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October 30, 2006

Failure To Deliver or "Deliverance"?
by Rob Kirby

This past Friday [Oct. 27, 2006] I had the opportunity to sit at my desk and listen to this slide / narrative presentation titled, Darkside of the Looking Glass. Anyone who owns or trades stocks must experience this presentation.

I suggest that this will cast light on the shadowy corners of our equity [capital] markets and the lack of probity and integrity of our regulators. These players, who till now have been left to self-regulate, are now self-serving at the expense of "WE" the public. This also calls into question just how far up the food chain knowledge of these improprieties really go?

Remember folks, knowledge is power.

Overview:

The narrative explains, with the aid of graphics, stock settlement mechanisms on the large exchanges. It clearly illustrates how some broker-dealers and their biggest clients - hedge funds and their financial backers can, and do "game" [commit FRAUD] the Depository Trust Clearing Corporation [DTCC]. The DTCC is supposed to act as a back office for Wall Street firms - electronically settling inter-dealer equity transactions.

It explains how a significant portion of the NYSE and NASDAQ's combined daily trade of roughly 2.5 billion shares - does not settle properly. This means the alleged seller of stock takes the buyer's money, but never delivers the shares they supposedly sold. Instead, they [or their broker dealer] send a "stock IOU" creating a Failure To Deliver, or FTD, to the buyer's agent/broker. The aforementioned article shows that the vast majority of these FTD's are DELIBERATE, STRATEGIC and occur with alarmingly high frequency in contrast with regulator's claims that these happenings are occasional, honest mistakes and of insignificant proportion.

What a cozy arrangement, ehhhhh? The buyer's agent allows his "client" to be relieved of his or her funds - all the while maintaining that the goods - namely, his or her shares have been delivered - when in reality they haven't. Isn't this a description of a grand kiting scheme? These revelations cast HUGE question marks as to whether this industry is capable of self regulation - doesn't it?

This means the following; the broker dealers [bankers], the Securities and Exchange Commission [SEC] and the National Securities Clearing Corporation [NSCC] under the auspices of the Depository Trust Clearing Corporation [DTCC] - these would be our REGULATORS - are complicit in the Deliberate, Strategic and ongoing FRAUD of FTD's outlined above. Deliberate, Strategic and ongoing FTD's equate to naked short selling and have negative implications for investors as well as listed companies.

For any of you who might be feeling somewhat nauseated right about now, you might want to pause for a few "deep breaths" and pour yourself a "real stiff drink" - cause this gets A WHOLE LOT UGLIER.

Here's How It Goes Down:

Naked Short Selling Is Illegal Because It's FRAUD.

Naked short selling is not to be confused with Selling Short - which is legal and involves incurring the financing charges associated with borrowing the equity to make delivery. When companies issue shares to raise money in the Capital Markets, they are selling "ownership" in their enterprise. Naked short sellers are in fact counterfeiting - creating false certificates of ownership.

When naked short sales of a company's stock occur - the increased supply of stock serves to FRAUDULENTLY drive the share price of the subject company DOWN.

For years, companies have complained that their share prices have been VICTIM of such practices. Folks over at the SEC have steadfastly maintained that naked short selling was not "an issue", didn't occur for nefarious reasons and firms that claimed to be victims were more likely at fault of poor management than outside interference. Hmmmmmmm? What do you think?

But incredibly, you can read right off the government's [SEC] own web site [pg. 5 - 6 of 73 pdf] - a published paper [Dr. John Finnerty - Fordham University] acknowledging the existence of naked short selling [manipulation] of stocks and laws "on the books" as to its illegality;

"Manipulation is the "intentional interference with the free forces of supply and demand." A manipulative trading strategy corrupts the market's price formation process to generate a riskless profit [Jarrow, 1992]. Market manipulation can be profitable when there is a difference between the price elasticities of purchases and sales that the manipulator can exploit. Stock market manipulators use a variety of devices, such as releasing false information about a company into the market, and employing trading strategies that impede the price formation process, such as naked shorting, wash sales, matched trades, and painting the tape, all of which inject misleading trading information into the market, to move market prices in the direction that benefits the manipulator. Illegal short selling, such as naked short selling, can distort market prices by creating artificial supply-demand imbalances [Thel, 1994]. Consequently, the securities laws in the United States proscribe various restrictions on short selling that are designed to constrain it so that it can not be misused to manipulate stock prices below the true asset value [Thel, 1994, SEC, 2003b, 2004]."

Manipulation can occur when informed traders can take advantage of uninformed traders who must trade to meet their liquidity needs [Glosten and Milgrom, 1985, Kyle, 1985, 1989, Easley and O'Hara , 1987, Allen and Gale, 1992, Allen and Gorton, 1992].

Regulators have long claimed that "BUY IN" provisions adequately safeguard the interests of investors by enforcing timely resolution of any naked short that might arise. Evidence suggests that these Buy In provisions are not sufficiently enforced. Hmmmmmm? A buy in involves the unwitting buyer of stock - their broker/dealer "demanding" delivery of shares from the DTCC. Here again, evidence suggests that Buy Ins do not occur with nearly sufficient frequency. Hmmmmmm?

Some highly regarded academic research has been published by Wharton and North Carolina Economists in a paper titled, Failure Is An Option, alleging that, in one clearing member they studied, there was a paltry 86 buy ins for an aggregate 69,036 FAILURES TO DELIVER over a two year period. One tenth of one percent adherence to protocol designed to protect the "little guy" hardly seems like a safeguard, ehhhh?

Simply put folks, our financial system was designed by the elites, for the elites.

This conclusion is reinforced by the fact that the SEC hired an economist from New Mexico State University named Leslie Boni; she conducted statistical research into Failure To Deliver data and she concluded that market makers [broker / dealers] DO STRATEGICALLY fail to deliver stocks [pg. 1 of 48 pdf];

"Sellers of U.S. equities who have not provided shares by the third day after the transaction are said to have "failed-to-deliver" shares. Using a unique dataset of the entire cross-section of U.S. equities, we document the pervasiveness of delivery failures and provide evidence consistent with the hypothesis that market makers strategically fail to deliver securities when borrowing costs are high. We also document that many of the firms that allow others to fail to deliver to them are themselves responsible for fails-to-deliver in other stocks. Our findings suggest that many firms allow others to fail strategically simply because they are unwilling to earn a reputation for forcing delivery and hope to receive quid pro quo for their own strategic fails."

Hmmmmmm? Can anyone smell anything rancid here? Smells like self-serving, errrr, self-regulating foxes to me - who have been left in charge of the hen house.

In case any of you folks are still doubting; consider that Boni's research concluded the "average" length of these fails is 57 days in duration. Some more of Ms. Boni's insights [pg. 3 of 48 pdf];

"On July 28, 2004, the Securities and Exchange Commission ["SEC"] adopted Regulation SHO to modify rules for short sales in U.S. equity markets. The adopting release states that one objective is to restrict "naked" short selling, which "generally refers to selling short without having borrowed the securities to make delivery." Toward that objective, Rule 203 of Regulation SHO imposes a number of new borrowing and delivery requirements on short-sellers, including additional requirements for stocks with long-lived delivery failures. To the extent SHO reduces strategic delivery failures, short selling should become more tightly constrained when Rule 203 becomes effective in January 2005."

So, while it appears on the surface that steps have been taken to rectify the identifiable improprieties, once again we need look no further than t the SEC's web site where they explain that,

11. Can I obtain fails information?

"Some investors have requested that SROs [Self Regulatory Organization = SEC] provide more detailed information for each threshold security, including the total number of fails, the total short interest position, the name of the borker-dealer firm responsible for the fails, and the names of the customers of responsible brokers and dealers responsible for the short sales. The fails statistics of individual firms and customers is proprietary information and may reflect firms' trading strategies. The release of this information could be used to engage in unlawful upward manipulation of the price of the securities in order to "squeeze" the firms improperly."

Well, there you have it folks. The SEC admits that malfeasance has occurred, but they are more interested in protecting the identities and financial positions of the perpetrators, who have committed illegal acts, than they are of providing honest answers and transparency to the capital markets. They actually have the nerve to say that these large scale illegalities are in some sense - Proprietary? Hmmmmmmmm?

I'd like everyone to take note of the "GO SLOW" approach of the SEC where this insidious MASSIVE problem is concerned relative to their "GET ROUGH" and highly public headline grabbing - "tarring" of Martha Stewart circa January 2002. Funny, isn't it, how Martha's case - with her being the "quintessential" good homemaker - her case was never "swept under a rug"?

But it sure made for good theatre, didn't it? Like wrong doers BEWARE! Hmmmmmm?

Clues As To How Big This Problem Really Is?

So how big is this problem, anyway? The folks who really know are the SEC and the DTCC - and while they now acknowledge the existence of the problem [remember, the one that didn't exist?] - they REFUSE to provide the juicy details and - THEY ASSURE US ALL IS OK. Hmmmmmm?

Do you all feel better now?

So Where's The Press?

In democracies - Like Ours Is Supposed To Be - a free press has some responsibilities. Even the folks in government share this view;

"The founders of the United States were suspicious of the tendency of government, even the best-intentioned government, to become tyrannical at times. Governments are composed of human beings, and human beings can and do commit wrongs. For this reason, the authors of the First Amendment envisaged the press, despite all of its imperfections, as a kind of critic, with a role apart and distinct from that of government.

Clearly, nothing in the Bill of Rights says that newspapers and government cannot cooperate on occasion. But the intent of the founders was that the press and government should not become institutional partners. They are natural adversaries with different functions, and each must respect the role of the other. Sometimes a free press can be a distinct annoyance and an embarrassment to a particular government, but that is one of the prices of liberty. A free press is responsible to its readers, and to them alone."

So why has the Wall Street Press failed to report on these developments? Why has it been left to the odd individual investigative sort to lobby institutions such as the SEC under the Freedom Of Information Act [FOIA] requests to get a handle on all of this? Perhaps it all boils down to this:

North Korea, Turkmenistan, Eritrea the worst violators of press freedom

France, the United States and Japan slip further Mauritania and Haiti gain much ground

New countries have moved ahead of some Western democracies in the fifth annual Reporters Without Borders Worldwide Press Freedom Index, issued today, while the most repressive countries are still the same ones....

The United States (53rd) has fallen nine places since last year, after being in 17th position in the first year of the Index, in 2002. Relations between the media and the Bush administration sharply deteriorated after the president used the pretext of "national security" to regard as suspicious any journalist who questioned his "war on terrorism." The zeal of federal courts which, unlike those in 33 US states, refuse to recognise the media's right not to reveal its sources, even threatens journalists whose investigations have no connection at all with terrorism.

Maybe freedom of the press has gone the same way as the steam engine? Then again, should anyone really expect much more than A FAILURE TO DELIVER from someone batting out of the 53 hole?

In response to repeated FOIA requests, in July 2005 the SEC only reluctantly provided data - reported to be the bare bones minimum under FOIA - showing the continuing extent and pervasiveness of Fails To Deliver [FTD], circa spring of 04 - spring 05, for the NYSE and NASDAQ, or senior exchange traded stocks that settle through the DTCC [meaning this is not an issue regarding OTC, pink-sheet or bulletin board - penny stocks]. This INCOMPLETE data set showed the existence of anywhere from 150 million to 230 million shares worth of aggregate FAILS TO DELIVER on any given date with DAY-TO-DAY adds on the failure list as large as 80 million or IN EXCESS OF 3 % OF A DAY'S TRADE.

In March of 2005, Mr. Larry Thompson - General Counsel of the DTCC - posted a "staged" interview [conducted with the DTCC's "in house" Public Relations Dept.] to the DTCC web site. When questioned as to the scope of this perceived malfeasance, Thompson replies,

"...In dollar terms, fails to deliver and receive amount to about $6 billion daily, again including both new fails and aged fails, out of just under $400 billion in trades processed daily by NSCC, or about 1.5% of the dollar volume...."

1.5 % doesn't seem like very much does it? I mean, who would be surprised if anticipated measurable results deviated by 1.5 % of expectation? Well folks, if your name happens to be J.P. Morgan Chase and you have a DERIVATIVES BOOK now measuring 58 TRILLION in notional value and you are OFFSIDE by 1.5 % - you would have a book-keeping LOSS of 870 BILLION DOLLARS. When you stop and consider that J.P. Morgan Chase sports a market capitalization of roughly 164 billion - 1.5 % suddenly seems like a pretty big number, doesn't it? Hmmmmmmm?

But I digress.

Thompson goes on to articulate,

"...The Stock Borrow program is able to resolve about $1.1 billion of the "fails to receive," or about 20% of the total fail obligation."

The implications of this statement could not be more damning. Here, Thompson let's the "cat out of the bag" that only 20 % of the systemic fails are contained within the DTCC - and that 20 % is pegged at $ 6 billion daily. Hmmmmmmmmm?

What this implies, folks, is that the "lion's share", or 80 %, of the fails are occurring outside the electronic DTCC settlement system and are in fact occurring DIRECTLY between brokers. The implications of this revelation are simply astounding - in that, if Shapiro is correct with his 37.5 % assessment [explanation below] - and the real problem is 4 x that size, well, you do the math? Hmmmmm?

While the numbers admittedly don't seem to add up, why do regulators still remain mum on the subject? What are they really hiding? Hmmmmmmm?

Strange Indeed............Someone Delivered The Goods

A very odd thing happened in response to Mr. Larry Thompson's public assertions about the insignificance of the Failure To Deliver issue. A high profile and lettered economist by the name of Dr. ROBERT J. SHAPIRO, rebuts Mr. Thompson in a letter dated April 13, 2005

"..Certain comments by Mr. Thompson in that interview were inaccurate or misleading, and I request that you allow me to correct the record by publishing this response.

Needless to say, the DTCC refused to oblige, so Mr. Shapiro went public with his findings. Hmmmmmmmm?

Shapiro goes on to say [pg. 2 of 6 pdf],

"..The $6 billion of fails-to-deliver securities existing on any given day are equivalent to 37.5 % of the average daily trades that require delivery of securities, or 25 times the 1.5 percent level cited by Mr. Thompson."

Hmmmm? Perhaps someone should "deliver" Mr. Shapiro a Congressional Medal of Honor - and another one for bravery too?

I trust that I do not need to tell any of you that if you were to comparatively take 37.5 % of 58 TRILLION - you would now be talking REAL MONEY, ehhhh?

By the way, has it is occurred to you folks that the SEC just happens to be a vital constituent of the President's Working Group [aka The Plunge Protection Team] on Financial Markets? Are the activities of this group not highly coordinated by the Secretary of the Treasury of the United States? John Crudele of the N.Y. Post seems to think so,

"Someone - and I don't know who - wants us all to know that since July Henry Paulson, the new secretary of the U.S. Treasury, has spent a lot of time on a little known Washington operation called the President's Working Group on Financial Markets.

That was the major message in a prominent piece this past Monday in The Wall Street Journal.

The big mystery is why do these people want us to know this? And why now? I wrote about the Working Group on Financial Markets back in June when Paulson left Wall Street powerhouse Goldman Sachs to accept the top job at Treasury..."

Another cozy relationship? Just a coincidence? Hmmmmmmm?

The authors of this ground-breaking research go on to explain how and why the brokerage Refco failed. It explains the most likely or at least offers a highly plausible explanation as to the fallout and continuing danger [another closely guarded secret of officialdom] the Refco collapse still poses to the financial system. It fingers the participants and it's beyond indicting to the whole regulatory regime. It's completely nauseating!

I bring all of this to your attention to make a point. The failure of officials to deliver sound and responsible stewardship and to take appropriate and timely remedial action might be characterized as negligence?

Regulators appear more interested in self-service than they do with the public good and by extension they are they not complicit in these activities?

Do they not care about the public? Hmmmmmm? What do you think?

Fade to banjo music....ta-da-ding-ding-blink-blink, blink-blink-bling....

Rob Kirby
Kirby Analytics

Copyright © 2004 - 2006 Rob Kirby

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