Brokers Face Their Worst Nightmare

There are about 9 million Overstock.com (OSTK - commentary - Cramer's Take) share that are currently short.

Here is the problem: My calculations and research indicate that there are only 4.5 million lendable shares in the float, so twice as many shares have been sold short by brokers as should have been permitted. This is not possible, if brokers are playing according to the rules.

It's important for investors to understand that all shares in the float are not lendable. If shares are in cash accounts or retirement accounts, they are not supposed to be lent. Even shares in margin accounts are not lendable if account holders ask their broker to move those specific shares from T2 (margin) into T1 (cash).

Of course, certificated shares are not lendable when they are in the possession of the shareholder. Certificated shares represent an unusually large number in the case of Overstock. (By way of full disclosure, our mutual fund is in the process of obtaining certificates for our Overstock shares.)

Figuring out the lendable float in any stock requires some time and effort. In the days when stock certificates were actively traded, anywhere from 10%-20% of a company's float was lendable. When the 10%-20% of the float threshold was reached, the supply of lendable certificates dried up.

While the 10%-20% level shouldn't be viewed as a hard-and-fast rule in today's market, it's a reasonable approximation for companies that have been around awhile. That's because there's a greater likelihood that shares are tucked away in pension and cash accounts (and are not lendable), or held at institutions that don't lend out stock.

Consider the shares of Fairfax Financial (FFH - commentary - Cramer's Take). The company has a short position of 16% of the float. But if you talk to lenders in the open market, they'll tell you that this stock is impossible to borrow. Most of the shares are held by long-term investors that won't lend the stock to short sellers. And many other shares are held in cash and retirement accounts and are not lendable.

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At time of publication, Alsin and/or ACM was long OSTK and BBI, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.