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Due Diligence and Investigatory Skills Reap Huge Profits for Short Sellers

A company is as valuable as its balance sheet says it is but what if that balance sheet is a work of pure fiction. Increasingly this has been discovered to be the case in companies from emerging markets. Muddy Waters Research and other companies understand this. Some have profited by it by doing real research that goes beyond just examining the books presented.

Shares of Sino Forest collapsed on Thursday 2 June 2011 after a negative research report by Muddy Waters Research. The report alleged that Sino-Forest had been fraudulently inflating its assets and earnings, and that the company's shares were essentially worthless. The report claimed that Sino Forest was a “multibillion-dollar Ponzi scheme”. Sino Forest denied the report and started an independent investigation by PriceWaterhouseCoopers.

The stock had been as high at $25 two months before the report was released. The stock opened at $18.21 on June 2nd and closed at $14.46, a 20.59% one day drop. As of April 18, 2012 the stock is at $4.81. Noted investor John Paulsonreportedly sold his entire stake at an estimated loss of $720 million.

On March 30, 2012 Sino-Forest filed for bankruptcy protection in Canada and that the company would be sold or restructured. Sino-Foreststated that they would Muddy Waters but it is questionable if they would be successful as their shares had been suspended by the Ontario Securities Commission which is reported to have cited that Sino-Forest had engaged in practices they “knew or should have known” perpetuated a fraud.

It is not just Chinese companies that are being accused of playing fast and loose with the books. Many companies and individuals foresaw the collapse of the subprime mortgage market and purchased Credit Default Swaps, CDS, on bundles of subprime loans which were rated at investment grade by major rating agencies. The idea behind these subprime investment bundles was that any loan which was poorly under written would somehow be safe when pooled with a block of poorly underwritten loans as people always do what they have to pay their mortgages and real-estate never declines. This relies on the greater fool theory of investment where there will always be a greater fool coming along who will purchase your asset for more than you paid.

CDS’ can be purchased on assets that the purchasing party has no exposure to. This is called a Naked CDS. This is equivalent to purchasing life insurance on your neighbor who is a motorcycle riding, base cliff jumping, scuba diver, crystal meth addict. It’s better than that, they don’t know you bought the life insurance so when you drop off a case of whisky and a handgun, they don’t know you have an incentive for them having an accident.
Now knowing that something is a Potential Over-risk Security, POS and being able to profit from it are two different things. Buying Naked CDS’ or short selling won’t do you any good unless everyone else finds out that the stock or investment is a POS.

This is why after the position is taken it is in the best interest of the entity holding the counter position that the negative information comes out. If it takes too long your short positions could expire and you could lose money or you could keep paying fees to maintain your CDS “Insurance” position. I put insurance in quotation marks as although it is just like insurance, it is not legally called insurance because if it were, it would be regulated and who would ever allow you to buy insurance on your neighbor dying without their knowledge. Well companies did, but that is for another day. This article is about short selling and CDS’, well actually it is not. It is about showing how a POS article written in around 15 minutes will be submitted to online article depositories and track how many instances show up over time.

This is all part of a security presentation demonstration to show how items proliferate and that a dedicated effort involving well financed parties attempting to manipulate working in conjunction with hackers could affect the financial industry.

The information provided on or within this website or in documents available herein is for assistance only and is not intended to be and must not be taken alone as the basis for an investment decision. Each recipient of this information should make such investigations as it deems necessary to arrive at an independent evaluation of an investment in the securities offered hereby, and should consult its own legal counsel and financial, accounting, regulatory and tax advisors to determine the consequences of such an investment. Well this is a standard legal disclaimer on investment but if you read this you will see that I did not actually write anything that could in any way be construed as investment advice.

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