Unconstitutionality of Short Selling and Private Market Clearing

April 25, 2010

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

April 25, 2010

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid and Richard J. Durbin

Honorable Oversight and Government Affairs Committee

Honorable Senate Banking and Finance Committee

Honorable Senate Permanent Subcommittee on Investigations

Honorable Senate Agriculture Committee

Sub:     Short Selling to Control the BOD, Raise CEO Compensation and Take over a Solvent, Valuable Company

Dear President Obama,

The U.S. constitution does not permit a private company or the government to seize private property, for example, taking over another company by zeroing out the current security holders of the latter. 

The Congress does not approve of such unconstitutional seizures.  The Congress has strong antitrust laws to prevent takeovers of rival competing companies.  The Congress has even broken up large companies that have grown too big to raise their product prices and to pay too little to employees.  

1.      I present below a numerical illustration of unconstitutional takeover of a solvent, valuable company by an acquirer that (a) controls the market clearing house and (b) uses the capital-destructive weapon of “short selling” granted by the Security and Exchange Commission.[1] 

2.      The acquirer does not need to lobby for government seizure of a valuable rival to achieve the takeover. 

3.      The acquirer simply creates a precarious situation to scare the government regulators as well as the Congress to achieve an unconstitutional takeover of a valuable, solvent rival. 

4.      The example below is about how JPMorgan and Chase could orchestrate a low-cost takeover of a highly valuable and solvent Washington Mutual through a panicky government seizure of the latter.  I cannot assert whether or not J.P. Morgan did it exactly the way illustrated in the example, without the private trading data at the Clearing House and at J.P. Morgan and Chase and at their affiliates. 

5.      This example illustrates how the FDIC and other regulatory agencies could simply be trapped by fear due to an acquirer’s unconstitutional short selling shenanigans, allowed by the Security and Exchange Commission. 

6.      This example shows why (a) illegalizing short selling and (b) a government takeover of the market clearing house are essential for prevention of unconstitutional seizure of hard earned private property and for maintenance of prosperity amid national security and stability. 

7.      This example also illustrates the importance of synchronizing all rules and practices permitted by regulatory agencies with the laws passed by the Congress.      

Example

(The figures are inexact.)

JPMorgan and Chase conceives of a plan (Project West) to acquire a successful, well-capitalized and valuable bank, Washington Mutual Bank (which is a subsidiary of Washington Mutual Incorporated, a bank holding company), to expand its operations to western parts of the United States.  At this time, mutual funds passively hold 90% of 1.7 billion common shares of WMI. 

JPM then floats its interest in buying WMI.  It does so to facilitate short selling of 1.5 billion shares of WMI common stock.  JPM creates these shares synthetically or by pulling out of thin air.  The Clearing House controlled by JPM does not question JPM on non-delivery of shares sold short.  JPM sells these shares to the passive mutual funds, pension plans and individual investors.  No buyer suspects anything when JPM has expressed interest in WMI. 

JPM simultaneously buys 500 million WMI shares through some of its subsidiaries.  JPM has to buy some and sell more to entice other buyers through talks of buying WMI.  At the end of the trading, JPM holds 1.5 billion shares short in its private trading-inventory account and 500 million shares long in its investment account.  JPM files its long positions with the SEC and wins confidence of all other mutual fund holders. 

JPM has helped create a rule to not let regulatory agencies inspect its trading-inventory account held in its market making subsidiary.  JPM has successfully justified and lobbied for keeping such accounts ultra secret. 

At the time of constitution of the BOD and appointment of key personnel like the Finance Director of WMI, JPM now dangles its long positions of 500 million shares to project its weight as a benevolent large shareholder of WMI seeking to place its people in a company planned to be acquired. 

JPM then obtains all important data to make a low-ball offer of $8 per share to buy WMI.  But the WMI CEO refuses.  Then JPM appointed WMI BOD fires the CEO with a golden parachute to replace him with a pliant WMI CEO to serve JPM’s interest.[2] 

JPM then uses its long and short positions to drive down the price of JPM stock to $1 per share.  Cohorts of JPM like Goldman Sachs recommend everyone to sell WMI short. 

JPM simultaneously compels the public rating agencies to downgrade WMI bonds and stocks.  The rating agencies have a model to downgrade securities based on dropping stock price. The rating agencies thus follow their model.[3]  JPM merely advises the rating agencies to perform their fiduciary duty of downgrading securities of a company with falling stock prices.  

The rating downgrades make sure that WMI cannot raise capital on a competitive basis.  Then rumors circulate in the grapevine about the FDIC contemplating seizure of WMI.  This leads to some WMB depositors withdrawing their funds.  The FDIC, Federal Reserve and Treasury are now scared.  So is Congress.  They are so scared that they have to now ask JPM to takeover WMB’s assets and deposits by zeroing all other security holders (WMI equity and debt and WMB bondholders).  

Private property is thus seized unconstitutionally and given away to JPM for pittance. 

JPM CEO, after 1.5 years of the seizure, brags before his shareholders about the immense value of WMI assets it brought for them: about $18 billion in annualized profits which amount to a present value of assets of $360 billion, by using even a very high cost of capital of debt (5%) employed in the acquisition, and by assuming no growth. 

Washington Mutual Bank was not in default at the time of seizure.  The WMB bonds were fully protected with the scheduled coupon payments duly paid on time.  WMB bonds would be protected fully even if WMB were not seized and stayed with its previous parent company.  Washington Mutual Incorporated (the parent holding company of WMB) was not in default at the time of seizure.  Even now, in the bankruptcy court, WMI is highly solvent with all WMI bonds trading in the market above par. 

That the WMI BOD has acted at the behest of JPM is obvious.  On bankruptcy, the WMI BOD has appointed a Debtor’s attorney to propose a plan of reorganization by giving away significant assets of the bankrupt WMI estate to JPM to void any legitimate claim of equity in the estate. 

So, JPM has accomplished its Project West plan, unconstitutionally, to grow bigger to dictate sharper terms to the Congress and Regulators, more vociferously than ever before. 

WMB was solvent with much more than the minimum required capital, as per the testimony of its primary regulator, the OTS, signed by the FDIC.  The FDIC now faces a legal suit from Washington Mutual Bondholders for about $20 billion.  These bondholders are too taxpayers. 

Thousands of families, whose security holdings have been zeroed out due to the seizure, have lost their wherewithal to live or retire.  Some of them have committed suicide.  Some have faced painful divorce.  They too are the taxpayers.  Should their possessions have been unconstitutionally seized? 

Such unconstitutional seizure and pervasive tragedy leading to depression is possible due to short selling.  Short selling creates shares to increase its supply (beyond the legally approved outstanding under the company law) to depress the price and rob the true owners of a company.  Short selling is unconstitutional and illegal, yet it is permitted by the Security and Exchange Commission. 

Whose interest is served by the SEC-permitted unconstitutional practice of short selling?  Obviously, not that of the taxpayers, of households whose perseverance props national prosperity and security, of the Congress who have enacted laws to preserve the constitutional rights to private property, or of the Regulators who face irreparable damage to their own reputation. 

The academic paradigm that rationalizes short selling as needed for hedging is itself unconstitutional.[4]  No research can ever prove that illegal and unconstitutional seizure of hard earned private property is justified by hedging or any such specious logic.[5] 

Wisdom has dawned on Senate Agriculture Committee to prevent commercial banks from speculative trading in derivatives and to make all derivative trades go through public exchanges.  This reflects my March 23, 2010 memo on constitutional rules to avert destruction of capital.[6] It is not a question of traders gambling on their own.  It is a profound issue of whether banks should have the privilege of using taxpayer insured deposits on speculative trading that destroys the hard earned capital (a measure of dignity of labor) of society. 

Even if private hedge funds do not use insured deposits, all their trades have to be cleared by public exchanges (not controlled by any trader including mega banks that trade) because the prices emerging from their trades are employed to mark to market the values of assets of levered companies.  Hedge funds (including mega bank hedge funds) can easily doom a commercial bank to take it over for pittance by recording lower prices for the bank’s assets to lower the value of its capital (based on the marked to market accounting rule) by using a few private trades of securities created synthetically in privately controlled exchanges. 

The exchanges and clearing houses have to be public, which means they cannot be controlled by any trader including mega bank traders.  The Senate Agriculture Committee’s proposed bill has to make explicit that the exchanges and clearing houses are not only public but also beyond the legal control of the bankers that trade.  This is necessary to avoid future catastrophes.    

                                                                                                                     

With profound regards,

Sankarshan Acharya

Disclaimer:  I do not like to join a bank to engage in an unconstitutional activity for private gain. I have, however, bought some WMI shares for investment in my belief that trust and constitutionality of the system will be restored.  This is a bet on restoration of trust in the system.  The value of learning through this investment is far greater than any loss to me. 

I do not want to lose by selling securities short.  Fisher Black was the architect of the first option pricing formula that was accepted by the profession.  I have heard a story that he lost all his personal savings in trading, which involved short selling.  He then approached a top investment bank to tell why his trading strategy needed a lot of money to win.  The investment bank agreed and they made massive fortunes for each other. 



[1]I have pursued for banning of short selling since 2001, as detailed in memos available at Pro-Prosperity.Com.

[2] I have shown that raising the CEO compensation can enhance growth in GDP, but cause financial depression due to decline in income and savings of the vast majority.  The paper is available on the interenet: http://pro-prosperity.com/Research/OptimalCEOCompensation.pdf

[3] I have proposed a new rating methodology published in the Financial Analyst Journal in 2000 and available at http://pro-prosperity.com/Research/ratingmethodology.pdf.  This paper also presents serious flaws in the rating models used by rating agencies.  The three ratings agencies have responded to this paper.  Moody’s even offered more than two times my current salary to hire me in 2002.  But I refused to consider the offer for money unless I had the responsibility to reform their rating methodology based on their proprietary data.  Moody’s CEO had expressed serious desire at the time, but the panel responsible for rating at Moody’s did not want to have me in a position reporting to the CEO and BOD of the company.

[4] http://pro-prosperity.com/Research/MoralHazardLiberty.pdf

[5] http://pro-prosperity.com/Research/Sub-Optimality%20of%20Short%20Selling.pdf

[6] http://pro-prosperity.com/Destruction%20of%20Capital%20and%20Short%20selling.html