A scheme to flood the market with
counterfeit stocks helped kill Bear Stearns and Lehman Brothers
— and the feds have yet to bust the culprits
By Matt Taibbi
Rolling Stone Magazine - Issue 1089
October
15, 2009
On Tuesday, March 11th, 2008, somebody — nobody knows who — made one of the craziest bets Wall Street has ever seen. The mystery figure spent $1.7 million on a series of options, gambling that shares in the venerable investment bank Bear Stearns would lose more than half their value in nine days or less. It was madness — "like buying 1.7 million lottery tickets," according to one financial analyst.
But what's even crazier is that the bet paid.
At the close of business that afternoon, Bear Stearns was trading at $62.97. At that point, whoever made the gamble owned the right to sell huge bundles of Bear stock, at $30 and $25, on or before March 20th. In order for the bet to pay, Bear would have to fall harder and faster than any Wall Street brokerage in history.
The very next day, March 12th, Bear went into free fall. By the end of the week, the firm had lost virtually all of its cash and was clinging to promises of state aid; by the weekend, it was being knocked to its knees by the Fed and the Treasury, and forced at the barrel of a shotgun to sell itself to JP Morgan Chase (which had been given $29 billion in public money to marry its hunchbacked new bride) at the humiliating price of … $2 a share. Whoever bought those options on March 11th woke up on the morning of March 17th having made 159 times his money, or roughly $270 million. This trader was either the luckiest guy in the world, the smartest son of a bitch ever or…
Or what? That this was a brazen case of insider manipulation was so obvious that even Sen. Chris Dodd, chairman of the pillow-soft-touch Senate Banking Committee, couldn't help but remark on it a few weeks later, when questioning Christopher Cox, the then-chief of the Securities and Exchange Commission. "I would hope that you're looking at this," Dodd said. "This kind of spike must have triggered some sort of bells and whistles at the SEC. This goes beyond rumors."
Cox nodded sternly and promised, yes, he would look into it. What actually happened is another matter. Although the SEC issued more than 50 subpoenas to Wall Street firms, it has yet to identify the mysterious trader who somehow seemed to know in advance that one of the five largest investment banks in America was going to completely tank in a matter of days. "I've seen the SEC send agents overseas in a simple insider-trading case to investigate profits of maybe $2,000," says Brent Baker, a former senior counsel for the commission. "But they did nothing to stop this."
The SEC's halfhearted oversight didn't go unnoticed by the market. Six months after Bear was eaten by predators, virtually the same scenario repeated itself in the case of Lehman Brothers — another top-five investment bank that in September 2008 was vaporized in an obvious case of market manipulation. From there, the financial crisis was on, and the global economy went into full-blown crater mode.
Like all the great merchants of the bubble economy, Bear and Lehman were leveraged to the hilt and vulnerable to collapse. Many of the methods that outsiders used to knock them over were mostly legal: Credit markers were pulled, rumors were spread through the media, and legitimate short-sellers pressured the stock price down. But when Bear and Lehman made their final leap off the cliff of history, both undeniably got a push — especially in the form of a flat-out counterfeiting scheme called naked short-selling.
That this particular scam played such a prominent role in the demise of the two firms was supremely ironic. After all, the boom that had ballooned both companies to fantastic heights was basically a counterfeit economy, a mountain of paste that Wall Street had built to replace the legitimate business it no longer had. By the middle of the Bush years, the great investment banks like Bear and Lehman no longer made their money financing real businesses and creating jobs. Instead, Wall Street now serves, in the words of one former investment executive, as "Lucy to America's Charlie Brown," endlessly creating new products to lure the great herd of unwitting investors into whatever tawdry greed-bubble is being spun at the moment: Come kick the football again, only this time we'll call it the Internet, real estate, oil futures. Wall Street has turned the economy into a giant asset-stripping scheme, one whose purpose is to suck the last bits of meat from the carcass of the middle class.
What really happened to Bear and Lehman is that an economic drought temporarily left the hyenas without any more middle-class victims — and so they started eating each other, using the exact same schemes they had been using for years to fleece the rest of the country. And in the forensic footprint left by those kills, we can see for the first time exactly how the scam worked — and how completely even the government regulators who are supposed to protect us have given up trying to stop it.
This was a brokered
bloodletting, one in which the power of the state was used to help effect a monstrous
consolidation of financial and political power. Heading into 2008, there were five major
investment banks in the United States: Bear, Lehman, Merrill Lynch, Morgan Stanley and
Goldman Sachs. Today only Morgan Stanley and Goldman survive as independent firms, perched
atop a restructured Wall Street hierarchy. And while the rest of the civilized world
responded to last year's catastrophes with sweeping measures to rein in the corruption in
their financial sectors, the United States invited the wolves into the government, with
the popular new president, Barack Obama — elected amid promises to clean up the mess
— filling his administration with Bear's and Lehman's conquerors, bestowing his papal
blessing on a new era of robbery.
To the rest of the world, the
brazenness of the theft — coupled with the conspicuousness of the government's
inaction — clearly demonstrates that the American capital markets are a crime in
progress. To those of us who actually live here, however, the news is even worse. We're in
a place we haven't been since the Depression: Our economy is so completely fucked, the
rich are running out of things to steal.
If you squint hard enough, you can see
that the derivative-driven economy of the past decade has always, in a way, been about
counterfeiting. At their most basic level, innovations like the ones that triggered the
global collapse — credit-default swaps and collateralized debt obligations —
were employed for the primary purpose of synthesizing out of thin air those revenue flows
that our dying industrial economy was no longer pumping into the financial bloodstream.
The basic concept in almost every case was the same: replacing hard assets with complex
formulas that, once unwound, would prove to be backed by promises and IOUs instead of real
stuff. Credit-default swaps enabled banks to lend more money without having the cash to
cover potential defaults; one type of CDO let Wall Street issue mortgage-backed bonds that
were backed not by actual monthly mortgage payments made by real human beings, but by the
wild promises of other irresponsible lenders. They even called the thing a synthetic
CDO — a derivative contract filled with derivative contracts — and nobody
laughed. The whole economy was a fake.
For most of this decade,
nobody rocked that fake economy — especially the faux housing market — better
than Bear Stearns. In 2004, Bear had been one of five investment banks to ask the SEC for
a relaxation of lending restrictions that required it to possess $1 for every $12 it lent
out; as a result, Bear's debt-to-equity ratio soared to a staggering 33-1. The bank used
much of that leverage to issue mountains of mortgage-backed securities, essentially
borrowing its way to a booming mortgage business that helped drive its share price to a
high of $172 in early 2007.
But that summer, Bear started
to crater. Two of its hedge funds that were heavily invested in mortgage-backed deals
imploded in June and July, forcing the credit-raters at Standard & Poor's to cut its
outlook on Bear from stable to negative. The company survived through the winter — in
part by jettisoning its dipshit CEO, Jimmy Cayne, a dithering, weed-smoking septuagenarian
who was spotted at a bridge tournament during the crisis — but by March 2008, it was
almost wholly dependent on a network of creditors who supplied it with billions in rolling
daily loans to keep its doors open. If ever there was a major company ripe to be
assassinated by market manipulators, it was Bear Stearns in 2008.
Then, on March 11th —
around the same time that mystery Nostradamus was betting $1.7 million that Bear was about
to collapse — a curious thing happened that attracted virtually no notice on Wall
Street. On that day, a meeting was held at the Federal Reserve Bank of New York that was
brokered by Fed chief Ben Bernanke and then-New York Fed president Timothy Geithner. The
luncheon included virtually everyone who was anyone on Wall Street — except for Bear
Stearns.
Bear, in fact, was the only major investment bank not represented at the meeting, whose list of participants reads like a Barzini-Tattaglia meeting of the Five Families. In attendance were Jamie Dimon from JP Morgan Chase, Lloyd Blankfein from Goldman Sachs, James Gorman from Morgan Stanley, Richard Fuld from Lehman Brothers and John Thain, the big-spending office redecorator still heading the not-yet-fully-destroyed Merrill Lynch. Also present were old Clinton hand Robert Rubin, who represented Citigroup; Stephen Schwarzman of the Blackstone Group; and several hedge-fund chiefs, including Kenneth Griffin of Citadel Investment Group.
The meeting was never
announced publicly. In fact, it was discovered only by accident, when a reporter from
Bloomberg filed a request under the Freedom of Information Act and came across a mention
of it in Bernanke's schedule. Rolling Stone has since contacted every major
attendee, and all declined to comment on what was discussed at the meeting. "The
ground rules of the lunch were of confidentiality," says a spokesman for Morgan
Stanley. "Blackstone has no comment," says a spokesman for Schwarzman. Rubin
declined a request for an interview, Fuld's people didn't return calls, and Goldman
refused to talk about the closed-door session. The New York Fed said the meeting, which
had been scheduled weeks earlier, was simply business as usual: "Such informal, small
group sessions can provide a valuable means to learn about market functioning from people
with firsthand knowledge."
So what did happen at that
meeting? There's no evidence that Bernanke and Geithner called the confidential session to
discuss Bear's troubles, let alone how to carve up the bank's spoils. It's possible that
one of them made an impolitic comment about Bear during a meeting held for other reasons,
inadvertently fueling a run on the bank. What's impossible to believe is the bullshit
version that Geithner and Bernanke later told Congress. The month after Bear's collapse,
both men testified before the Senate that they only learned how dire the firm's liquidity
problems were on Thursday, March 13th — despite the fact that rumors of Bear's
troubles had begun as early as that Monday and both men had met in person with every key
player on Wall Street that Tuesday. This is a little like saying you spent the afternoon
of September 12th, 2001, in the Oval Office, but didn't hear about the Twin Towers falling
until September 14th.
Given the Fed's cloak of
confidentiality, we simply don't know what happened at the meeting. But what we do know is
that from the moment it ended, the run on Bear was on, and every major player on Wall
Street with ties to Bear started pulling IV tubes out of the patient's arm. Banks, brokers
and hedge funds that held cash in Bear's accounts yanked it out in mass quantities (making
it harder for the firm to meet its credit payments) and took out credit- default swaps
against Bear (making public bets that the firm was going to tank). At the same time, Bear
was blindsided by an avalanche of "novation requests" — efforts by worried
creditors to sell off the debts that Bear owed them to other Wall Street firms, who would
then be responsible for collecting the money. By the afternoon of March 11th, two rival
investment firms — Credit Suisse and Goldman Sachs — were so swamped by novation
requests for Bear's debt that they temporarily stopped accepting them, signaling the
market that they had grave doubts about Bear.
All of these tactics were
elements that had often been seen in a kind of scam known as a "bear raid" that
small-scale stock manipulators had been using against smaller companies for years. But the
most damning thing the attack on Bear had in common with these earlier manipulations was
the employment of a type of counterfeiting scheme called naked short-selling. From the
moment the confidential meeting at the Fed ended on March 11th, Bear became the target of
this ostensibly illegal practice — and the companies widely rumored to be behind the
assault were in that room. Given that the SEC has failed to identify who was behind the
raid, Wall Street insiders were left with nothing to trade but gossip. According to the
former head of Bear's mortgage business, Tom Marano, the rumors within Bear itself that
week centered around Citadel and Goldman. Both firms were later subpoenaed by the SEC as
part of its investigation into market manipulation — and the CEOs of both Bear and
Lehman were so suspicious that they reportedly contacted Blankfein to ask whether his firm
was involved in the scam. (A Goldman spokesman denied any wrongdoing, telling reporters it
was "rigorous about conducting business as usual.")
The roots of short-selling date back to
1973, when Wall Street went to a virtually paperless system for trading stocks. Before
then, if you wanted to sell shares you owned in Awesome Company X, you and the buyer would
verbally agree to the deal through a broker. The buyer would take legal ownership of the
shares, but only later would the broker deliver the actual, physical shares to the buyer,
using an absurd, Brazil-style network of runners who carried paper shares from
one place to another — a preposterous system that threatened to cripple trading
altogether.
To deal with the problem, Wall Street established a kind of giant financial septic tank called the Depository Trust Company. Privately owned by a consortium of brokers and banks, the DTC centralizes and maintains all records of stock transactions. Now, instead of being schlepped back and forth across Manhattan by messengers on bikes, almost all physical shares of stock remain permanently at the DTC. When one broker sells shares to another, the trust company "delivers" the shares simply by making a change in its records.
This new electronic system
spurred an explosion of financial innovation. One practice that had been little used
before but now began to be employed with great popularity was short- selling, a perfectly
legal type of transaction that allows investors to bet against a stock. The basic premise
of a normal short sale is easy to follow. Say you're a hedge-fund manager, and you want to
bet against the stock of a company — let's call it Wounded Gazelle International
(WGI). What you do is go out on the market and find someone — often a brokerage house
like Goldman Sachs — who has shares in that stock and is willing to lend you some. So
you go to Goldman on a Monday morning, and you borrow 1,000 shares in Wounded Gazelle,
which that day happens to be trading at $10.
Now you take those 1,000
borrowed shares, and you sell them on the open market at $10, which leaves you with
$10,000 in cash. You then take that $10,000, and you wait. A week later, surveillance
tapes of Wounded's CEO having sex with a woodchuck in a Burger King bathroom appear on
CNBC. Awash in scandal, the firm's share price tumbles to 3½. So you go out on the market
and buy back those 1,000 shares of WGI — only now it costs you only $3,500 to do so.
You then return the shares to Goldman Sachs, at which point your interest in WGI ends. By
betting against or "shorting" the company, you've made a profit of $6,500.
It's important to point out
that not only is normal short-selling completely legal, it can also be socially
beneficial. By incentivizing Wall Street players to sniff out inefficient or corrupt
companies and bet against them, short-selling acts as a sort of policing system; legal
short- sellers have been instrumental in helping expose firms like Enron and WorldCom. The
problem is, the new paperless system instituted by the DTC opened up a giant loophole for
those eager to game the market. Under the old system, would-be short-sellers had to
physically borrow actual paper shares before they could execute a short sale. In other
words, you had to actually have stock before you could sell it. But under the new system,
a short-seller only had to make a good-faith effort to "locate" the stock he
wanted to borrow, which usually amounts to little more than a conversation with a broker:
Evil Hedge Fund:
I want to short IBM. Do you have a million shares I can borrow?
Corrupt Broker
[not checking, playing Tetris]: Uh, yeah, whatever. Go ahead and sell.
There was nothing to prevent
that broker — let's say he has only a million shares of IBM total — from making
the same promise to five different hedge funds. And not only could brokers lend stocks
they never had, another loophole in the system allowed hedge funds to sell those stocks
and deliver a kind of IOU instead of the actual share to the buyer. When a share of stock
is sold but never delivered, it's called a "fail" or a "fail to
deliver" — and there was no law or regulation in place that prevented it. It's
exactly what it sounds like: a loophole legalizing the counterfeiting of stock. In place
of real stock, the system could become infected with "fails" — phantom IOU
shares — instead of real assets.
If you own stock that pays a
dividend, you can even look at your dividend check to see if your shares are real. If you
see a line that says "PIL" — meaning "Payment in Lieu" of
dividends — your shares were never actually delivered to you when you bought the
stock. The mere fact that you're even getting this money is evidence of the crime: This
counterfeiting scheme is so profitable for the hedge funds, banks and brokers involved
that they are willing to pay "dividends" for shares that do not exist.
"They're making the payments without complaint," says Susanne Trimbath, an
economist who worked at the Depository Trust Company. "So they're making the money
somewhere else."
Trimbath was one of the first
people to notice the problem. In 1993, she was approached by a group of corporate transfer
agents who had a complaint. Transfer agents are the people who keep track of who owns
shares in corporations, for the purposes of voting in corporate elections. "What the
transfer agents saw, when corporate votes came up, was that they were getting more votes
than there were shares," says Trimbath. In other words, transfer agents representing
a corporation that had, say, 1 million shares outstanding would report a vote on new board
members in which 1.3 million votes were cast — a seeming impossibility.
Analyzing the problem,
Trimbath came to an ugly conclusion: The fact that short-sellers do not have to deliver
their shares made it possible for two people at once to think they own a stock. Evil Hedge
Fund X borrows 100 shares from Unwitting Schmuck A, and sells them to Unwitting Schmuck B,
who never actually receives that stock: In this scenario, both Schmucks will appear to
have full voting rights. "There's no accounting for share ownership around short
sales," Trimbath says. "And because of that, there are multiple owners assigned
to one share."
Trimbath's observation would
prove prophetic. In 2005, a trade group called the Securities Transfer Association
analyzed 341 shareholder votes taken that year — and found evidence of over-voting in
every single one. Experts in the field complain that the system makes
corporate-election fraud a comically simple thing to achieve: In a process known as
"empty voting," anyone can influence any corporate election simply by borrowing
great masses of shares shortly before an important merger or board election, exercising
their voting rights, then returning the shares right after the vote is over. Hilariously,
because you're only borrowing the shares and not buying them, you can effectively
"buy" a corporate election for free.
Back in 1993, over-voting
might have seemed a mere curiosity, the result not of fraud but of innocent bookkeeping
errors. But Trimbath realized the broader implication: Just as the lack of hard rules
forcing short-sellers to deliver shares makes it possible for unscrupulous traders to
manipulate a corporate vote, it could also enable them to manipulate the price of a stock
by selling large quantities of shares they didn't possess. She warned her bosses that this
crack in the system made the specter of organized counterfeiting a real possibility.
"I personally went to
senior management at DTC in 1993 and presented them with this issue," she recalls.
"And their attitude was, 'We spill more than that.'" In other words, the problem
represented such a small percentage of the assets handled annually by the DTC — as
much as $1.8 quadrillion in any given year, roughly 30 times the GDP of the entire
planet — that it wasn't worth worrying about.
It wasn't until 10 years
later, when Trimbath had a chance meeting with a lawyer representing a company that had
been battered by short-sellers, that she realized someone outside the DTC had seized
control of a financial weapon of mass destruction. "It was like someone figured out
how to aim and fire the Death Star in Star Wars," she says. What they
"figured out," Trimbath realized, was an early version of the naked-shorting
scam that would help take down Bear and Lehman.
Here's how naked short-selling works:
Imagine you travel to a small foreign island on vacation. Instead of going to an exchange
office in your hotel to turn your dollars into Island Rubles, the country instead gives
you a small printing press and makes you a deal: Print as many Island Rubles as you like,
then on the way out of the country you can settle your account. So you take your printing
press, print out gigantic quantities of Rubles and start buying goods and services. Before
long, the cash you've churned out floods the market, and the currency's value plummets. Do
this long enough and you'll crack the currency entirely; the loaf of bread that cost the
equivalent of one American dollar the day you arrived now costs less than a cent.
With prices completely
depressed, you keep printing money and buy everything of value — homes, cars,
priceless works of art. You then load it all into a cargo ship and head home. On the way
out of the country, you have to settle your account with the currency office. But the
Island Rubles you printed are now worthless, so it takes just a handful of U.S. dollars to
settle your debt. Arriving home with your cargo ship, you sell all the island riches you
bought at a discount and make a fortune.
This is the basic outline for
how to seize the assets of a publicly traded company using counterfeit stock. What naked
short-sellers do is sell large quantities of stock they don't actually have, flooding the
market with "phantom" shares that, just like those Island Rubles, depress a
company's share price by making the shares less scarce and therefore less valuable.
The first documented cases of
this scam involved small-time boiler-room grifters. In the late 1990s, not long after
Trimbath warned her bosses about the problem, a trader named John Fiero executed a series
of "bear raids" on small companies. First he sold shares he didn't possess in
huge quantities and fomented negative rumors about a company; then, in a classic
shakedown, he approached the firm with offers to desist — if they'd sell him stock at
a discount. "He would press a button and enter a trade for half a million
shares," says Brent Baker, the SEC official who busted Fiero. "He didn't have
the stock to cover that — but the price of the stock would drop to a penny."
In 2005, complaints from investors about naked short-selling finally prompted the SEC to try to curb the scam. A new rule called Regulation SHO, known as "Reg SHO" for short, established a series of guidelines designed, in theory, to prevent traders from selling stock and then failing to deliver it to the buyer. "Intentionally failing to deliver stock," then-SEC chief Christopher Cox noted, "is market manipulation that is clearly violative of the federal securities laws." But thanks to lobbying by hedge funds and brokers, the new rule included no financial penalties for violators and no real enforcement mechanism. Instead, it merely created a thing called the "threshold list," requiring short-sellers to close out their positions in any company where the amount of "fails to deliver" exceeded 10,000 shares for more than 13 days. In other words, if counterfeiters got caught selling a chunk of phantom shares in a firm for two straight weeks, they were no longer allowed to counterfeit the stock.
A nice, if timid idea —
except that it's completely meaningless. Not only has there been virtually no enforcement
of the rule, but the SEC doesn't even bother to track who is targeting companies with
failed trades. As a result, many stocks attacked by naked short-sellers spent years on the
threshold list, including Krispy Kreme, Martha Stewart and Overstock.com.
"We were actually on it
for 668 consecutive days," says Patrick Byrne, the CEO of Overstock, who became a
much-ridiculed pariah on Wall Street for his lobbying against naked short-selling. At one
point, investors claimed ownership of nearly 42 million shares in Overstock —
even though fewer than 24 million shares in the company had actually been issued.
Byrne is not an easy person for anyone with any kind of achievement neuroses to like. He is young, good-looking, has shitloads of money, speaks fluent Chinese, holds a doctorate in philosophy and spent his youth playing hooky from high school and getting business tips from the likes of Warren Buffett. But because of his fight against naked short-selling, he has been turbofragged by the mainstream media as a tinfoil-hat lunatic; one story in the New York Post featured a picture of Byrne with a flying saucer coming out of his head.
Nonetheless, Byrne's howlings
about naked short-selling look extremely prescient in light of what happened to Bear and
Lehman. Over the past four years, Byrne has outlined the parameters of a naked-shorting
scam that always includes some combination of the following elements: negative rumors
planted in the financial press, the flooding of the market with enormous quantities of
undelivered shares, absurdly high trading volumes and the prolonged appearance of the
targeted company on the Reg SHO list.
In January 2005 — at the
exact moment Reg SHO was launched — Byrne's own company was trading above $65 a
share, and the number of failed trades in circulation was virtually nil. By March 2006,
however, Overstock was down to $28 a share, and Reg SHO data indicated an explosion of
failed trades — nearly 4 million undelivered shares on some days. At those moments,
in other words, nearly a fifth of all Overstock shares were fake.
"This really isn't about
my company," Byrne says. "I mean, I've made my money. My initial concern, of
course, was with Overstock. But the more I learned about this, the more my real worry
became 'Jesus, what are the implications for the system?' And given what happened to Bear
and Lehman last year, I think we ended up seeing what some of those implications
are."
Bear Stearns wasn't the kind of company
that had a problem with naked short-selling. Before March 11th, 2008, there had never been
a period in which significant quantities of Bear stock had been sold and then not
delivered, and the company had never shown up on the Reg SHO list. But beginning on March
12th — the day after the Fed meeting that failed to include Bear, and the mysterious
purchase of the options betting on the firm's imminent collapse — the number of
counterfeit shares in Bear skyrocketed.
The best way to grasp what
happened is to look at the data: On Tuesday, March 11th, there were 201,768 shares of Bear
that had failed to deliver. The very next day, the number of phantom shares leaped to
1.2 million. By the close of trading that Friday, the number passed 2 million —
and when the market reopened the following Monday, it soared to 13.7 million. In less than
a week, the number of counterfeit shares in Bear had jumped nearly seventyfold.
The giant numbers of undelivered shares over the course of that week amounted to one of the most blatant cases of stock manipulation in Wall Street history. "There is not a doubt in my mind, not a single doubt" that naked short-selling helped destroy Bear, says Sen. Ted Kaufman, a Democrat from Delaware who has introduced legislation to curb such financial fraud. Asked to rate how obvious a case of naked short-selling Bear is, on a scale of one to 10, former SEC counsel Brent Baker doesn't hesitate. "Easily a 10," he says.
At the same time that naked
short- sellers were counterfeiting Bear's stock, the firm was being hit by another classic
tactic of bear raids: negative rumors in the media. Tipped off by a source, CNBC reporter
David Faber reported on March 12th that Goldman Sachs had held up a trade with Bear
because it was worried about the firm's creditworthiness. Faber noted that the hold was
temporary — the deal had gone through that morning. But the damage was done; inside
Bear, Faber's report was blamed for much of the subsequent panic.
"I like Faber, he's a
good guy," a Bear executive later said. "But I wonder if he ever asked himself,
'Why is someone telling me this?' There was a reason this was leaked, and the reason is
simple: Someone wanted us to go down, and go down hard."
At first, the full-blown
speculative attack on Bear seemed to be working. Thanks to the media-fueled rumors and the
mounting anxiety over the company's ability to make its payments, Bear's share price
plummeted seven percent on March 13th, to $57. It still had a ways to go for the
mysterious short-seller to make a profit on his bet against the firm, but it was headed in
the right direction. But then, early on the morning of Friday, March 14th, Bear's CEO,
Alan Schwartz, struck a deal with the Fed and JP Morgan to provide an emergency loan to
keep the company's doors open. When the news hit the street that morning, Bear's stock
rallied, gaining more than nine percent and climbing back to $62.
The sudden and unexpected
rally prompted celebrations inside Bear's offices. "We're alive!" someone on the
company's trading floor reportedly shouted, and employees greeted the news by high-fiving
each other. Many gleefully believed that the short-sellers targeting the firm would get
"squeezed" — in other words, if the share price kept going up, the bets
against Bear would blow up in the attackers' faces.
The rally proved short-lived
— Bear ended the day at $30 — but it suggested that all was not lost. Then a
strange thing happened. As Bear understood it, the emergency credit line that the Fed had
arranged was originally supposed to last for 28 days. But that Friday, despite the rally,
Geithner and then-Treasury secretary Hank Paulson — the former head of Goldman Sachs,
one of the firms rumored to be shorting Bear — had a sudden change of heart. When the
market closed for the weekend, Paulson called Schwartz and told him that the rescue
timeline had to be accelerated. Paulson wouldn't stay up another night worrying about Bear
Stearns, he reportedly told Schwartz. Bear had until Sunday night to find a buyer or it
could go fuck itself.
Bear was out of options. Over
the course of that weekend, the firm opened its books to JPMorgan, the only realistic
potential buyer. But upon seeing all the "shit" on Bear's books, as one source
privy to the negotiations put it — including great gobs of toxic investments in the
subprime markets — JPMorgan hedged. It wouldn't do the deal, it announced, unless it
got two things: a huge bargain on the sale price, and a lot of public money to wipe out
the "shit."
So the Fed — on whose New
York board sits JPMorgan chief Jamie Dimon — immediately agreed to accommodate the
new buyers, forking over $29 billion in public funds to buy up the yucky parts of Bear.
Paulson, meanwhile, took care of the bargain issue, putting the government's gun to
Schwartz's head and telling him he had to sell low. Really low.
On Saturday night, March 15th,
Schwartz and Dimon had discussed a deal for JPMorgan to buy Bear at $8 to $12 a share. By
Sunday afternoon, however, Geithner reported that the price had plunged even further.
"Shareholders are going to get between $3 and $5 a share," he told Paulson.
But Paulson pissed on even
that price from a great height. "I can't see why they're getting anything," he
told Dimon that afternoon from Washington, via speakerphone. "I could see something
nominal, like $1 or $2 per share."
Just like that, with a slight nod of Paulson's big shiny head, Bear was vaporized. This, remember, all took place while Bear's stock was still selling at $30. By knocking the share price down 28 bucks, Paulson ensured that the manipulators who were illegally counterfeiting Bear's shares would make an awesome fortune.
Although we don't know who was behind
the naked short-selling that targeted Bear — short-traders aren't required to reveal
their stake in a company — the scam wasn't just a fetish crime for small-time
financial swindlers. On the contrary, the widespread selling of shares without delivering
them translated into an enormously profitable business for the biggest companies on Wall
Street, fueling the growth of a booming sector in the financial-services industry called
Prime Brokerage.
As with other Wall Street abuses, the lucrative business in counterfeiting stock got its start with a semisecret surrender of regulatory authority by the government. In 1989, a group of prominent Wall Street broker-dealers — led, ironically, by Bear Stearns — asked the SEC for permission to manage the accounts of hedge funds engaged in short-selling, assuming responsibility for locating, lending and transferring shares of stock. In 1994, federal regulators agreed, allowing the nation's biggest investment banks to serve as Prime Brokers. Think of them as the house in a casino: They provide a gambler with markers to play and to manage his winnings.
Under the original concept, a
hedge fund that wanted to short a stock like Bear Stearns would first "locate"
the stock with his Prime Broker, then would do the trade with a so-called Executing
Broker. But as time passed, Prime Brokers increasingly allowed their hedge-fund customers
to use automated systems and "locate" the stock themselves. Now the conversation
went something like this:
Evil Hedge Fund: I just sold a million shares of Bear Stearns. Here, hold this shitload of money for me.
Prime Broker:
Awesome! Where did you borrow the shares from?
Evil Hedge Fund:
Oh, from Corrupt Broker. You know, Vinnie.
Prime Broker: Oh, OK. Is he sure he can find those shares? Because, you know, there are rules.
Evil Hedge Fund:
Oh, yeah. You know Vinnie. He's good for it.
Prime Broker:
Sweet!
Following the SEC's approval
of this cozy relationship, Prime Brokers boomed. Indeed, with the rise of discount brokers
online and the collapse of IPOs and corporate mergers, Prime Brokerage — in essence,
the service end of the short- selling business — is now one of the most profitable
sectors that big Wall Street firms have left. Last year, Goldman Sachs netted $3.4 billion
providing "securities services" — the lion's share of it from Prime
Brokerage.
When one considers how easy it
is for short-sellers to sell stock without delivering, it's not hard to see how this can
be such a profitable business for Prime Brokers. It's really a license to print money,
almost in the literal sense. As such, Prime Brokers have tended to be lax about making
sure that their customers actually possess, or can even realistically find, the stock
they've sold. That point is made abundantly clear by tapes obtained by Rolling Stone
of recent meetings held by the compliance officers for big Prime Brokers like Goldman
Sachs, Morgan Stanley and Deutsche Bank. Compliance officers are supposed to make sure
that traders at their firms follow the rules — but in the tapes, they talk about how
they routinely greenlight transactions they know are dicey.
In a conference held at the JW Marriott Desert Ridge Resort in Phoenix in May 2008 — just over a month after Bear collapsed — a compliance officer for Goldman Sachs named Jonathan Breckenridge talks with his colleagues about how the firm's customers use an automated program to report where they borrowed their stock from. The problem, he says, is the system allows short-sellers to enter anything they want in the text field, no matter how nonsensical — or even leave the field blank. "You can enter ABC, you can enter Go, you can enter Locate Goldman, you can enter whatever you want," he says. "Three dots — I've actually seen that."
The room erupts with laughter.
After making this admission, Breckenridge asks officials from the Securities Industry and Financial Markets Association, the trade group representing Wall Street broker-dealers, for guidance in how to make this appear less blatantly improper. "How do you have in place a process," he wonders, "and make sure that it looks legit?"
The funny thing is that Prime
Brokers didn't even need to fudge the rules. They could counterfeit stocks legally, thanks
to yet another loophole — this one involving key players known as "market
makers." When a customer wants to buy options and no one is lining up to sell them,
the market maker steps in and sells those options out of his own portfolio. In market
terms, he "provides liquidity," making sure you can always buy or sell the
options you want.
Under what became known as the "options market maker exception," the SEC permitted a market maker to sell shares whether or not he had them or could find them right away. In theory, this made sense, since delaying the market maker from selling to offset a big buy order could dry up liquidity and slow down trading. But it also created a loophole for naked short-sellers to kill stocks easily — and legally. Take Bear Stearns, for example. Say the stock is trading at $62, as it was on March 11th, and someone buys put options from the market maker to sell $1.7 million in Bear stock nine days later at $30. To offset that big trade, the market maker might try to keep his own portfolio balanced by selling off shares in the company, whether or not he can locate them.
But here's the catch: The
market maker often sells those phantom shares to the same person who bought the put
options. That buyer, after all, would love to snap up a bunch of counterfeit Bear stock,
since he can drive the company's price down by reselling those fake shares. In fact, the
shares you buy from a market maker via the SEC-sanctioned loophole are sometimes called
"bullets," because when you pump these counterfeit IOUs into the market, it's
like firing bullets into the company — it kills the price, just like printing more
Island Rubles kills a currency.
Which, it appears, is exactly what happened to Bear Stearns. Someone bought a shitload of puts in Bear, and then someone sold a shitload of Bear shares that never got delivered. Bear then staggered forward, bleeding from every internal organ, and fell on its face. "It looks to me like Bear Stearns got riddled with bullets," John Welborn, an economist with an investment firm called the Haverford Group, later observed.
So who conducted the naked short- selling against Bear? We don't know — but we do know that, thanks to the free pass the SEC gave them, Prime Brokers stood to profit from the transactions. And the confidential meeting at the Fed on March 11th included all the major Prime Brokers on Wall Street — as well as many of the biggest hedge funds, who also happen to be some of the biggest short-sellers on Wall Street.
The economy's financial woes might have
ended there — leaving behind an unsolved murder in which many of the prime suspects
profited handsomely. But three months later, the killers struck again. On June 27th, 2008,
an avalanche of undelivered shares in Lehman Brothers started piling up in the market.
June 27th: 705,103 fails. June 30th: 814,870 fails. July 1st: 1,556,301 fails.
Then the rumors started. A
story circulated on June 30th about Barclays buying Lehman for 25 percent less than the
share price. The tale was quickly debunked, but the attacks continued, with hundreds of
thousands of failed trades every day for more than a week — during which time Lehman
lost 44 percent of its share price. The major players on Wall Street, who for years had
confined this unseemly sort of insider rape to smaller companies, had begun to eat each
other alive.
It made great capitalist sense
to attack these giant firms — they were easy targets, after all, hideously mismanaged
and engorged with debt — but an all-out shooting war of this magnitude posed a risk
to everyone. And so a cease-fire was declared. In a remarkable order issued on July 15th,
Cox dictated that short-sellers must actually pre-borrow shares before they sell them. But
in a hilarious catch, the order only covered shares of the 19 biggest firms on Wall
Street, including Morgan Stanley and Goldman Sachs, and would last only a month.
This was one of the most
amazing regulatory actions ever: It essentially told Wall Street that it was enjoined from
counterfeiting stock — but only temporarily, and only the stock of the 19 of the
richest companies on Wall Street. Not surprisingly, the share price for Lehman and some of
the other lucky robber barons surged on the news.
But the relief was
short-lived. On August 12th, 2008, the Cox order expired — and fails in Lehman stock
quickly started mounting. The attack spiked on September 9th, when there were over 1
million undelivered shares in Lehman. On September 10th, there were 5,877,649 failed
trades. The day after, there were an astonishing 22,625,385 fails. The next day:
32,877,794. Then, on September 15th, the price of Lehman Brothers stock fell to 21 cents,
and the company declared bankruptcy.
That naked shorting was the tool used to kill the company — which was, like Bear, a giant bursting sausage of deadly subprime deals that didn't need much of a push off the cliff — was obvious to everyone. Lehman CEO Richard Fuld, admittedly one of the biggest assholes of the 21st century, said as much a month later. "The naked shorts and rumormongers succeeded in bringing down Bear Stearns," Fuld told Congress. "And I believe that unsubstantiated rumors in the marketplace caused significant harm to Lehman Brothers."
The methods used to destroy
these companies pointed to widespread and extravagant market manipulation, and the death
of Lehman should have instigated a full-bore investigation. "This isn't a trail of
bread crumbs," former SEC enforcement director Irving Pollack has pointed out.
"This audit trail is lit up like an airport runway. You can see it a mile off.
Subpoena e-mails. Find out who spread false rumors and also shorted the stock, and you've
got your manipulators."
It would be an easy matter for
the SEC to determine who killed Bear and Lehman, if it wanted to — all it has to do
is look at the trading data maintained by the stock exchanges. But 18 months after the
widespread market manipulation, the federal government's cop on the financial beat has
barely lifted a finger to solve the two biggest murders in Wall Street history. The SEC
refuses to comment on what, if anything, it is doing to identify the wrongdoers, saying
only that "investigations related to the financial crisis are a priority."
The commission did repeal the
preposterous "market maker" loophole on September 18th, 2008, forbidding market
makers from selling phantom shares. But that same day, the SEC also introduced a comical
agreement called "Rule 10b-21," which makes it illegal for an Evil Hedge Fund to
lie to a Prime Broker about where he borrowed his stock. Basically, this new rule formally
exempted Wall Street's biggest players from any blame for naked short-selling, putting it
all on the backs of their short-seller clients. Which was good news for firms like Goldman
Sachs, which only a year earlier had been fined $2 million for repeatedly turning a
blind eye to clients engaged in illegal short-selling. Instead of tracking down the
murderers of Bear and Lehman, the SEC simply eliminated the law against aiding and
abetting murder. "The new rule just exempted the Prime Brokers from legal
responsibility," says a financial player who attended closed-door discussions about
the regulation. "It's a joke."
But the SEC didn't stop there
— it also went out of its way to protect the survivors from the normal functioning of
the marketplace. On September 15th, the same day that Lehman declared bankruptcy, the
share price of Goldman and Morgan Stanley began to plummet sharply. There was little
evidence of phantom shares being sold — in Goldman's case, fewer than .02 percent of
all trades failed. Whoever was attacking Goldman and Morgan Stanley — if anyone was
— was for the most part doing it legally, through legitimate short-selling. As a
result, when the SEC imposed yet another order on September 17th curbing naked
short-selling, it did nothing to help either firm, whose share prices failed to recover.
Then something extraordinary
happened. Morgan Stanley lobbied the SEC for a ban on legitimate short-selling of
financial stocks — a thing not even the most ardent crusaders against naked short-
selling, not even tinfoil-hat-wearing Patrick Byrne, had ever favored. "I spent years
just trying to get the SEC to listen to a request that they stop people from rampant
illegal counterfeiting of my company's stock," says Byrne. "But when Morgan
Stanley asks for a ban on legal short-selling, they get it literally overnight."
Indeed, on September 19th, Cox
imposed a temporary ban on legitimate short- selling of all financial stocks. The stock
price of both Goldman and Morgan Stanley quickly rebounded. The companies were also bailed
out by an instant designation as bank holding companies, which made them eligible for a
boatload of emergency federal aid. The law required a five-day wait for such a conversion,
but Geithner and the Fed granted Goldman and Morgan Stanley their new status overnight.
So who killed Bear Stearns and
Lehman Brothers? Without a bust by the SEC, all that's left is means and motive. Everyone
in Washington and on Wall Street understood what it meant when Lehman, for years the hated
rival of Goldman Sachs, was chosen by Treasury Secretary Hank Paulson — the former
Goldman CEO — to be the one firm that didn't get a federal bailout.
"When Paulson, a former Goldman guy, chose to sacrifice Lehman, that's when you knew
the whole fucking thing was dirty," says one Democratic Party operative. "That's
like the Yankees not bailing out the Mets. It was just obvious."
The day of Lehman's collapse,
Paulson also bullied Bank of America into buying Merrill Lynch — which left Goldman
Sachs and Morgan Stanley as the only broker-teens left unaxed in the Camp Crystal Lake
known as the American economy. Before they were hacked to bits, Merrill, Bear and Lehman
all nurtured booming businesses as Prime Brokers. All that lucrative work had to go
somewhere. So guess which firms made the most money in Prime Brokerage this year?
According to a leading industry source, the top three were Goldman, JPMorgan and Morgan
Stanley.
We may never know who killed Bear and Lehman. But it sure isn't hard to figure out who's left.
While naked short-selling was the weapon
used to bring down both Bear and Lehman, it would be preposterous to argue that the
practice caused the financial crisis. The most serious problems in this economy were the
result of other, broader classes of financial misdeed: corruption of the ratings agencies,
the use of smoke-and-mirrors like derivatives, an epidemic tulipomania called the housing
boom and the overall decline of American industry, which pushed Wall Street to synthesize
growth where none existed.
But the "phantom" shares produced by naked short-sellers are symptomatic of a problem that goes far beyond the stock market. "The only reason people talk about naked shorting so much is that stock is sexy and so much attention is paid to the stock market," says a former investment executive. "This goes on in all the markets."
Take the commodities markets,
where most of those betting on the prices of things like oil, wheat and soybeans have no
product to actually deliver. "All speculative selling of commodity futures is 'naked'
short selling," says Adam White, director of research at White Knight Research and
Trading. While buying things that don't actually exist isn't always harmful, it can help
fuel speculative manias, like the oil bubble of last summer. "The world consumes
85 million barrels of oil per day, but it's not uncommon to trade 1 billion barrels
per day on the various commodities exchanges," says White. "So you've got 12
paper barrels trading for every physical barrel."
The same is true for
mortgages. When lenders couldn't find enough dope addicts to lend mansions to, some simply
went ahead and started selling the same mortgages over and over to different investors.
There are now a growing number of cases of such double-selling of mortgages: "It
makes Bernie Madoff seem like chump change," says April Charney, a legal-aid attorney
based in Florida. Just like in the stock market, where short-sellers delivered IOUs
instead of real shares, traders of mortgage-backed securities sometimes conclude deals by
transferring "lost-note affidavits" — basically a "my dog ate the
mortgage" note — instead of the actual mortgage. A paper presented at the
American Bankruptcy Institute earlier this year reports that up to a third of all notes
for mortgage-backed securities may have been "misplaced or lost" — meaning
they're backed by IOUs instead of actual mortgages.
How about bonds? "Naked
short-selling of stocks is nothing compared to what goes on in the bond market," says
Trimbath, the former DTC staffer. Indeed, the practice of selling bonds without delivering
them is so rampant it has even infected the market for U.S. Treasury notes. That's right
— Wall Street has actually been brazen enough to counterfeit the debt of the United
States government right under the eyes of regulators, in the middle of a historic series
of government bailouts! In fact, the amount of failed trades in Treasury bonds — the
equivalent of "phantom" stocks — has doubled since 2007. In a single week
last July, some $250 billion worth of U.S. Treasury bonds were sold and not
delivered.
The counterfeit nature of our economy is troubling enough, given that financial power is concentrated in the hands of a few key players — "300 white guys in Manhattan," as a former high-placed executive puts it. But over the course of the past year, that group of insiders has also proved itself brilliantly capable of enlisting the power of the state to help along the process of concentrating economic might — making it less and less likely that the financial markets will ever be policed, since the state is increasingly the captive of these interests.
The new president for whom we
all had such high hopes went and hired Michael Froman, a Citigroup executive who accepted
a $2.2 million bonus after he joined the White House, to serve on his
economic transition team — at the same time the government was giving Citigroup a
massive bailout. Then, after promising to curb the influence of lobbyists, Obama hired a
former Goldman Sachs lobbyist, Mark Patterson, as chief of staff at the Treasury. He hired
another Goldmanite, Gary Gensler, to police the commodities markets. He handed control of
the Treasury and Federal Reserve over to Geithner and Bernanke, a pair of stooges who
spent their whole careers being bellhops for New York bankers. And on the first
anniversary of the collapse of Lehman Brothers, when he finally came to Wall Street to
promote "serious financial reform," his plan proved to be so completely absent
of balls that the share prices of the major banks soared at the news.
The nation's largest financial players are able to write the rules for own their businesses and brazenly steal billions under the noses of regulators, and nothing is done about it. A thing so fundamental to civilized society as the integrity of a stock, or a mortgage note, or even a U.S. Treasury bond, can no longer be protected, not even in a crisis, and a crime as vulgar and conspicuous as counterfeiting can take place on a systematic level for years without being stopped, even after it begins to affect the modern-day equivalents of the Rockefellers and the Carnegies. What 10 years ago was a cheap stock-fraud scheme for second-rate grifters in Brooklyn has become a major profit center for Wall Street. Our burglar class now rules the national economy. And no one is trying to stop them.