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Patrick Byrne Vindicated

22 September 2008 10,743 views One Comment

Patrick Byrne, CEO of Overstock.com (OSTK), was one of the lone voices sounding caution while the market was steadily marching upward to record levels. In good times when everyone in the market is making money, few will listen to the radical iconoclast in the corner warning of an impending end to the party. Contrarians are often seen as party poopers. The financial press regularly ridiculed Byrne for his passionate crusade against naked short selling. Many perceived his actions as a desperate attempt to save his own company from short sellers. Some smug journalists included his name on lists of the worst chief executive officers of 2006 and 2007 – judging him not on the performance of his company but for his vocal admonitions. Now, a year later and after a series of momentous market upheavals, it appears that Byrne is vindicated.

Maria BartiromoThis video on YouTube, apparently uploaded by employees at Overstock.com, does a good job summarizing the Byrne Saga and the reactions of incredulous journalists. A few highlights:

  • “It’s going to be something (naked short selling) that makes Enron look like a tea party.” The Bloomberg interviewer responds with skepticism and says, “That’s a pretty powerful thing to say, Enron was a $100+ billion company.” To which Byrne replies, “This is bigger.” — The market has collectively lost trillions and we’ve seen the collapse of some of our most prestigious and once-profitable financial institutions.
  • The Money Honey, Maria Bartiromo’s expression of disbelief is priceless, “House of cards?!?!” — She has a deficit of imagination that prevented her from even entertaining the possibility that Byrne had a chance at being right.
  • Dylan Ratigan, the host of Fast Money, illogically equates warning about the potentially damaging consequences of naked short selling with “not giving the market any credit for the prosperity that has been created.” — Ratigan is an entertaining fellow is the best I can say about him.

Cartoon - Journalism

To be sure, naked short selling is not the only culprit in this financial market meltdown. I also don’t agree with Byrne that cheap money is another problem; inflation rates in the recent past has been manageable and well within safe ranges. In my opinion (which I have put money on by being short or in cash during the last couple quarters), the problem stems from financial institutions’ ability to employ unprecedented levels of leverage. Sure, cheap money increases the attractiveness of borrowing but that does not excuse the absence of common sense and sound risk management indicated by debt-principal ratios of up to twenty times! I will watch for headlines about the demise of hedge funds that were overaggressive with margin; they have been notably missing from the recent obituaries.

The Bear Dance
William Holbrook Beard – The Bear Dance

Plenty of attention has been paid to the exotic derivatives instruments that is the fuel to this financial fire, so I won’t dwell too much on the specifics. Warren Buffett has called exotic derivatives “financial weapons of mass destruction.” My main point here is that naked short selling is in essence a method of creating derivatives instruments. Derivatives are contracts that represent an underlying security; they are loosely or tightly tied to a certain asset, but they are not the real thing. Naked short selling is the practice of selling stock short without first borrowing the underlying shares or ensuring that the underlying shares can be borrowed as is done in a conventional short sale. When someone shorts a stock without first borrowing it, that act is essentially the creation of a put derivative on the underlying stock. When a bunch of “naked bears” pile in to short a stock that isn’t balanced by corresponding borrowed shares, we have, in reality, a malicious multiplier effect. At its most logical extreme, you cannot short more shares than actually exist for a company.

I short but I do it fully clothed. I use leverage on occasion and only when I’m way ahead of my benchmarks. But as a little guy I cannot leverage up 10x like the big institutions do. Nor would I want to do that even if I am able to. Patrick Byrne was right to have shone a light on abusive shorting practices. His predictions have been right on target as well. Bittersweet vindication.

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One Comment »

  • Patrick Byrne said:

    Allan,

    Thanks for the kind words and the sound thinking. Yes, there is no joy in seeing this one come true.

    On the cheap money question…. You do not think that it has been a problem, on the basis, it seems, of containment of underlying inflation. Of course, you could be right. But there are some who plausibly argue that the government is cooking the books in that regard (e.g. Shadow Government Statistics website). If we truly are experiencing an 8-12% inflation rate, but DC is cooking the books, it would explain a lot of things (e.g., the US’s lack of savings: why should a consumer save if she knows, at some level anyway, that her dollars are growing less valuable?) That does not make the argument true, of course. But it is worth looking into.

    Anyway, thanks for being an independent thinker.

    Regards,
    Patrick Byrne

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