Pulling Margin from long customers during a short attack serves two purposes. Obviously the flood of shares that are “forced” sales help drive the price down, which aids the short cause in general. More important, for the broker dealers who clear for their retail customers at the same time they short against them, it creates a built-in source of cheap shares from which they can cover their open short positions.
Some of the broker dealers short against their retail customers from their proprietary trading desks, or “prop” desks. These are trades owned by the broker dealer, and, while they are not illegal, ethical questions certainly exist. The retail customers, who may be purchasing long investments that are being pushed by the broker dealer's retail network, have no inkling that the broker is taking a large short position contrary to the retail investor's position. With the encouragement of easy margin credit, i.e. 30% equity, the retail customers load up on stock and margin debt.
The broker dealer, in concert with other shorts, may crash the stock by flooding the board with counterfeit shares, dropping the stock price. The broker dealers know the amount of margin debt and the price at which their retail customers get into margin trouble. They can accelerate the squeeze on their retail customers by arbitrarily increasing the equity (percentage) requirement as the price is dropping, frequently citing “volatility”; which is really the shorts flooding the board with counterfeit shares.
The compounding effect of a dropping price and increasing equity requirement flushes out more shares. The broker dealers sometimes will take over the account during a margin sell-off. By engaging in poor trading practices, such as heavy selling over lunch hour; concentrated “dumps” of shares; hitting the bid with market orders; and conspiring with other trading desks, they can further plummet the value of the stock and maximize the shares they have stripped from their retail customers.
Most of the broker dealers who have both retail customers and prop-desk trading appear to engage in these practices. Goldman, Morgan Stanley and Merrill Lynch have been named in suits alleging these practices. Goldman made billions shorting against the subprime mortgage industry at the same time they were selling subprime investments to their customers.