SEC Follow Up Exhibits Part C SEC_OEA_FCIC_001760-2501

hearing that naked short selling was a big problem. Using the words “phantom stock,” he said many companies had been
affected and vowed to crack down.
For a few weeks after that, there was not much new naked short selling.
Then, on May 21, short-seller David Einhorn gave his famous speech accusing Lehman’s executives of cooking their
books. Though Lehman, like most banks, was guilty of participating in the dodgy business of securitized debt, it was not
cooking its books. It had, however, failed to mark some of its assets down to levels prescribed by Einhorn, who waved the
CMBX index as the proper barometer of commercial mortgages.
The CMBX comes from a company called Markit Group, which is owned by four hedge funds, the names of which the
Markit Group will not disclose. I don’t know if the managers of those hedge funds are friends of David Einhorn, but the
Wall Street Journal’s Lingling Wei published a story in February noting that the CMBX “doesn’t make sense.” It grossly
undervalues commercial property, implying default rates, for example, that are four-times higher than they are in reality.
Nonetheless, the media, including the Wall Street Journal, trumpeted Einhorn’s analysis, which was distorted in many
other ways – but that is a tale for a future blog.
For now, it is enough to know that coinciding with Einhorn’s speech, somebody naked shorted more than 200,000 shares
(the settlement date for that sale was May 27, three business days after the speech, owing to a holiday weekend). Thus
began a five day stretch of failures to deliver (ranging from 120,000 to 450,000 shares). On day six, as usual, there were
few failures to deliver, so Lehman did not appear on the threshold list.
After a pause of a few days, somebody circulated the falsehood that Lehman had gone to the Fed for a handout.
Coinciding with that rumor, hedge funds naked shorted close to 1.5 million shares. Those shares failed to deliver three
days later, on June 9. The next day, there were 650,000 failures. The day after that, 263,000 failures. On day four, there
were 510,000 failures. On day five, there were 623,000 failures. Time for Lehman to appear on the threshold list. But, on
day six, of course, the failures to deliver stopped. No list – no flashing red light at the SEC.
Throughout this time, Einhorn continued to appear on CNBC and in the major newspapers, doing his best to make
Lehman’s problems (which were real, but probably, at this stage, manageable) appear to be both catastrophic and
criminal. From May 21, the day of Einhorn’s speech, to June 15, the stock lost almost half its value.
For reasons that I cannot fathom, Lehman then opted for a strategy of appeasement. Rather than challenge Einhorn’s
assumptions, Lehman aimed to silence him and his media yahoos by doing what they asked. It “reduced its exposure” to
mortgages, primarily by marking them down to levels dictated by Einhorn’s bogus index – the CMBX. This is the main
reason why it booked a 2.8 billion loss in the second quarter.
When Lehman announced its quarterly results, on June 16, there was another blast of naked short selling, with failures to
deliver at threshold levels from June 19 to June 24. Exactly five days. Then the failures stopped. No threshold list. No
flashing red light.
I look forward to the day (in a few months) when the SEC will release data covering July to September. But I can tell you
right now what happened next.
On June 30, somebody floated the false rumor that Barclays was going to buy Lehman at 15 dollars a share (it was then
trading at 20). Simultaneously, hedge funds no doubt naked shorted large blocks of shares. It’s a safe bet that the data
will show failures to deliver lasting precisely five days.
On July 10, somebody (SAC Capital?) circulated the false rumor that SAC Capital was pulling its money out of Lehman.
Hours later, there was another false rumor — that PIMCO was pulling out its money. Quite certainly, these rumors were
accompanied by naked short selling, with failures to deliver beginning three days later, and probably continuing at
threshold levels for precisely five days. Lehman’s stock lost almost 50% of its value in the four weeks leading to July 15..
At this point, the SEC finally came to realize what was happening to Lehman. It realized that similar madness had
destroyed Bear Stearns. It realized that AIG, Citigroup, Fannie Mae, Freddie Mac, Bank of America and fifty other
financial companies were getting clobbered in exactly the same fashion.
Clearly, naked short selling posed a real threat to the stability of the financial system. So the SEC issued an emergency
order forcing hedge funds to borrow real stock before they sold it. No more saying “Yeah, my cousin Louie has the stock
in a drawer somewhere.” No more naked short selling.
This order protected only 19 big financial institutions – which is as far as the SEC thought it could go and still retain
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