Friday, June 14, 2013

In The News: Swaps and Naked Shorts

A flurry of recent events suggest that many of the provisions of the Dodd-Frank Act are finally being implemented by rule or coming of age. The June 11, 2013 edition of the Wall Street Journal lays out some perfect examples of the regulatory ripple effect of the 2008 financial markets meltdown.

I still recall happening upon a discussion between a securities regulator from Vermont and a securities regulator from Utah during the early months of my tenure as Commissioner of Securities. The two of them were discussing “naked shorts” and I initially thought I was interrupting a private discourse. Luckily, I stayed around long enough to learn about a stock option practice—now restricted—that can be used as a legitimate equity market hedge strategy or abused as a market manipulation strategy.

The Wall Street Journal reported on page C-1 that a SEC administrative law judge had ruled against a former Maryland banker in finding him liable for “naked short selling.” As you probably know, a short sale is accomplished by selling stock you don't own by borrowing it from someone who is “long” in the stock (owns it). The goal is to buy the stock back out of the market if and when the stock’s price goes down, and return the new shares to the original owner. For example—if you sold the borrowed shares for $10 and bought the replacement shares for $5, you made a nice little profit. “Naked” short selling distorts the market price of the shares because the shares being sold were never actually borrowed. This does damage to current shareholder's because it creates a negative downward market pressure on the price of the stock at issue.

The SEC judge in the case also ordered a brokerage firm owned by Charles Schwab to disgorge $1.6 million in profits and pay a $2 million fine. The judge even went so far as to bar the firm's former CEO from the securities industry. It seems the brokerage turned a blind eye towards the banker's failure to clear his short sales.

Along the lines of new and tighter restrictions mandating timely clearance, the same edition of the Wall Street Journal has an article about the new rules that recently took effect regarding swaps. A swap is a “derivative” of an actual equity. Reporter Katy Burne Succinctly explains that:

“Derivatives allow users to protect against everything from moves in interest rates to the cost of raw materials, and swaps are more-complex derivatives that have generally been traded away from exchanges. As of Monday, more are being routed to central clearing houses, which take fees to guarantee trades in the nearly $650 trillion global swaps market. The 2010 Dodd-Frank financial-overhaul law mandated that many swaps be cleared in an effort to help prevent a financial system meltdown by forcing traders to post collateral known as margin. When Lehman Brothers Holdings, Inc. failed in 2008, just a fraction of its multitrillion-dollar swaps book was cleared. Lehman's failure sent shock waves through financial markets and accelerated a general pullback by investors from riskier investment classes.”

I can't say it any better than that.

The same edition covers the rating agencies’ new-found “lack of sway” (loss of credibility) since they fell in love with and heaped AAA ratings on mortgage-backed collateralized debt obligations that were packed with junk. Journalists Nicole Hong and Carolyn Cui, however, attribute the diminished influence to factors such as “the prominence of global economic factors driving bond prices” (as opposed to the intrinsic credit soundness of the bond issuer I suppose). Finally, the edition at issue ran a story about another child of the Dodd-Frank Act—the Bureau of Consumer Financial Protection—scrutinizing bank overdraft fee practices. And it is about time on that score.

In sum, if you missed the Wall Street Journal on June 11, 2013, you are lucky you found this blog. Food for thought.

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