Why the SEC Just Doesn't Get Short Sellers

| About: iShares U.S. (IYF)

Originally Monday’s essay was going to counter the most common inflationists’ arguments. However, over the weekend the SEC announced it is considering reinstating rules that make it more difficult to go short in the market. This move warrants immediate attention for a number of reasons, namely:

  1. It shows how much the SEC is on the side of Wall Street
  2. It’s another move that fixes nothing but looks good on paper
  3. It further sets us up for a full-blown repeat of 2008’s collapse.

Regarding the first point, the SEC first instated these rules temporarily back in July 2008. At that time, the story presented to the public was that “evil” short sellers are the guys responsible for taking down the market, resulting in Americans losing trillions of dollars.

Of course, as everyone knows, Wall Street banks collapsed due to greed, lack of oversight, excessive leverage, bad business practices, outright corruption, and fraud. However, these facts didn’t stop the SEC from vilifying investors who actually did the analysis to discover that the Wall Street firms were insolvent and went short as a result.

What I find so strange is that the SEC blamed short-sellers for allegedly taking Wall Street down… but didn’t investigate Wall Street analysts how continuously listed themselves and their competitors as “buys” all the way down to $0. Apparently bullishness that stems from corruption (or brazen stupidity) is OK. But fundamental analysis based on financial realities is considered “evil” or lacking in integrity.

Indeed, once the “anti-short” rules lapsed in August, the SEC was urged to take up more “anti-short” policies by none other than mega-Wall Street legal firm, Wachtell, Lipton, Rosen, & Katz. On this count, it’s worth noting that one of the lawyers who wrote the letter personally oversaw numerous Wall Street mergers (JP Morgan & Bear Stearns, Bank of America & Merrill Lynch, Wells Fargo & Wachovia). Obviously he’s an objective source and only interested in protecting the public from “evil” short selling activity (You can read the actual letter with highlighted passages here).

On a final note, anyone believing the SEC’s “anti-short” policies are aimed at protecting the public should note that the SEC just celebrated its 75th anniversary with an expensive dinner funded (in part) by Fidelity, Standard & Poor’s, D.E. Shaw & Co. (the hedge fund that paid Obama’s economic advisor Larry Summers $5 million) and other firms that the SEC is meant to regulate.

Aside from the various conflicts of interest, banning short selling or making it more difficult does NOTHING to help the financial system. It doesn’t clean up banks’ balance sheets, it doesn’t end market manipulation, it doesn’t clear crummy debt, it doesn’t stop insider trading… in fact it really doesn’t do much of anything except prop up financial stocks temporarily.

Here’s a chart of the Financials ETF from May 2008 to the end of last year. The SEC implemented its “anti-short” rules in July. Suffice to say, these rules didn’t do much in terms of preventing the inevitable.

Markets can be propped up and manipulated for a time… but ultimately they follow what fundamentals dictate. If financial firms own trillions in crummy debt and are effectively insolvent, it doesn’t matter if a government body makes it illegal to short sell them… they will eventually collapse regardless.

Indeed, one could quite easily argue that banning short-selling actually intensifies financial collapses rather than averting them. To go short, you have to borrow shares from a brokerage firm. Once the stock you’re shorting collapses you then have to buy the shares on the market in order to return them to the brokerage firm.

This is called “covering your shorts.” It’s not difficult to see how this can actually help stop a collapse. After all, at some point stocks will have fallen far enough that the shorts will want to take their profits. When they do this, they have to buy stocks… which brings the collapse to a halt and can actually kick off a rally (as it did for the rallies in November 2008 & March 2009).

By taking out short-sellers you’re removing a group of investors who HAVE to buy stocks once they collapse, leaving only those who are crazy enough to step in and buy during a full-blown collapse.

In conclusion, the SEC’s decision to potentially ban short selling again protects Wall Street, not individual investors. It also accomplishes nothing in the way of helping the financial system… and may in fact only make the eventual collapse even worse.

I already thought the market was due for a collapse in the coming weeks. However, if the SEC does implement these rules, we’ll probably see a short rally followed by a full-blown Crash again.