This is what it looks like when short sellers have a company totally surrounded (SIG)

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Signet, the largest diamond retailer in America — it owns Zales, Jared’s Galleria and Kay Jewelers — has been in trouble for some time.

Since June it’s been rocked by reports that it has been switching diamonds that its customers send in for repairs, replacing the original diamonds for ones of inferior quality.

Now Wall Street’s short sellers have started digging in in earnest. Short interest in the stock has exploded in October to 134%.

“Signet Jewelers Ltd (SIG US) short interest has been climbing since November 2015 when it topped $300 million for the first time after averaging just $201 million in 2015 and $194 million in 2014,” say research firms S3 Partners and BLACKLIGHT in a new report.

“SIG short interest continued to grow and traded in a $500 – $700 million range for the first three quarters of 2016. Short interest has exploded in October, increasing 134% to $1.4 billion in less than 3 weeks.”

Short selling is a bet that a stock will go down. To do it, an investors borrows a stock from someone who owns it, then sells it. Ideally, the stock falls and the short seller buys the stock on the open market to replace what they borrowed. They then pocket the difference.

Because of that borrowing action, short interest can be over 100%.

This is about credit

It isn’t the diamond replacing scandal that has Wall Street’s bears out of their caves. It’s the company’s in-credit facility.

According to the report, most short sellers are concerned that its system for marking debtholders as current is too lax. This idea made business news headlines last June when venerable Wall Street newsletter, Grant’s Interest Rate Observer, noted that Signet has an odd method of marking customers as current in their payments.

The method is called “regency.” Here’s how it works: As long as the customer makes a “qualifying payment” by its due date, that customer is considered current. That payment has to be at least 75% of the amount due and be paid on time, according to a company presentation from earlier this year.

So if you owe $1,000 and pay only $750, that is marked as a “qualifying payment” and you (the customer) are good to go, for the first 60 days. A full scheduled payment is demanded 60 to 90 days after purchase. After that, the customer must start making payments on money past due, according to the company.

This is dangerous given that total sales are growing at a rate of less than 7%. Credit sales, on the other hand, make up over 60% of total purchases, and 75% of wedding and engagement ring sales.

“Signet is relying more and more on relatively easy in-store financing to close sales and increase sales growth,” says the report. “In fact, more than a third of Signet’s revenues come from interest income on their customer credit balances rather than the sales of diamonds.”

And that, to short selling sharks, is just blood in the water.

Investing.com