TED BUTLER COMMENTARY

July 21, 2008

A Modest Proposal

(This essay was written by silver analyst Theodore Butler, an independent consultant.

Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

If there has been one issue which I have focused more on than any single issue over the years, it has to be short selling in silver related investment vehicles, primarily the concentrated short selling in COMEX futures, and more recently, the naked short selling of the shares of the silver (and gold) ETF’s. Naturally, I was very interested in the just announced emergency order by the Securities and Exchange Commission (SEC), temporarily restricting naked short selling in selected financial stocks.

While the SEC’s surprise action has generated much commentary and debate on the issue of short selling, it has also confirmed that a regulatory body is concerned with the issue. Let me be clear upfront - I think their order was brilliant. (As regular readers will attest, I am not generally an enthusiastic supporter of most regulatory initiatives). Certainly, no one can argue that the intent behind the SEC’s measure was ineffective, as the financial stocks in question immediately rallied by the largest amount in history.

Unfortunately, the backpedaling by the SEC has already begun, under heavy lobbying from the securities industry, as exemptions to the restrictions are being enacted even before the order was made effective. This may render the brilliant move largely ineffective in the long run. But, at least it raised the issue of stock short selling to the highest levels of debate.

The main fault I have with the initiative was that it didn’t go far enough, namely, it should have been extended to all stocks, not just the 19 primary dealers included in the plan. That would only be fair. Further, it was unnecessarily complicated, weakened by new exemptions. The SEC crackdown also distinguished between short selling in which the stock was first borrowed and "naked" short selling in which no stock was first borrowed. Most importantly, the naked variety of short selling was already considered illegal, although the SEC has refused to crackdown on it.

There appears to be universal agreement that there is a world of difference between the two types of stock short selling, namely, between shorts in which shares are first borrowed and the naked type. There has been non-stop commentary in the financial media confirming and lecturing on this difference. Rarely have I seen public commentary so consistent and unanimous. Or wrong.

The SEC’s edict, and the discussion it generated, got me to thinking about short selling in ways I never thought about before. What I have concluded is bound to set you back. I promise you that your knee-jerk reaction will be that I may have taken leave of my senses. I assure you that I (still) am of relatively sound mind, and that it has been the collective investment community (me included) that has completely misjudged the issue of stock short selling for many decades. I simply ask that you hear me out.

I think the SEC should permanently ban short selling of any type in all stocks. That includes what is currently considered "legitimate" short selling, namely, the type that involves the borrowing of shares to be delivered to the purchaser of the shorted shares. I think there should be no exceptions, not even for specialists and market makers. No short selling of any stock by anyone. Period.

I know this sounds outrageous and, to my knowledge, has not been widely proposed before. I know that there is universal consensus that short selling is a necessary and vital component of the stock market. I know it is hard, if not impossible, for most people to accept a thought process that is radically different from a previous strongly held and popular belief. But please consider my reasoning.

First and foremost, the banning of all short selling would undoubtedly cause a huge rally in the stock market, as an important source of selling pressure would disappear. Now some may say that this would be an artificial boost to stock prices, but I would counter that it was the cumulative effect of all past and open short selling that was an artificial depressant to stock prices. Any price boost would be the result of breaking that artificial price depressant.

Do not underestimate the great collective benefit that the banning of all short selling in all stocks would have to the many millions of investors who depend on the stock market for a good part of their savings and wealth. I’m talking about pensions and retirement accounts and the funds that provide for education and health care. Compare the benefit to all those tens of millions of investors of banning stock short selling versus the damage that might be suffered by the few thousand dedicated short sellers. This is about the greater good and the welfare of the country. We have many big problems that we can do little about in the short term. Banning all stock short selling is something that can be done easily and effectively, especially if there are no exceptions. By allowing no exceptions, enforcement becomes a breeze. Any short selling should cause a securities firm or individual to lose their license or be banned from trading. Nice and simple. No big government bureaucracy or taxpayer burden.

Second, stocks are legal assets and property, like real estate, or bonds or bank deposits. In just about every other asset and property, short selling doesn’t exist. Try selling a piece of real estate that doesn’t belong to you, and see how fast you go to jail. Selling something you don’t own, whether borrowed from someone else or not, is fraud, pure and simple. (For the purpose of this article I am using the first definition of fraud given by Wikipedia, namely, "In the broadest sense, fraud is a deception made for personal gain").

Ask yourself this, why is selling something you don’t own fraudulent in every walk of life, except in stocks? Why isn’t it considered a fraud in stocks? The answer is because it has been going on for so long, that no one thinks any longer about why we allowed it to exist in the first place.

I am not suggesting that short sellers have been doing anything illegal, as short selling has been allowed by law to date. But because it is inherently fraudulent to sell something you don’t own, the law must be changed to make this stock shorting fraud illegal, as it is with any other asset. I am not suggesting, for a moment, that short selling be banned in futures, options or any other derivatives contracts. In derivatives, there must be a short for every long. Otherwise, you couldn‘t create a contract. (In silver and gold futures, the legal issue is the large concentrated nature of the short position, not just that shorts exist). But that doesn’t apply to a common stock, which is not a derivative, but a source asset. Not only does there not need to be a short for every long in stocks, I’m proposing there shouldn’t be any shorts.

Further, the short sale of stock automatically and effectively increases the amount of stock outstanding, as I have written previously. This occurs regardless of whether the stock sold short is borrowed first or is a naked short sale. That is largely a distinction without a difference. Even when stock is borrowed before a short sale, the original owner of the short still owns it, in addition to the new buyer.

Borrowing stock to sell short does not make the short sale less fraudulent, it just allows the new buyer to receive delivery of the stock (even while the original owner still owns the stock he loaned). In other words, the whole exercise of loaning and borrowing stock obscures what really happens in a short sale and merely makes it sound legitimate enough so that it confuses normally intelligent people into thinking the transaction is somehow legitimate. Would it make it less fraudulent if someone sold a piece of real estate he didn’t own, if he first borrowed it from the real owner?

Please consider that any company that wants to issue new stock must adhere to rigid rules and disclosure requirements. Everything must be done in a very transparent manner. Yet short sellers take the money that buyers pay for shares and create new stock at will, on a completely unauthorized and opaque basis. Companies must disclose everything in order to issue shares, while shorts don’t disclose anything. That’s messed up. Banning short sales would end that. Why the managements of every public company don’t speak up against short selling is beyond me.

The unsuspecting legitimate buyer of shorted shares is purchasing, in a very real sense, illegitimate shares. If a buyer holds shares "issued" by a short seller, it may negate voting rights on corporate affairs, among other things. At a minimum, heavy shorting of any stock creates the incentive and raises the potential for dirty tricks, such as illegal rumor mongering, another issue the SEC has said it was pursuing. If heavy short positions didn’t exist, there would be much less likelihood of false negative rumors or bear raids. Banning short selling would eliminate a whole host of potential problems.

To be fair and balanced, there is merit to the argument that legitimate short sellers help ferret out overvalued situations and increase liquidity, particularly trading by market makers. But the loss of those advantages must be balanced by the net benefits of higher stock prices and transparency. How much does it matter if we lose a bit of liquidity if stock prices move much higher? And the fear that we could develop into a bubble in stocks in the absence of short selling is not well founded at the present time. Let’s deal with problems in the here and now, not what may or may not occur in the future. Besides, if a stock becomes overvalued, legitimate owners will ultimately sell and invest in more undervalued securities. And anyone looking to speculate or hedge to the downside can employ futures, options or other derivatives contracts.

I admit that I have changed my mind a lot on the validity of stock short selling recently. While the vast majority of investors would never go short, I have on occasion. So it’s not like I was always against the practice. But the short selling of stocks has turned so pervasive that I think it’s time to stand back and reflect on what we have created. I’ve even gotten the feeling recently that much short selling is occurring as a quick and efficient and illegal way to raise capital without disclosure, as big short sellers receive the proceeds of the sale.

I think we have been collectively hoodwinked by the whole issue of short selling in stocks. When it is analyzed for what it really is, it becomes obvious that it is pure fraud and everyday it is allowed to exist is one more day we unnecessarily hurt ourselves and our capital markets. I realize my proposal is unconventional to the extreme., but conventional thought is not always correct.

Undoubtedly, there are strong and entrenched interests in place that profit from the practice of short selling. From the short sellers themselves, to the lenders and borrowers of shares, to the brokers the execute the transactions, this is big business. They will lobby for the status quo. But I would ask you to step back and imagine that stock short selling never before existed, but was being proposed for the very first time. Try to frame the issues on that basis, starting with the question, "how can you sell a real asset that you don’t own, or worse, that belongs to someone else?"

There is an old market saying that goes something like this -

In fact, if the law is changed, as it should be, in my opinion, the new market saying should be -

On The Edge

The latest Commitment of Traders Report (COT), indicates that we are back to extreme readings in both COMEX silver and gold futures, as the commercial shorts increased their already sizable short positions. Such extreme readings in the past have presaged sharp sell-offs at some point, although there have been times when prices continued to rally for quite some time, in spite of negative COT readings. That‘s a nice way of saying a sharp move in either direction would not surprise me.

In the COT for positions held as of 7/15, both the gold and silver net commercial positions climbed to levels not seen since the extreme high prices of March. In the past three weeks, the gold commercials added 60,000 contracts, increasing their net short position to more than 246,000 contracts (24.6 million ounces), one of the largest COMEX net short positions in history. In the past week, the smaller gold commercials (the raptors) joined in the short-selling spree, accounting for 16,000 of the 18,000 net short positions added.

In silver, the selling by the commercials was virtually all of the concentrated variety, for the past week and the past 3 weeks. The eight largest traders in COMEX silver futures now hold more than 76,000 contracts net short, or an astounding 380 million ounces. That’s more than 211 days of world mine production, almost double the equivalent figure for gold (the next most concentrated short position). By way of comparison, the concentrated net positions of the 8 largest traders in Nymex crude oil futures, are the equivalent of less than 3 days on the long side and 2 days on the short side in terms of daily world production.

If you add to the documented concentrated net short position of COMEX silver futures, the suspected naked net short position in the shares of the big silver ETF, SLV, it is easy to imagine the motivation of the big concentrated shorts to engineer a sharp sell-off in silver and gold prices. It’s also easy to imagine the shorts losing control considering the growing tightness and shortage developing in the physical silver market. Whether we get a sharp sell-off or a explosion to the upside, it should be clear to everyone in advance why either occurred.

An "Outing" By The CFTC?

There was an extraordinary development in the Commitment of Traders Report (COT) for this week. The CFTC issued a special announcement concerning the energy markets. Do to recent pressure, principally by lawmakers, on the CFTC to do something about oil prices, the Commission took a closer look at large traders in the energy market. You can read the special announcement for yourself -

http://www.cftc.gov/marketreports/commitmentsoftraders/index.htm

What you won’t read in the announcement is the real story. That you can only get from studying the different tables provided. Please allow me to summarize what those tables reveal. As a result of the closer scrutiny, the CFTC suddenly "discovered" that a very large trader in crude oil needed to be reclassified from the commercial category to the non-commercial category because the position that this trader held did not represent a bona fide hedge and was, therefore, a speculative position.

What was shocking about this position is its size. This one trader held a spread position of 147.000 contracts in NYMEX crude oil futures and a spread position of 326,000 contracts in futures and options combined, a position of more than 10% of both the entire futures market and futures and options combined. While this percentage of concentration does not come close to the concentrations in silver or gold, it was still largely unknown that one trader held such a large position in crude oil, even if it was a spread position (being long and short different contract months simultaneously.

Of course, the CFTC did not identify this trader by name, as that is contrary to current law (why, I am not sure), but the Commission clearly revealed the trader by size. To give you some perspective of the size of this trader’s futures only position, in the non-commercial spread category to which the position was reclassified, this single trader holds a position more than 90 times as large as the average trader in this category (147,000 contracts vs. an average spread position of 1,630 contracts). How could such a dominant position not control spread price changes?

The reclassification and revelation of the size of this single trader’s positions raises some disturbing questions -

1. Why has the CFTC allowed such a large position to exist?

2. What effect has this position had on the market to date?

3. What potential does this position hold for disorderly market conditions, should the position be unwound in distress conditions? (Think of Amaranth)

4. How many misclassifications are there in other commercial positions? (Think of the short side of silver and gold)

5. What is the economic justification for such a large position? (Think of the large concentrated short position in silver).