to engage in the short selling transaction the borrower must put up collateral for the borrowed stock in an amount greater than the value of the borrowed stock. This collateral is cash or other stocks. If the value of the borrowed stock or the collateral stock changes such that the collateral level dips, the borrower must deposit additional collateral to maintain the collateral integrity. This is known as a margin call. A margin call can also occur when a speculator buys "on margin," that is, buys using borrowed money, the debt for which is secured by securities and cash held in the speculator’s brokerage account. If the value of that account dips, a margin call can result.

A severe fluctuation in a given stock can lead to widespread margin calls, which in turn can drastically increase the volatility in the stock because if you are unable to "meet the margin call"–that is, put more cash or stocks into your account to top up the collateral level–the brokerage firm has the right to liquidate your position, which usually means selling things at the worst possible time.

In the old days, short sales involved depositing numbered stock certificates in various stages of the transaction. When I was a child, bonded couriers ran back and forth between brokerage houses delivering stock certificates and other securities. These documents had serial numbers on them and you could track the movement of a given stock certificate.

Today of course, we have come to the point of the naked short sale. If you only read one link from this post, read this one. If you don’t work on Wall Street, it’ll be a real eye-opener.

In our modern computer age, stock certificates in publicly traded companies have become a quaint notion. Instead, there are simply electronic book entries of the number of shares a person holds in their brokerage account. There are no certificate numbers. No equivalent to an automobile’s "vin" number or a dollar bill’s serial number to allow you to track a single share of stock in the stream of commerce.

Among the many problems this can lead to is the stock equivalent of the miracle of the loaves and fishes. In other words, it results in the absurd situation where there are more people voting shares of stock at a stockholder’s meeting than there are total shares of stock outstanding.

"What???" you say.

Here’s the problem. John owns 100 shares of Widget Co. His brokerage account agreement allows the brokerage firm to "borrow" stock from his account. Sam, another client of the firm wishes to sell ten shares of Widget Co. "short." Sam has 1,000 shares of AT&T in his account, a portion of which he used as collateral for the loan of the Widget shares. Sam’s loan agreement with the brokerage firm gives him 60 days until he is required to replace the ten borrowed shares. Sam sells ten shares of Widget on the open market to Sally.

Widget Co. calls for a stockholder’s meeting during the 60 day period before Sam is required to replace the shares.

John votes 100 shares of Widget, because he knows that he owns 100 shares of Widget, and he DOES own 100 shares of Widget. Sally votes ten shares of Widget, because she owns ten shares, and she DOES own ten shares. Except we now have somehow created an extra ten votes out of ten non-existent shares of stock, or have found a way for one object–a share of stock–to be in two places–both John and Sally’s brokerage accounts–at the same time. This is an amazing feat of Quantum Mechanics! Or a miracle. Somebody should alert the Nobel Prize Committee, or the Vatican.

The multiplying shares of stock phenomenon can get even worse in a multi-layered short sale where the brokerage firm may lend shares out of its own account, but may need to borrow shares from a client’s account during the interim payback period to provide shares of that stock to other clients or for trades on its own account. And I am willing to bet that on single day, Sam is not the only client of that firm involved in a short sale of that stock. Aside from the potential for bookkeeping errors, the lack of track-ability of the shares makes this situation perfect for fraud.

Further, too many average Joe’s engage in these kinds of sophisticated speculations. Even MOTU (masters of the universe) get burned using these trading techniques.

As Pecora so presciently pointed out:

The celerity with which margin transactions were arranged and the absence of scrutiny by the broker of the personal credit of the borrower, encouraged persons in all walks of life to embark upon speculative ventures in which they were doomed by their lack of skill and experience to certain loss. Excited by the vision of quick profits, they assumed margin positions which they had no adequate resources to protect, and when the storm broke they stood helplessly by while securities and savings were washed away in a flood of liquidation.

(Pecora Commission report at p. 9).

How many of you had a friend or relative quit their job in the early days of the 21st century to become a "day trader" for their own account? How many of you have seen your 401Ks used for sophisticated transactions for which you never actually understood the details?

Every page of the Pecora Commission report is like déjà vu all over again.

This is the fifth part of a continuing series on the original Pecora Commission and its relevance today. Previous posts can be found here: part one, part two, part three, part four.