“How do short-sellers’ brokers find stock to borrow? Is there an electronic system offering stock to lend? Is there a market, so that thinly traded stock or other stock that’s being squeezed gets more rent than just the dividend income?” –David Williams

When you sell stock short, you are selling shares you don’t own, hoping they will go down. Your broker just borrows someone else’s shares for you to sell. Eventually, you have to buy them back and return them (unless you’re really lucky and the stock goes all the way to zero and disappears, in which case there’s nothing to return). If you can buy the shares back for less then you got for them, you make a profit; if you have to pay more, you suffer a loss.

But where do brokers get shares to lend short-sellers?

The first thing they do is look to see whether one of their other customers holds the same stock in a margin account. Anyone with a margin account has signed an agreement authorizing the broker to lend his shares. He will not know they’ve been loaned, and he needn’t worry about it either way. He’ll still get his dividend (it will come out of the short-seller’s account); he will still be able to sell at a moment’s notice. (The broker will just replace the shares by borrowing someone else’s shares. Or, if that proves impossible, he’ll “buy in” the short-seller, forcing him to cover his short — typically at a loss — and return the shares. This doesn’t often happen, but it definitely can. It’s one more risk of the hazardous short-selling game.)

Brokers love short sales, because although you take all the risk, they typically get the interest on the proceeds of the stock you’ve sold. That’s right: you shorted 1,000 shares of some stock at $50; well, that means the broker got $50,000 in cash money in return . . . but you won’t find that money in your account. It’s earning interest in his account, whether he be a deep discounter or the most expensive full-service firm on the block.

(Active, pushy customers can sometimes twist arms and, if they do enough short-selling, persuade their brokers to share some of that interest. But few even know to ask and fewer still will be told yes. If you do $20,000 a year in commissions, say, well, that might be a different story.)

If your own broker doesn’t have shares of stock in one of his other client’s margin accounts to lend you, he will call around to find a broker or institution that does have shares to lend. Harvard, with its $10 billion endowment, makes some good money this way.

When a broker or institution lends stock, the “rent” it charges is interest on the value of the shares. In other words, your own broker has to split some of the largess with the lender (making him all the less eager to share any of his share with you).

I don’t know of an electronic listing of shares-to-lend. (Knowledgeable readers: chime in if I’m behind the times.) So far, anyway, it’s more a matter of my broker’s picking up one of the dedicated lines he’s got to the stock-loan departments at other shops. If the other shop does have stock to lend, it will be lent at whatever is its then prevailing rate. And, yes, they do charge more for hard-to-borrow shares. If it’s GM that everybody owns and few bother shorting, it might be one percent or even just half a percent interest. But if it’s some stock people are desperate to borrow, the lender may even charge more than the prime rate (in which case the broker not only won’t share anything with his big-time short-seller customer, he’ll actually charge a little something).

Tomorrow: Beware the Short Squeeze

 

 

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