"Getting naked in short selling"-New Video from American Public Media's Marketplace

Brad Robideau of NPR says:

The practice of short selling has been blamed for the collapse of several major companies’ shares during the financial crisis. What is short selling? In this video, “Getting naked in short selling,” Marketplace senior editor Paddy Hirsch is back at the whiteboard to explain the complexities of the markets.

All of the videos can be accessed at www.marketplace.org and are part of "Fallout: America's Financial Crisis," Marketplace's comprehensive coverage of the current financial crisis.

Getting naked in short selling

[#1 posted by zuzu , October 23, 2008 9:07 AM]

Max Keiser also had a video about the fraud of naked short selling (like backdating), aired in May 2007.

[#2 posted by CharlesSpongeworth , October 23, 2008 12:14 PM]

I find his description really confusing because he brings in so many details that are irrelevant to the explanation e.g. Sam, John, orange juice, the weather etc, and all those arrows and pictures. I think my mind works differently. My explanation of short selling, that doesn't take 7 minutes to read is this:

Short selling is borrowing shares for a fee, and selling them. If the price of those shares should later fall the borrower can repay the lender by re-buying the same number of shares cheaper from somewhere else (and hence keep the difference in price for himself). But if the shares should rise instead, he would have to pay more money to buy back the same shares so would lose out.

Naked short selling is agreeing to sell someone shares that you don't have (or haven't borrowed yet) at a certain price, in the hope that prices will drop before you have to get round to handing them over. If it works out, you can buy the shares cheaper than you sell them for. It fails if you either have to pay more for the shares than you sell them for, or if you can't buy any at all.

I think that's about right.

[#3 posted by John H. , October 23, 2008 4:35 PM]

I thought it was a great explanation, and sent me off to find his previous videos.

[#4 posted by Cool Products , October 24, 2008 8:13 AM]

I am a Finance major, and I think that he did a really good job in describing what naked short selling actually is. Great video, I'll have to pass this on to some of my professors to show in class. My only complaint for this video, is how he did not explain thoroughly how naked short selling is negatively affecting the U.S. financial market.

[#5 posted by nprnncbl , October 24, 2008 9:10 AM]

Between the marketplace video and the Max Keiser video, I still don't quite get why shorting is OK but naked shorting isn't. After all, when it works, they seem the same, except that the bank hasn't taken a cut. If the short seller can't buy stock, then he defaults on his promise to deliver: either to the bank that loaned him the stock, or in the naked case, to the person he sold it to. Either way, somebody gets screwed.

I suspect the reason, which Max Keiser hints at more through inflammatory language than an explanation, has to do with the market effects of short selling, and the fact that having to have the shares limits the amount of short-selling that can take place. In naked shorting, with no requirement to have shares, there is no limit. So what happens as a result?

Also, Zuzu, while I enjoy the Max Keiser vids, and have learned something from them, I find it a little challenging to filter out the political bias: some seems obvious, like interviewing the goldmoney.com founder or someone saying on Al Jazeera that the US market is unethical and investors should look to other countries. It's not that I'm challenging their claims, but rather that they seem to be projecting a message that their target demographic wants to hear.

[#6 posted by nprnncbl , October 24, 2008 10:06 AM]

On further reflection, maybe I do get it (and maybe MK did explain this):

In naked short selling, the buyer thinks they are getting something real, but the seller has nothing. Rather than getting an existing share, the buyer essentially receives a virtual share. The effect of the sale is that it pushes the price down: the virtual share dilutes the value of existing shares; it is inflationary.

Here's where the network effect kicks in: because the price goes down, more people sell short, driving the price down further, and becoming a self-fulfilling prophecy: the stock price is driven down further than share-backed short selling could do, simply because the volume is larger.

So, if I were a large investor, I could theoretically (1) do a large naked short sell, which (2) artificially reduces the price, then I (3) buy back shares at the artificially reduced price, making a profit. I create virtual shares in (1) that are destroyed in (3).

And then if I were really sneaky, and I knew that the price reduction were do to my intervention, I could then (4) buy even more shares at the depressed price, which (5) drives the price back up, enabling me to (6) sell those shares at a profit.

Win-win! What's the problem?