• Investing Insights & Exclusive Offers → Get Our FREE “Market Brief”
    Sign-up for our free weekly newsletter. Get unparalleled investing insights and exclusive Summer Sale discounts on Hedgeye research.

    Disclaimer: By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails. Use of Hedgeye and any other products available through hedgeye.com are subject to our Terms Of Service and Privacy Policy

The Big Easy

Ex nihilo, nihil fit.

- Parmenides

The ancient Greeks posited that "nothing comes from nothing" - a passable translation of the above (Yes, we know it's Latin, not Greek.  We are conspiracy theorists, not classics scholars).  Parmenides authored the ontological argument against nothingness, saying there can not be a state of existence in which nothing exists.  Aristotle took up the argument for a beginningless cosmos.  He was countered by Maimonides, who identifies a definite moment of origin of the cosmos: the Biblical Creation.  Before this moment, argues Maimonides, there was no "before", as Time itself did not yet exist. This identical statement about Time was made by physicist Steven Hawking, in describing the Big Bang.

Thus, whether one is a Judaeo-Christian-Moslem theist, a secular Platonist-Aristotelian, or an atheist scientist, we all agree there can be no moment in Time when Nothing exists.

Unless, that is, you are short it.

With the SEC now mobilizing its resources and its PR facilities to press for re-introduction of the Uptick Rule, we thought this an apt moment to touch on the topic of short selling.

Both securities law and common sense dictate that you can not sell something that does not exist.  Yet every day, under the watchful eye of the regulators, financial firms sell millions of phantom shares of stock, on which they pocket very real money. 

The rules governing short sales do not require that all shares sold short actually be physically delivered, but that the seller, prior to entering the order, identify a source where such shares can be borrowed, should they come due for delivery.  Once the trader has recorded a "Locate", the short sale can be entered.

Here's how it works:

Trader Joe, a hedge fund portfolio manager, gets a tip from a salesman at a major Wall Street firm, indicating that a well-considered company is about to issue a dismal earnings report.  This, despite management having given positively glowing guidance as recently as a month before.

With minutes to go before the market open, Trader Joe calls his securities lending department.  There, the manager scrolls down his computer screen looking at the spreadsheet emailed to him at 5:00 that same morning from their prime broker's Stock Loan desk.  The spreadsheet is the prime broker's Easy To Borrow list and has entries for several thousand stocks.

Today, Trader Joe's stock in question - we shall call it XYZ Corp, prosaic though it may seem - is showing as Easy To Borrow for up to 500,000 shares.  The prime broker - a major Wall Street firm that operates its own brokerage business, as well as acting as clearing broker for several hundred broker dealers, and as prime broker for over 100 hedge funds - holds over 500,000 shares of XYZ Corp stock, all covered by hypothecation agreements permitting the firm to loan the shares for correspondents and customers to make short sales.  From the hedge fund point of view, half a million shares is much more than Trader Joe will ever do in a single day, so the securities lending desk simply tells Joe "You're good."

When, in the opening minutes of trading, Joe sells short 140,000 shares of XYZ, his trading desk marks their orders "Locate at Prime Broker - 500,000 shares."

Joe's prime broker also acts as prime broker for over one hundred of the largest hedge funds in the business, all of which hold their assets with the broker.  And the same email that went to Trader Joe's firm also went out to all 112 hedge fund prime brokerage clients of this broker, and to all 848 of their correspondent broker dealers.

Joe, it turns out, is one of more than three hundred traders who will short XYZ Corp today, all using the same brokerage firm's Easy To Borrow list.  And, while the broker's list has 500,000 shares available, total short sales off that same list will be far more.  Some of the hedge funds will short the full 500,000, while others will run much smaller orders.  In our example, the average short sale off this Easy to Borrow list will be for 125,000 shares of XYZ.  The resulting number of shares sold short in the first hour of trading will be

          314 traders X average 125,000 shares = 39,250,000 shares

Note that this applies only to the prime broker or correspondent relationships at this brokerage firm.  Many hedge funds have multiple prime brokers and will ask for additional locate from their other relationships.  It is a multiple multiplier effect.

All but a handful of traders will cover their shorts in the early stages of the stock's decline.  Since most of the short sales are covered on the same day, the prime broker's stock loan desk will calculate offsets on all the closed trades, meaning that very few XYZ shares will actually have to be delivered on settlement date, three days hence.

Thus hath Wall Street wrought Something out of Nothing.  In our example, 500,000 shares of stock have given birth to over thirty-nine million shares, each of which resulted in a profit for a trading desk, and none of which will ever be delivered.  For, with the exception of the original 500,000 XYZ shares, none of them ever existed.

With this type of trading being the Order of the Day on Wall Street, should the SEC be pulling out all the stops to re-introduce the Uptick Rule, and nothing more?

On one side stand corporate executives such as Overstock.Com CEO Patrick Byrne, who has been waging an articulate campaign against short selling abuses.  Or former Lehman Chief Dick Fuld, whose personal fortune was inflated by his firm's participation in the Street's short selling party, only to turn on his own customers when he complained that short sellers were driving down the price of Lehman's stock. 

On the other side, we have reality, which is that short sellers are among the foremost drivers of market transparency and enablers of liquidity.  They are the better informed and more alert traders.  Inside information aside, the shorts' legitimate market information is more thorough, better researched, and more timely than their counterparts on the long side.  This is partly the effect of the widespread prohibition of shorting by mutual funds, which has created slow-moving behemoths who are vulnerable to swift commando-style attacks from the short side.  It's hard not to describe these activities in military terms.

The turnover in volume in our example is fundamental to the functioning of our markets.  We would suggest that, if there were fears the banks might fail the stress test (which is the equivalent of a Big Ten quarterback on track to win the Heisman Trophy being allowed to flunk freshman English...) one area critically affected would be the ability to sustain current levels of short selling.  The thirty-nine million-odd "phantom" shares traded in our example generate considerable wealth.  The lending broker charges for the lending, the traders and brokers are all paid for the transactions, the firms on either side of the trades charge to process, clear and settle the trades - and taxes, as well as substantial political contributions, flow from all these activities. "Stressing-out" the banks that facilitate these trades would eliminate a huge chunk of the equities markets.  Meanwhile, taking the extreme view - hard physical borrow and delivery on every short sale - is not realistic, and would eviscerate both the markets, and the politicians' war chests.

But taking the view -as the SEC appears to be doing - that "nothing" needs to be done is blatantly irresponsible.  The highly political nature of the debate - the SEC is being pushed along its current course by such market luminaries as Barney Frank and Hillary Clinton - perpetuates the damage done by the real abuses that continue.

The legitimate activity of short selling is based in large part on creating Something out of Nothing, a phenomenon that also prevails in the long side of the market, relying as it does on margin, which multiplies customers' assets, miraculously enabling them to purchase securities they can not afford.  Is this so different?

Until the SEC sets aside politics and addresses the Big Easy from top to bottom, we will not truly understand where legitimate market action ends and the scamming begins.

Brave New World

If what you have done yesterday still looks big to you, you haven't done much today.

- Mikhail Gorbachev

No less a light of Capitalism than David Rubenstein, co-founder of the storied Carlyle Group, appeared on Bloomberg Television this week mapping out a New World Order of Capitalism.  He stated - as our CEO, Keith McCullough has been patiently explaining for most of the past year - that America has lost its single most important quality as the leader of world capitalism: its moral credibility.  Rubenstein did not use those words, but the sense was unmistakable: The American Handshake is not worth what it once was.  And because we have so blatantly lied to our global customers, American ingenuity is no longer seen as the touchstone for the world's financial markets.

Now that the whole world has grasped this reality - and in the wake of the worldwide market meltdown that America was powerless to prevent - Rubenstein observed that the world will move inexorably towards a multi-central capitalism, in which market centers will spring up in China, the Middle East, Latin America, Europe and beyond.  Wall Street will never be the same again.  In our view of the Brave New World, capitalism will be fully democratized.  From Silicone Valley to Singapore, and from Karachi to Machu Picchu, anyone with a laptop, a Blackberry - even a cell phone - will manage their own personal Fund of Funds.

The democratization of information is unstoppable, and those who can not lead will be tossed aside.

In this environment the new administration is pressing forward resolutely on all fronts.  We hope the resoluteness will not give way to wantonness. 

The latest chapter in the undoing of American credibility centers around the newly-released CIA torture memos.

Contrasting views abound, notably from sources who have firsthand knowledge of interrogation methods.  We are not legal scholars and can not judge the Bush Administration's memos; we don't know how many times a person has to undergo waterboarding for it to qualify as torture.  But we note that recent polls indicate a large percentage of the American public - in many polls, over half - are willing to accept outright torture if it serves a specific and identifiable end of preventing disaster.  Torture ends up being a societal construct, like Theft and Murder.  In a stable society the use of force is the sole prerogative of the state, as constrained and defined by the society which either approves or condemns actions by their designated agents.

The debate about interrogation methods rests on notions of transparency, and of the affirmation - or denial - that there is one set of Rules on which America rests.  It entails discussion of sticking to the rules, bending the rules, making it up as we go along, or outright breaking of the very rules by which we believe we identify ourselves as Americans.  Current attempts from both sides of this argument have tried calling it different names in an effort to divert open discourse.  In business this is known as fudging the books. 

Government officials were certainly advised of certain procedures and programs.  Attempts to recast this as "But I didn't mean that!" undermine America's credibility.  Meanwhile, putting a name like Extraordinary Rendition on a practice merely converts it to off-balance-sheet torture.  Like Enron's SPE's - from which the company drew revenues and profits, but whose debt and leverage were kept off the corporate books until they exploded - the offshoring of our dirty work always comes back to haunt us.  This was true of Iran-Contra, it is true of the Mujahedeen-turned-Taliban in Afghanistan, and it is now true of the dark warrens into which inconvenient individuals - among them citizens of friendly nations - disappeared with hands bound and sacks over their heads.

The judgment of history will show that these phenomena were all of a piece.  The ill-conceived notion that, if we ignore bad things long enough, they will go away.  Wall Street, Main Street, Pennsylvania Avenue and Capitol Hill have all been under the sway of Out Of sight, Out Of Mind.  We have created a Bad News Bubble, just as surely as our ignoring the issues created a dot-com bubble and a housing bubble.

Now the chickens are coming home to roost, ably shepherded (or whatever it is one does with chickens) by President Obama.  Lost in the non-debate is the fact that governments all over the world, and throughout history, have relied on people - often highly-principled ones - doing extremely naughty things to their enemies in secret.  The broad uncovering of the CIA memos may be President Obama's cleverest gambit: there is much political capital to be gained - and little efficacy lost - in noisily outlawing the interrogation techniques in question.  They are well known by now, and the argument that terrorists will train to resist them is a red herring.  These techniques have been reported in detail by everyone from the New York Times to "60 Minutes", and the terrorists already know more about these techniques than will emerge in six months of Congressional hearings. 

At home, this highly visible action enables us to believe we have retained the moral high ground that was always the bailiwick of the True America.  Internationally, it sets the underpinnings of a new global dialogue where America can re-emerge as an honest broker, a role we long enjoyed before squandering it.  Finally, it is better to appear weaker than one is, than to show all one's strength up front.

We suspect this is Obama's deep, dark secret.  That, if we make enough noise about what the whole world already knows, we will score a political win.  Meanwhile, we will be able to keep quiet the newest truly frightening stuff we now rely on to keep our country secure.

What?  The President playing at politics?!


You're only as good as your last envelope.

          - Silvio, "The Sopranos"

So, let's say we knew this guy Mikey (not his real name).  And let's say Mikey knew the Buongiornos (not a real Family) who used to hang out down on Mulberry Street in New York's Little Italy (not their real address).  Only now, Tony Buongiorno is doing 15 to 22 years (not his real sentence) for Man One in the killing of New York police officer (not his real crime).

So, when we would read about goings-on in the tabloids, Mikey would say "let's go out for a walk", and he would tell us what he had heard about how things really went down.

According to Mikey, the key slip-up that led to the FBI raid on the Ravenite Social Club in December, 1990 - where John Gotti and Sammy "The Bull" Gravano were arrested - was that the mobsters got lazy and forgot Rule Number One: don't talk indoors.  Gotti and his cronies got cocky and fell out of the habit of taking walks.  Instead, they held business conversations wherever they found themselves, be it in a taxicab, in a restaurant, or standing in line at the ballpark.  More than anything else, Mikey said, this is what led to their being caught.

If even "Dapper Don" John Gotti lost his bearings, we suppose a mere hedge fund manager can be forgiven the occasional lapse.  Though as reported in the Financial Times (6 May, "SEC investigates first CDS insider trading case") we may be the only ones in a forgiving mood.

The SEC has charged Renato Negrin (as far as we know, his real name), a former portfolio manager at Millennium Partners, with trading on the basis of inside information passed to him by Jon-Paul Rorech (ditto on the name) a bond salesman at Deutsche Bank.  The information in question related to repricing of a junk-bond offering for which Deutsche was the banker, and the trade in question was the purchase by Negrin of credit default swaps. The CDS were priced based on the then-anticipated issue price of the forthcoming bonds.  When the actual pricing was revealed, according to the SEC compliant, Millennium took a quick profit of $1.2 million.

The SEC is making much of this story, because it is the first time they have launched a case on CDS.  The SEC does not regulate the CDS market - neither does anyone else - but they do regulate hedge funds.  We wonder what took them so long?

Embedded in this cautionary tale is a moral that is definitely not just for compliance officers.  We reprint here the last paragraph of the FT story:

"The SEC complaint repeats fragments of recorded conversations between the two men. After Mr Negrin asked Mr Rorech for some way to 'handicap' the probability that VNU would issue new bonds at the holding company level, Mr Rorech paused and allegedly said: 'You're listening to my silence, right?' Mr Negrin then said: 'Okay, I'll call you back.' The men then had a three-minute, unrecorded conversation on their mobile phones."

As our alleged friend Mikey might say, This needs no f***ing explanation.

An Offer We Can't Refuse

"You don't s**t where you eat.  And you really don't s**t where I eat!"

- Tony Soprano

While we're on the topic, a friend of ours reports that his firm has had a TAMMS (Trading and Market Making Surveillance) exam, plus nine additional FINRA examinations and reviews in the last six weeks alone, culminating in a sweep where the examiners handed him a year's worth of the firm's own trades and said "tell us which ones were crooked."  One would think these guys were desperate to raise money, looking to generate fines and settlements By Any Means Necessary.

Is FINRA broke?

As avowed Conspiracy Theorists, it's comforting to know there are folks out there whose imaginations run even wilder than ours.  Blogging in the website of the Securities Industry Professional Association (thesipa.com) former professional trader Rogan LaBier (author of The Professional Trader's Toolkit, published by Wiley & Sons) speculates on the possibility that the 45% of the FINRA endowment allocated to "alternative investments" were invested with Bernard Madoff.

The FINRA Endowment is estimated to be (or to have been?) on the order of $1.5 billion.  The Alternative investments portion of it is invested in unidentified hedge funds.  Bernard Madoff, former Chairman of Nasdaq - in the years before the market oversight function was separated from the marketplace - had his hands on plenty of OPM ("other people's money").  Why not FINRA's own?

The neat thing about Conspiracy Theories is that they explain everything. It fits perfectly, if Madoff was in fact managing the NASD's endowment, that they would never audit him.  Still, we recognize it may not be financial panic spurring FINRA's efforts, but desperation to be seen as efficacious.  ("Hah!" we say.  "Hah!")  And we will not even mention some of the more outlandish suspicions raised - that FINRA's own investigation of the auction rate securities markets led it to dump more than $800 million of these very securities from its Endowment portfolio, well in advance of the widespread meltdown in that market, and before they had raised this issue to a level of public awareness, thus making this a case of insider trading by a regulatory agency. Oops - we said we weren't going to mention that.  Sorry, FINRA. 

How much credence do we give to all this?  Just because you're paranoid, doesn't mean they aren't really out to get you.

Moshe Silver

Chief Compliance Officer