CRACK... ...HOUSE UNCOVERED

STOCKGATE TODAY- Crisis of Convenience for Roiling SEC - October 30, 2008

David Patch

To say that support for the Securities and Exchange Commission is at an all time low would be an understatement. With Congressional Investigations into the agencies handling of critical investigations and recent reports out of the Office of Inspector General, investors are left guessing as to what exactly the agency is doing to police our markets. Heck, even a presidential candidate has suggested that the SEC Chairman should be fired and it was his party that hired him.

What most want to understand is, has the SEC gone rogue in actually aiding the white collar criminals that lurk out there?

With claims by the OIG that the SEC’s Director of Enforcement was engaged in inappropriate communications regarding an insider trading investigation into the politically connected CEO of Morgan Stanley, and has likewise been accused of having inappropriate communications with the General Counsel of JP Morgan regarding a Bear Stearns investigation it is not a far stretch to think something is remiss.

Question is, how deep does it go? How far have some within the agency gone to protect wealthy and powerful individuals?

Consider this decade old issue of abusive short selling. I say decade old because it was 1998 that the SEC first presented a concept release on short sale reforms whereby nearly 3000 comment letters suggested an abuse existed in the short sale process.

A decade later, the issue is temporarily resolved in what has become a crisis of convenience for the SEC. What do I mean by that? Let’s look at the facts and begin with a picture worth a 1000 words.

This chart illustrates the level of threshold companies on the Regulation SHO Threshold security list since inception in January 2005.

(see Link at bottom for viewing chart)

Chart provided by DeepCapture.com

Anybody see a trend? A correlation?

What we can timeline together since 1998 is that in October of 2003 the SEC proposed Regulation SHO where the Division of Market Regulation admits that abusive short selling [naked shorts] could be used to generate market leverage necessary to manipulate our markets. They put this right in the language of the proposal. These naked shorts as they are now identified would show up in the markets as failures to deliver within the continuous net settlement system.

By December 2004, as the first reforms were coming into play, we also catch wind of a conference call that was held by the now deceased Bear Stearns in which the General Counsel of Bear Stearns admitted that regulators had been approaching them for years voicing concern over the increased level of failures in the market. According to the General Counsel these fails were being attributed to “prime brokers, executing brokers and clients not following already established rules [in the short sale process]”.

To address the surmounting level of fails in the system the SEC did not merely create reforms but created loopholes to protect those that were not following already established rules. The first identifiable loophole in regulation SHO was the grandfather clause.

According to a document by the SEC’s Division of Market Regulations, and in response to an inquiry by Congressman John Tierney, “SHO does not require the close-out of fails to deliver that existed before a stock became a threshold security (known as "grandfathered" securities) because the Commission was concerned about creating volatility through short squeezes if existing positions had to be closed out quickly. “

So by the illustrated chart, not only did the grandfather clause not require the closeouts of pre-existing fails to deliver, the grandfather clause became a tool used to increase the market levels of fails to deliver in the system. And to whose benefit did this become; those that would have suffered had the agency demanded that these trades settle.

With the market still chugging along, the agency was under attack as the fails to deliver grew exponentially from an average daily dollar value in January 2005 of $3 Billion to over $8.5 Billion by March 2008.

March 2008 was the month Bear Stearns skirted bankruptcy through an emergency sale to an opportunistic JP Morgan. It was this opportunistic sale, in the midst of inappropriate communications between the SEC and JP Morgan General Counsel regarding an on-going Bear Stearns investigation that has again questioned the integrity and alliances of SEC director Linda Thomsen. Again with Bear Stearns.

By November 2007 the Agency had removed the grandfather clause from the short sale policies but by then the levels had accumulated to dangerous levels representing severe liabilities to the market place. And with the short sellers moving to the next loophole of opportunity, the options market and the options market making exemption, the SEC witnessed little relief from the abusive trading patterns. Settlement failures by June 2008 had now reached a daily average value of over $10 Billion.

What the SEC needed now that the pressure was on was a crisis. A means in which the trend could be turned and the unhealthy fails settled.

Open curtain, scene 3, the crash of 2008.

The Bankruptcy of Lehman, the near fall of Morgan Stanley, and a precipitous drop of the Dow Jones to near 8000 and a federal bailout as panic overcame the markets. What a distraction.

As the dust settles and the smoke dissipates few have noticed the playfield in the back right corner of this stage. The playfield of those who carried this tremendous burden of failed deliveries.

As the chart illustrates, the peak level of securities on the threshold security list happened to coincide with the day the SEC first enacted an emergency order that restricted the short selling in 17 financial institutions along with Freddie Mac and Fannie Mae.

Since the June 2008 temporary ban was put into place, as the market went into a free fall so too did the level of threshold securities. It only started to rise again when Morgan Stanley was under attack in September but a second ban again turned that trend around. Then again, the market turned as well.

Ultimately this economic crisis has become a crisis of convenience for the SEC. The failed trades they have tried so desperately to eradicate from the markets have temporarily disappeared. These trades can easily cover quickly since failed trades in a free falling market can always be covered efficiently for a profit. It is only when a trade that should not have been executed can’t be covered for a profit that creates the market inefficiencies.

But what does that say about our market rules, our market regulators, and the possibility of collusion amongst market participants? Why does it take a market crisis to clean up failed trades and what happens when the crisis subsides?

Shouldn’t the market run this efficiently during normalized times or can we expect more ‘crisis of convenience’ events to transpire over the years in order to periodically cleanse away the sins of those that have been allowed to get away with theft?

Now I am not saying that the SEC orchestrated this crisis, although the OIG found cause to think they had the opportunity to thwart it long ago. That opportunity would have come with an SEC investigation into the accounting of assets by ---you guessed it--- Bear Stearns.

I am finding it rather peculiar however that while the SEC was willing to allow this abuse to accumulate in order to prevent appreciation in the markets to the very advantage of every shareholder, that the SEC did very little to prevent the abuses that drove our markets down in a frenzied panic. Abuses such as short and distort schemes, rumor mongering, and bear raids.

For those interested, Linda Thomsen will be speaking November 6, 2008 at Fordam Law School in New York City. In the advertisements for her speech Ms. Thomsen is quoted as saying "Abusive short-selling, market manipulation and false rumor-mongering for profit by any entity cuts to the heart of investor confidence in our markets. Such behavior will not be tolerated. We will root it out, expose it, and subject guilty parties to the full force of the law."

I can only laugh at such hypocrisy as I lay witness to the decade of abuse that has taken place where the SEC’s Division of Enforcement has done nothing but protect those that engaged in the very abuses she speaks of. Ms. Thomsen herself a central figure in two OIG Investigations where one has already concluded seeking some form of discipline against the Director.

Maybe somebody in the audience will challenge her on the agencies performance to date and challenge her on the profits reaped under this crisis by those abusive short sellers and rumor mongers she has failed to take actions against.

For more on this issue please visit the Host site at www.investigatethesec.com
Copyright 2008

http://investigatethesec.com/drupal-5.5/node/466 (see link for chart)