The last couple of weeks have seen some inconvenient stories about Chinese stocks under scrutiny by U.S. regulators. Considering how poor a job the U.S. regulators do of policing our own markets, it makes sense that the SEC would turn its attention elsewhere.

The Carlyle group has substantial stakes in two U.S.-traded Chinese companies, both of whose stocks were halted because of allegations of fraud, according to the Financial Times. Carlyle owns a stake in China Agritech (CAGC), a stock it acquired through a 2009 private placement made through two Carlyle-affiliated entities, according to public records. The $10 million acquisition represented a meaningful infusion for CAGC, which reported $76 million in top-line revenues in 2009. For Carlyle, with over $90 billion in assets, it is hardly a major investment. Speculation about Carlyle’s involvement included questions about the role of a young Carlyle VP out of their Shanghai office who has a seat on CAGC’s board.

There was also a report that made the rounds of the world of financial electronic Samizdat. Issued by an operation called Lucas McGee Research, the unattributed piece carried a boldface (in both senses of the word) statement that “writers and contributors to this report have short positions in CAGC and therefore stand to realize significant gains in the event that the price of the stock declines.” The report alleges that no trucks were seen going in or out of CAGC’s fertilizer factories, even though the company supposedly produces 50,000 tonnes of organic fertilizer annually. The quick and dirty analysis (one truckload = 20 tonnes; 2500 truckloads = 50,000 tonnes) led the report’s authors to surmise they should see an average of 10 trucks passing in and out of the factories every day, instead of the zero they report having seen.

So far nothing has been proven, but the SEC is asking questions about these companies’ financial reporting and imposing trading halts until they get clear answers. CAGC has been held for trading for two months. So far, there are no clear allegations of fraudulent dealings. We hasten to point out that nothing we have seen accuses Carlyle of wrongdoing, nor do we intend to imply any improper action by them. Anyone is capable of making a mistake, but when you’re the Carlyle Group, the negative PR consequences can be considerable.

But Carlyle’s not alone. A well-regarded Wall Street money management firm was sucked into the fray when 29 year-old Jesse Glickenhaus bought $4 million worth of CAGC for his family-owned asset management firm, according to Bloomberg. His grandfather, well-regarded investor Seth Glickenhaus, said he had “never run into” such a situation. At age 97, “never” is a long time.

Trapped investments

The consequences of a trading halt are that no one can get their money out of a position. Owners cannot liquidate their shares, and shorts can’t cover. This is something of a bonanza for the clearing firms, which get to collect interest on the credit balances, and charge interest on the debits associated with the frozen investor positions.

Options traded on these shares also cannot trade – there is no underlying market to quote them against. Option holders must wait for expiration, then make a best guess whether to exercise their options, or allow them to expire. According to the Wall Street Journal, “borrowing rates for many of the stocks have skyrocketed, a boon for hedge funds and other owners that are willing to lend shares out.”

When the illegal shorting business came to a particularly ugly head, back in 1995 , regulators sought the logical solution: take what is illegal, and make it legal. Short selling rules were stepped up, and more procedures were put in place to ensure that a short seller would be able to deliver stock on settlement date. What it really ensured was that clearing firms should increase their investment, as the stock loan business continues to be a major profit center for clearing firms and prime brokers, as well as hedge funds and other large firms that hold large and diversified stock portfolios.

Major Wall Street firms routinely engage in naked short selling on a massive scale, though we cannot measure it, because of the way they account for it. This naked shorting is not only legal, it constitutes one of the biggest profit centers in the financial markets. Clearing firms, prime brokers, hedge funds, and other substantial holders of large diversified portfolios loan securities for short sellers. Many firms make a business of loaning against what is known as an “easy to borrow” list – a blanket approval for short sales for a single trading day. Stocks on the easy to borrow list do not have to be located individually on a trade-by-trade basis.

Some firms track the positions on their lists during the course of the day and send notification to brokers when the quantities available for borrowing get low. But some firms don’t, meaning that if a stocks gets talked down, and short sellers start flooding into the name, by the end of a single day it is possible that more stock has been sold in the market than exists in the hands of the clearing firms for delivery. Naked shorting? By definition, yes. Illegal? Lobbyists are undoubtedly browbeating the SEC even as you read this.

The Chinese are smart. They appear to have taken the most important page out of Wall Street’s book: create a good story, and people will buy it without looking too closely. CAGC has gotten its money, all based on a story. Jesse Glickenhaus says he focused on the fundamentals, and it is implied that one important factor in his decision was the Carlyle stake.

Any risk manager will tell you to get to know the market into which you are about to plunge. Keynes’ dictum certainly holds true for Chinese reverse-merger companies with opaque financials: the market can remain irrational longer than your cash can hold out.

It remains to be seen whether CAGC is a real company. The SEC trading ban may clarify things, because sooner or later the shorts will want their money. And in our experience, the shorts are the ones in control, very much like the mysterious and oceanic sway of the market itself. We might suggest a corollary to Keynes’ Irrationality Principle: the Shorts can remain short longer than you can continue holding a long position at such a depressed price.