CMKM Diamonds Inc. (fka CMKX)

[jetfish]

I was on the phone this week with a friend of mine who has been following my travails, and we got to talking about the FTD/naked short selling issue, and I realized that even a fairly sophisticated guy could still be unclear on the whole picture. His background is in the securities industry at a regulatory level. This is not a dumb guy.

Here’s how the conversation sort of went:

Me: “So there are these miscreant hedge funds, and many of the same names that were gaming the system twenty years ago, and their captive research companies, their network of complicit journalists, their class action attorneys, their contacts at the SEC (to initiate inquiries at favorable points). They pick on maybe 15 or 20 companies, and play them, for years.”

Friend:: “But that is really a localized problem then, once you roll up that network. Where does the systemic risk you are always harping on come in?”

Me: “Well, if each fund is worth a billon in assets, just for the sake of conversation, and each one is leveraging those assets about 10 to 1, each fund could easily be running 10 billion in short positions – and there are international brokers in Canada and the Caribbean and Malaysia and Thailand who will require little or no collateralization to put on a naked short position – just a commitment from one of these larger funds to move money in should the position move against them – a rarity.”

Friend:: “Sort of the Donald Trump thing – the banks have a problem if the hedge fund blows up, more than the funds do.”

Me: “Exactly. So they are pre-disposed to want the targeted companies to go down, and stay down. And you know they are trading right alongside the funds, mirroring their trades, thinking if that stock is a target, might as well make some of the easy money from taking them down.”

Friend:: “So they are de facto partners in it.”

Me: “I think it’s worse than that – they could be holding hundreds of billions of liabilities if 10 of the wrong funds blew up.”

Friend:: “So that’s where the systemic risk comes in.”

Me: “Partially. But remember that these brokers and clearing entities are all also playing fast and loose with investor money. That´s a different, but related, aspect of the larceny. They are taking a certain percentage of trades, maybe it started off being only ½%, and instead of going out and buying shares when their clients place a buy order, they just desk them internally, pocketing the borrow fees.”

Friend:: “Desk?”

Me: “They tell you on your statement that you bought your shares, but in fact they never did – they are just playing the odds that few will ever need to trade their shares at any given time, and that fewer still will call their certificates and check the system.”

Friend:: “So that’s free money for them?”

Me: “Exactly. And imagine how seductive it is to be able to do that, especially in companies where you know the stock is in play and headed lower, because your hedge fund buddies and your own trading desk are pummeling it. It’s pure gold. And I’m sure there’s a ton of special purpose entities set up where they can park those and fool the auditors, who aren’t looking all that close anyway.”

Friend:: “Like Refco.”

Me: “Exactly. That´s what the recent suit is about – the hedge fund clearing firm claims the brokers were ripping them off for borrows on stock that was never borrowed – it underscores how big this is, as it names the biggest brokers in the business.”

Friend:: “But back to the hedge funds, isn’t it contained then, in terms of how badly the hedge funds working these companies over can take them down? There are finite shares, and they have to be afraid of other hedge funds coming in and causing a squeeze.”

Me: “Did you know there are companies that will allow you to create hundreds of thousands of trades via the ECNs and then just cancel them at the end of the day? So you could theoretically do all these trades and take a company down a few dollars, and then poof, the transactions are gone, but the market for the stock is still lower. So the idea that there is some sort of reasonable limit is an abstract concept – if a network of these guys wants to give a company a 50% haircut, they can and will. That’s what they do. As to the idea that “good” hedge funds will come in and counteract the “bad ones, that is naïve. The brokers are in bed with the bad guys, and if you take the position on to make a few dollars, you are hurting your survival network, the old boy’s club – and you will need them after this trade, so you don’t want to piss them off. Who would sacrifice their entire future to make a few million on one trade? It isn’t worth it. That’s why you don’t see it happening.”

Friend:: “But at the end of the day, that is just a handful of companies, maybe a hundred or two out of the thousands out there. It wouldn’t happen with a GE or Coke.”

Me: “Why not? If you knew you had to deliver for all your institutional customers, but that the retail rubes would buy their 100 shares of GE and then just hold them, why would you buy the shares for the retail customers? I mean, why, exactly? Nobody will know. There’s no real mechanism to check. The DTCC doesn’t check, and the SEC doesn’t seem to care.”

Friend:: “So the Peter Lynch buy and hold thing actually works for the brokers – they can pocket a percentage of the money, and as long as there’s no run on the stock bank, they are golden. Dude, that is the Federal Reserve System!”

Me: “Except nobody gave the for-profit brokerage houses on Wall Street the right to act like a central bank for stock and just print it out of thin air, or to play the odds that everyone won’t want their certificates all at once. That is more like a reverse Ponzi scheme, like selling the same timeshare condo 100 times, even though there are only 52 weeks in a year – they are just playing the odds that not everyone will be able to use their condo any given year, which is a safe bet. But it is basically fraud. When owner of week 53 insists that he will take any week, but he wants it now, and all 52 have already been booked, that is when it hits the fan. That’s the equivalent of demanding certificates en masse.”

Friend:: “Holy shit. So what you are saying is that there could be 2 or 3 or 5 or 10% of all trades in the market that aren’t actually ever done? That money just went into someone’s pocket?”

Me: “How do YOU think that the brokers can have years where they are breaking all records for profits and bonuses, when commissions have never been lower, and investment banking is almost dead? How do you suppose they do it? That is one of the big ways.”

Friend:: “But if that is correct, then the entire integrity of the system is a sham.”

Me: “Yup. Buffet has been warning about derivative risk for years – that there is this huge unregulated market where companies are creating huge IOUs to trade as vehicles, and that nobody even really understands how they would ever cover if one of the big events happened – a lot of the hedging is done by buying yet more derivatives, never the underlying asset. What has happened is that I think Wall Street has converted a segment of the equities market into a derivatives market without telling anyone, and has placed the entire system in profound jeopardy.”

Friend:: “But that isn’t naked short selling.”

Me: “Yes, it is, because a sales transaction is recorded, but no share is ever delivered.”

Friend:: “And it doesn’t matter if it is marked a long sale or a short sale – failure to deliver after the fact is still failure to deliver, whatever the front end of the trade was called.”

Me: “Correct. That’s why the whole naked short selling thing is a misnomer – and I think the press feeds on that because it makes it easier to muddy the water. Then they can jump in and claim that short selling is good, and legal, and whatnot – but what we are talking about is really not short selling, per se, it is creating a sales transaction, and then failing to deliver the product. I really think that my description of how it works is accurate – the whole system is defrauding retail investors, and lining its pockets, but simultaneously creating the mother of all financial crisis.”

Friend:: “I hope your are wrong about this. I mean, that is so scary.”

Me: “I wish I was wrong about it. My sense is that Wall Street has made it so bad a problem, that they are relying in the idea that they are too big to fail – that the government will just let them rip off the country “for the good of the country” rather than risk collapsing the system. I think that is why you don’t see ANY government action.”

Friend:: “It’s kind of like a junky that needs a bigger and bigger fix, and he is also the guy that wrote the code for your company’s software, and is the only one that understands it, so you look the other way while he’s shooting up in the company bathroom because without him, you’re screwed.”

Me: “Yeah. But it really is worse, because it is the retail guys that are getting screwed, the moms and pops depending on the market for their retirements.”

Friend:: “But how did it get so nuts?”

Me: “I think that back in the early nineties, after all the insider trading and Milken stuff had gone down, that the SEC couldn’t keep up with the growth of the market, and was seeing all these pump and dumps as the internet/high tech boom was just starting. I think they sort of struck a gentlemen’s agreement with the short sellers, figuring that they would act as a counterbalance to the pump con men. The problem is that the SEC never imagined that the two would quickly join forces, or that the short side of the manipulation would turn out to be so lucrative that it quickly overshadowed the very threat it was intended to counterbalance. So they created a monster, and couldn’t handle it any more.”

Friend:: “So Reg SHO was a happy hope that the industry would rein itself in and police itself – that worked great.”

Me: “The only way I can explain SHO to myself is that they were hoping by giving the bad guys a hall pass on all the past larceny, and by publicizing the names of the companies that were being scammed, they could introduce market counterbalances where good guy funds would come in and offset the selling of the scamsters. They failed to appreciate how entrenched the broker dealers were in the networks, and how aligned they were with the bad guys. Like I said, no fund in their right mind would take the other side of the bet, when they know that they would be pissing on the biggest houses on Wall Street. Who would? I mean, let’s say you knocked one out of the park on ABC company – you still need those brokers to cooperate with you, and now you are on their enemy list. Who would sign up for that? No single deal’s profit would be worth it.”

Friend:: “But why don’t the journalists break the story? I mean, there has to be some Woodward or Bernstein out there. If you are right, this is the biggest financial crime in hundreds of years.”

Me: “My theory is that the bad guys have cultivated many of the prominent names, either through the favor/influence bank, or directly. And they own a lot of the editors the same way. There’s this pervasive mindset of “Why take on an unbeatable machine” that has turned much of the press into a public relations spin machine for Wall Street. It has corrupted the profession more than you can imagine. When a blogger like me is breaking more of the story than any of the mainstream press, the press sucks.”

Friend:: “You should read “The World Is Flat.” It speaks to that.”

Me: “I’ll pick it up.”

Friend:: “This is really depressing. What do you think is going to happen?”

Me: “Honestly? I think that just like with Milken, they will nab a Levine, and sit down and have a chitty chat, and say, “Buddy, we got you cold. You are going to jail. Now the question is for how long. Give us a bigger fish, and maybe it’s a small amount of time. Don’t, and think decades.” And then they work their way up the food chain. That’s how the US attorneys work – and once it isn’t a money game, but a queen for the day game, I bet the weak links start blowing up.”

Friend:: “But what about the system?”

Me: “I think that you start to see more and more of the brokers sued, and then eventually the DTCC gets handed their head. It will take years, and in the meantime they will shift the crookery to a different flavor, and the government will run interference for their cronies on Wall Street, all for the “good of the system.” Big fines will get paid, and a few prominent brokers will go down hard, and most will wind up disgorging some of, but not all of, their ill-gotten gains, and they will find new ways to rip off the investors to pay the tab for disgorging some of the cash for their past rip-offs.”

Friend:: “And what happens to the stocks in the meantime?”

Me: “There’s probably opportunity once it really starts to unwind, just has there has been opportunity as it has run unchecked. The difference is that Wall Street runs the risk of losing when it is unwound, so they will fight that tooth and nail.”

Friend:: “That’s a cheery day’s thoughts.”

Me: “Welcome to my world. It sucks. I can see why most want to go through life never understanding how the world really works. It’s depressing.”

Friend:: “I’ll say.”

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