I do not directly trade in stocks although like anyone with a retirement account, someone is trading on the stock market with my savings. My lack of interest may be related to my lack of interest in gambling generally and to my lack of a desire to make more money. I have a job that pays me enough for my needs and that is enough. My main interest in the financial world is more on the macro side, to understand how it impacts the political and social worlds. But the recent global financial turmoil has resulted in me learning more about the world of high finance than I ever wanted.
Matt Taibbi, the scourge of Goldman Sachs, writes about how a slip by one of its lawyers resulted in the release of information about its activities that the company had vigorously sought to conceal. As Taibbi says, “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.”
In the process, he explains some investment terminology that I did not fully understand, such as ‘short selling’ and ‘naked short selling’.
Short selling is a gamble that an investor makes when he or she thinks that a company’s stock is overvalued and likely to go down in price. The investor then borrows stock from someone who has them, sells them at the current price, and then buys them back later when the price drops and returns them to the lender. Of course if the stock price goes up instead of down, the investor loses money. The investor can actually sell the stock before borrowing it because there is a small window of time that the investor has to actually borrow the stocks after he has sold it and properly close the books on the deal, but (I think) the investor is expected to have arranged the borrowing before doing the actual selling, so that all that remains is the bookkeeping.
Short selling is legal and in some cases serves a desirable goal. Suppose that a stock is over-valued for some reasons that are not widely known. Savvy deep-pocketed investors who are aware of the weakness will short sell it and thus nudge the price down towards more realistic levels, and this may actually benefit the stock market which is supposed to reflect the ‘true’ value of stocks. This in theory helps prevent price bubbles though as we have seen recently, even savvy investors can get sucked into bubble hype.
But in some cases, people wishing to short sell a stock may find that the people holding the stock are not be willing to lend it out or may charge a fee for doing so. In such cases, some investors sell stock they do not actually have, thus effectively creating virtual stock. This is what is known as ‘naked short selling’. This practice seems bizarre and many people denied that it happened at all and that reports of such actions were myths.
The reason this practice is frowned upon by regulators, if not downright illegal, is that by selling stocks that you do not possess, you are artificially inflating the amount of stock for sale and thus can drive down the price for reasons that have nothing to do with the actual worth of the stock. If the naked short seller sells so much stock as to be able to force the price downward, he or she is guaranteed to make money on the deal. It becomes a sure thing, rather than a gamble.
Goldman Sachs had been accused of naked short selling but had vigorously denied the allegations. But what the accidentally released documents reveal is that they have been engaged in short selling on behalf of their clients. As Taibbi writes:
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.
I know that some commenters (‘Tis Himself for one) are far more knowledgeable about the financial world than I am and would be curious to hear their insights on this topic.