When the Dow Jones Industrial Average was hovering in the stratosphere in the mid 13k range in July of 2007, a federal agency known as the Securities and Exchange Commission, which was formed to regulate our financial markets in a positive way, did something so antithetical to their goals that I must question its reasons for doing so.
The uptick rule was created in 1938 with clear intentions to prevent short sellers of stock to be able to drive prices artificially low and cause mass panic. The way the rule worked was simple enough: one was not able to continuously sell stocks that one does not own in an attempt to cause fear and anxiety in the markets. One was forced to wait for an "uptick" or another party to buy shares before resuming the predatory selling.
The rule achieved its goals and survived from 1938 until 2007 due to its effectiveness. Obviously it must have had some success to have survived for so long. When it was removed, the results themselves prove how effective it had been. The fate of Lehman Brothers, formerly the fourth largest investment bank in the world, and Bear Stearns were closely tied to the fate of the uptick rule as all three entities are no longer with us.
The DJIA went from 13,633.63 to below 7,000 in the ensuing months and we have all seen the carnage unfold in front of our eyes. There are a multitude of factors that have contributed to the decline in stock prices and the freezing of credit markets and the uptick rule has been infrequently cited as a major cause. The Federal Reserve, Fannie Mae, Freddie Mac, the U.S. Treasury Department, corrupt bankers and politicians have all thrown their hat in the ring and made horrible decisions. However, had this old rule simply remained in place and naked short-selling curtailed I believe there would be a very different economic landscape than we currently see.
The removal of the uptick rule was one of the catalyzing events which sparked the crash of financial stocks in October of 2008. Once the uptick rule was removed hedge funds and large banks could target the stock of whatever firm they felt vulnerable enough to exploit. Lehman Brothers and Bear Stearns were the most vulnerable according to the charts. Lehman was weakened and their market capitalization eroded to the point where folks began opting to do business with other more stable companies and the river of assets began to flow out of Lehman like a mountain river in early spring. The collapse of LEH shares was profound in its quickness and momentum and many have wondered why this particular bank was targeted. While not a likely primary motivation, the Wall Street Journal pointed out that Hugo Chavez owned Lehman Brothers bonds that may have been defaulted on to the tune of $300 million.
The uptick rule would not have entirely eliminated the opportunity to short Lehman or Bear shares. Rather it would have delayed the speed that shares could have been shorted, allowing more rational investors to exploit momentary weaknesses in the market for profit. When fraudulent naked short-selling runs rampant it is relatively easy to destroy trillions in market capitalization if one has enough money to finance the endeavor using leverage.
If the SEC had sought to fulfill the task it was created to achieve, the uptick rule would have never been abolished and the world we live in would have a couple more investment banks and the number of U.S. dollars in circulation would be significantly less.
As Gary Matsumoto writes in Bloomberg, fraud suspicions abounded prior to the meltdown in financial stocks:
While the commission’s Enforcement Complaint Center received about 5,000 complaints about naked short-selling from January 2007 to June 2008, none led to enforcement actions, according to a report filed yesterday by David Kotz, the agency’s inspector general. The way the SEC processes complaints hinders its ability to respond, the report said.
This clearly indicates that a significant number of individuals noticed that the SEC had stopped enforcing some very important rules which help keep the markets orderly and free of fraud and panic.
Matsumoto goes on to analyze what are known as "failed trades" resulting from naked short sales. A failed trade is when a person sells a stock short and fails to properly procure the borrowed shares, and then proceeds to buy back the shares for a profit if successful, all the while ignoring the laws governing the shorting process.
Failed trades correlate with drops in share value -- enough to account for 30 to 70 percent of the declines in Bear Stearns, Lehman and other stocks last year, Trimbath said.
Failing to deliver is like "issuing new stock in a company without its permission," Trimbath said. "You increase the number of shares circulating in the market, and that devalues a stock. The same thing happens to a currency when a government prints more of it."
Trimbath attributes the almost ninefold growth in the value of failed trades from 1995 to 2007 to a rise in naked short sales.
"You can’t have millions of shares fail to deliver and say, ‘Oops, my dog ate my certificates,’" she said. (Matsumoto)
In case folks can't imagine who could possibly be responsible for such actions, the NYSE almost got a confession from a bank responsible for such activity. A consent decree is equal to admitting guilt in this writer's opinion and they should not be a part of our justice system. They are the ultimate plea bargain for corporations that have been criminal and are not allowed for use by individuals.
Since July 2006, the regulatory arm of the New York Stock Exchange has fined at least four exchange members for naked shorting and violating other securities regulations. J.P. Morgan Securities Inc. paid the highest penalty, $400,000, as part of an agreement in which the firm neither admitted nor denied guilt, according to NYSE Regulation Inc. (Matsumoto)
The key fact to remember here is that J.P. Morgan was the entity that eventually gained the most from the plight of Lehman and Bear. The remaining assets of Bear Stearns were swallowed up by J.P. Morgan for pennies on the dollar after the company folded. If this isn't clear probable cause that something is rotten in the house of Morgan then I don't know what evidence would suffice. This behavior should be investigated and Morgan CEO Jamie Dimon should be publicly walked to a windowless cell for allowing this to occur under his watch.
This evidence of fraud is strikingly similar to the examples cited regarding the Bernie Madoff ponzi scheme. When the SEC is handed evidence of fraud and does nothing they are a party to the fraud itself. I would like to see the SEC staffed by more competent or honest individuals as one of the two admirable qualities appear to be missing entirely from the agency.
In recent weeks Ben Bernanke of the Federal Reserve and Massachusetts congressman Barney Frank have openly advocated bringing back the uptick rule. I find this grandstanding to be more disingenuous and empty than equally appalling as the "anger" we now hear from all politicians regarding the AIG bonuses.
Fox has published similar sentiment recently as well since it seems as if it is now okay to talk about the 10,000 pound elephant that's been in our stock markets. The only rational conclusion that I've come up with so far is that the SEC was acting to help consolidate the financial sector as quickly and cheaply as possible. Since the SEC doesn't own stocks itself one can only assume that the actions were taken for the benefit of others.
It seems that the SEC has become part of the problem rather than it's former role as part of the solution. This is eerily similar to the Federal Reserve and the federal government in general. I for one have no more patience for this type of blatant disregard for justice and equality in our economy. If the SEC would like to behave in this manner I suggest they change their acronym to Stupid, Embarrassing and Corrupt.
©2009 Rhode to Surfdom, all rights reserved. You must have written permission from the author in order to republish this work.
Published: Sunday, March 22, 2009
Last modified: Sunday, March 22, 2009
The views expressed in this article are those of Rhode to Surfdom only and do not represent the views of Nolan Chart, LLC or its affiliates. Rhode to Surfdom is solely responsible for the contents of this article and is not an employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.
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Reader Comments:
Posted By: Walt Thiessen
Date: 2009-03-22 11:36:43
The long, drawn out crash of the stock market over the past six months is due to the removal of the uptick rule? That's insane.
Perhaps you feel that the stock market should never experience a sustained decline, and that if it does it means that the wrong regulations have been removed? Get real.
Posted By: Rhode to Surfdom
Date: 2009-03-22 12:08:49
Walt,
I agree with you that the removal of the uptick rule is not the primary nor the only cause of the stock maket decline.
Maybe you should re-read the article because the point I make is that removing the uptick rule allowed bear raids to happen. Targeting certain stocks and forcing their collapse is the result of the removal. I do not claim that the entire market would be higher had the rule been in place- just that Lehman and Bear were taken down as a result.
Posted By: Randy
Date: 2009-03-22 22:17:14
Restoring the uptick rule would definately do more to stabilize the market, so you don't see such erratic losses and gains in such short periods of time. The lack of the uptick rule may have exagerrated losses but I would be a little reluctant to blame it as any one firm's undoing, rather I would point to the repeal of Glass-Steagall during the late 90's as the primary catalyst of the current state of affairs. Interesting article and conclusions though.
Posted By: Judd Bagley
Date: 2009-03-23 07:43:16
The Bloomberg article on naked shorting bringing down Lehman is likely the most important pieces of journalism you'll read all year. I've examined the same issue in this video, posted -- coincidentally -- the day before the Bloomberg story.