Naked shorting, stock loans, and how you can fight back
By Craig Cunningham
Naked Shorting
Ok, by now it should be painfully obvious that naked shorting is a problem that the government is absolutely, positively, not going to do anything about. The government is simply not concerned with your money or wellbeing and is firmly committed to not doing anything to protect you. If you get ripped off by a crooked broker or hedge fund, then that is just too darned bad.
Want proof the government doesn’t care? Take a look at REFCO. Look at Novastar or Overstock, millions of FTD shares between them, and where, oh where, is the SEC? They are probably out to lunch, as usual, or perhaps they’ve gone fishing after a hard day of wrist slapping. Reg SHO has been on the books for a year and a half with no discernable impact; although for laws to be effective, you generally need someone to enforce them.
Want to write your congressman? Go ahead, they won’t do anything. You’ll probably get some generic form letter about this great “new” law called Reg SHO that the SEC has created to combat the exact problem you are writing about. See how hard your government works for you!
Try the SEC. All you’ll get is a “duly noted” response. If you should dare to ask them about why NFI has been on the list for 300+ days or why there haven’t been any investigations, you’ll get the standard “we don’t comment on current investigations.” This is especially disingenuous, since there are no active investigations into Reg SHO going on right now.
The SEC is so worthless, that I’m certain you’ll see President George Bush will sit down and have dinner with Kim Jong Il and Osama Bin Ladin before the agency decides to take any action on Reg SHO and prosecute their future employers. It just isn’t going to happen.
So, what’s a person to do?
Well, once again, as so many other times in history, it is incumbent on ordinary folks like you and me to fight back against the morally bankrupt and professionally inept. You saw it start with folks like Bob O’ Brien with the NFI-INFO.net site. He was joined by Mary Helburn later and started up NCANS. Patrick Byrne fired off a major volley with his lawsuit against David Rocker and Gradient for unfair business practices. Now, you have Novastar investors suing as well. They aren’t alone. There are the David Patch’s, the Bud Burrell’s, and many, many others. The shouts of outrage grow louder and louder.
Now, I understand that not everyone is capable or willing to sue or have their name in the paper, but here is something you, yes YOU reading this, can do, right now.
Stock secured loans
Stock lending is a new frontier to many investors. For many years, brokers have typically lent out your shares to hedge funds and institutional type investors. Now, stock lending is available to ordinary investors. Novastar investors, check your “payment-in-lieu” vs. a regular dividend on your quarterly statement to see how many of your “shares” are really IOUs.
Stock lending is a fabulously profitable endeavor for brokers. The message board on Novastar was buzzing about the Schwab program that was offering a fat 9% kicker, which has been reduced to 5% if you want to hand over your shares. Now, I was no math major, but you have to figure if the brokers are willing to pay 9% to borrow shares, someone else is willing to pay at least that much and probably quite a bit more. Outside of that, brokers generally have the green light to lend your shares out at a profit if you carry a margin balance.
This activity generally is done to aid the shorts who want to drive the stock price lower. Some shareholders have decried the practice of lending shares out in the Schwab program, since it ultimately helps the shorts.
Well, it doesn’t have to be that way.
There are many ways to beat the system and put the screws to the crooked brokers and hedge funds that have your assets marked for destruction. If you are familiar with my other work on using credit cards or home equity lines to invest, to eliminate the risk of margin calls, you’ll know where I am heading with this.
Stock secured loans are the ticket: flip your broker the bird and lend out your own stock.
Stock secured loans are NOT margin. Margin is limited to 50% of the market value, and is offered by brokers. Stock loans are offered by banks and credit unions. The loan-to-values I’ve seen offered range from 60-85% of the underlying value. The interest rates are fairly competitive in relation to margin. Generally they vary, but I have seen fixed rates top out at 8.5%. Margin rates are generally tied to some sort of index, plus a margin, and are largely above 10% across the board, unless you are carrying a mid-6-figure debt load or more.
The benefits don’t stop there. As stated, margin loans allow for your friendly broker to lend out your shares to the shorts. With stock secured loans, you typically have to obtain the stock certificates to complete the deal. This is the first step to fight back, since it reduces the pool of shares available to the shorts. When fewer shares are available to borrow, it means less shorting activity, or having to pay more to do it.
Margin calls are also the risk you have to run when dealing with traditional margin loans. You eliminate the risk of margin calls when you use other forms of debt to invest such as term loans, home equity lines, or credit cards with cherry low or no interest rates. While the risk is not eliminated with stock secured loans, it is substantially less than traditional margin.
If the stock value drops below the loan balance, you will at some point have to pony up the difference between the loan balance and the stock value, according to the terms of the loan, which varies from lender to lender. I’ve seen figures suggesting you’ll get a call if your stock values fall below 95% of the loan balance. Keep in mind, there probably aren’t people watching the intraday values as you have with regular margin, so there probably is a larger window of time to act. Further, since the loans generally are amortizing (there are interest only options from some companies) over time, you’ll repay the loans and have a greater cushion against a downturn in the market each month, as opposed to margin, which just racks up interest charges each month.
How to fight back
I know what you are thinking: Ok, I’ve got this stock loan, but where is the payoff?
Well, you limit the ability of the shorts to short more stock, since you took your shares in certificate form. You can complete the 1-2 punch by adding some buying pressure. Now, you can’t directly buy more stock with 100% of your loan proceeds. In this regard, it is similar to margin, as you can’t directly buy marginable securities with more than 50% of the underlying collateral’s value.
Presumably, you could buy stocks with 50% and put the rest in a CD or high-yield money market account. If you used the basic strategy of using credit cards or lines of credit to fund your initial stock purchase, you can simply use the loan proceeds to repay the original loan and you are free to double down and buy more shares at your leisure.
For example, take one of the most shorted companies out there: Novastar. Disclaimer: I own it, and I have a financial interest in the stock price going up via a short squeeze or other buying pressure.
Say you own 4,000 shares of NFI worth about $120,000, and you want to do your part and put the hurt on any hedge funds or brokers that might be flouting the rules - and make a profit while doing so. Well, you could give your shares to Schwab for a 5% payoff, but you can certainly do better than that.
You could go to a bank like Digital credit union, Chase, Patelco, or any other financial institution that does stock secured loans, get 70% LTV for $84,000, and stick $24,000 in a CD or high yield savings and make 5-6% on your money, and the other $60,000 (50% of $120,000) and buy some more Novastar or other high yield security. I can easily think of a dozen to choose from in the Canadian oil/gas royalty trust sector or tanker stocks.
Assuming you gave your funds to Schwab, you’d be looking at an extra $6,000 a year roughly. Your new Novastar shares will pay roughly $10,200 every year, and the CD assuming a 5% yield, an extra $1200 or a total of $11,400. Your original NFI dividends can more than cover the loan payments, and given the shorter terms of stock loans, the majority of your payments are principal, so you aren’t paying much in interest. In this scenario, the interest payments start out at $132 per month, assuming a 7.2% rate. Subtract out the interest paid, and you should still be ahead of the current Schwab program by about $3800.
In closing, using borrowed funds to invest is not for everyone. If you are 25 with many happy years of investing ahead of you, you can afford to take shots like this. If you are 65, retired, and living off the dividends, this may not be the best move to make. If you are considering lending your shares out, I suggest you consider this alternative.