The video makes a bunch of assumptions
1. That whoever bought way out of the money Bear Stearns PUTs "knew" something and illegally acted on it.
2. The same institution that bought the PUTs was illegally shorting shares.
3. There is a conspiracy to protect those evil doers.
How The System Really Works
Fact #1: When someone buys PUTs the market maker or counterparty who sold them is short those PUTs. This is a mathematical statement of fact.
Fact #2: The market maker who sold the PUTs, shorts stocks as a hedge against those short PUTs.
Fact #3: The lower the share price, the more shares the market maker has to short to stay delta neutral.
Fact #4: Market Makers are not governed by naked shorting rules
The video alleges that it was the person buying way out of the money PUTs that was doing the shorting. The reality is the market makers who sold PUTs were most likely those doing the allegedly "illegal" naked shorting.
To stay delta neutral, the market makers were forced to short more shares the lower the price dropped. Also remember this happened with every PUT at every strike all the way down, not just on that batch of way out of the money PUTs.
It should not take a genius to figure out how easily this could spiral out of control.
Who Was Shorting?
It was probably Goldman Sachs, Citigroup, Morgan Stanley, Merrill Lynch or whoever sold the PUTs. Moreover, those market makers probably lost money shorting because of how quickly the stock plunged.
The irony is everyone blames the naked sellers for making a fortune by short selling when the PUT sellers lost more on the PUTs they were short than they gained shorting the shares.
Did Someone Know Something?
The video alleges that someone "knew something". Well someone did know something, and that something is what we all knew: Bear Stearns was not only the most leveraged of the large institutions, but also held the highest concentration of subprime mortgage garbage.
Also other institutions could see or at least feared a run on the bank at Bear Stearns and started pulling money.
Three Reasons To Buy Puts
Someone might have bought those PUTs speculating on a cascade as described above. They probably got a great deal because the seller erroneously figured it would never happen.
Are there other reasons for buying those PUTs? Yes, certainly. Someone holding Bear Stearns might have wanted to buy cheap PUTs as a protection against total calamity.
There is also a distinct possibility that someone was acting on a rumor and took a chance.
Those are three logical alternatives to the popular conspiracy theory that Naked Short sellers and "someone who knew something" conspired to sink Bear Stearns.
The Real Deal
- Neither naked shorting nor someone acting on inside information brought down Bear Stearns.
- Bear Stearns brought this upon itself.
- Bear Stearns deserved to go under.
Blaming naked shorting for the demise of Bear Stearns is ridiculous. The market makers shorting Bear Stearns did so for purely mathematical reasons, to remain delta neutral, and did not even profit from it. Moreover, unless someone can prove insider trading, whoever bought those PUTs deserves whatever profit they made.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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