Short Sales: SEC Turns Back the Clock to 1931

This past week, the SEC issued an emergency order prohibiting naked short selling in 19 financial stocks, including Fannie Mae (FNM), Freddie Mac (FRE), Lehman Brothers (LEH) and other names in the news. Beginning on Monday (July 21), it won’t be enough to make a good-faith effort to locate shares to borrow. Short sellers will have to have a formal agreement to borrow the shares in these stocks before they actually initiate a short position.

Emergency orders don’t happen every day, so you might think we are in uncharted waters. But when stocks go down sharply, it’s actually a fairly common response by regulators to try to throw sand in the gears and slow down the shorts. Perhaps the SEC was looking to the 1930s for guidance.

Back in September 1931, the world economy was spiraling downward into the depths of the Great Depression. U.S. stocks had fallen about 70% (!) from their 1929 peak, and short sellers were blamed. Many people called for an outright ban on shorting. When Great Britain abandoned the gold standard on Sunday, September 21, 1931, the NYSE capitulated and issued an emergency order prohibiting all short selling. The gold standard news should’ve led to a sharp decline, but stocks advanced, mostly because specialists and other market-makers had no ability to provide liquidity on one side of the market. It became clear that the rise in prices was completely artificial, and after two days the NYSE repealed the ban.

Early 1932 brought an even closer parallel. By then stocks had fallen further. Opponents of short selling were encouraging stockholders to throttle short sellers by not lending shares to them. But like today, most brokerage customers held their shares in “street name”, and back then brokers could lend these shares without permission from the investor. On February 18, 1932, the NYSE announced that, effective April 1, brokers would need written authorization before lending an investor’s shares.

Brokers had trouble securing the needed signatures. This wreaked havoc on the securities lending market, but the effect was completely temporary. Within two weeks, conditions had returned to normal. Stock prices rose on the February 18 announcement, but actually fell on April 1, because the market was expecting the havoc to be worse. Ultimately there was only a short-term, temporary reduction in short interest.

I expect something similar here. None of the 19 stocks on the list are particularly hard to borrow. The vast majority have never been on the so-called “threshold list”, which identifies stocks with a significant amount of naked short selling. For these stocks, the SEC’s order really just adds more hoops for brokers. There could be a temporary effect if brokerage firm back offices can’t figure out right away how to jump through these hoops, but it will be very short-lived. Plus there are plenty of other ways for investors to take a bearish view. If a hedge fund can’t short, it can still buy puts. The options market-maker who sells the put will hedge by shorting the stock, and it looks like that options market-maker will be exempt from the naked shorting ban. At most, all we’ve done is add a middleman. So I suspect we won’t see much effect on Monday.

The pre-borrow requirement is actually a reasonable idea. You can’t buy stocks unless you have the money or borrow it. You shouldn’t be able to sell stocks unless you have the shares or borrow them. But regulations implemented under pressure aren’t always designed well, and I hope the SEC will study the results and think it through carefully before extending the new rules beyond these 19 stocks.

Disclosure: None

Comments

[TheBookkeeper:]

However you slice it a naked short bet that pays off is somehow collecting counterfeited money. And if the short bet loses money, who gets that profit? The broker? There is no way that such practices could be being posted to a proper double entry bookkeeping framework of rules.

2008 Jul 20 04:51 PM

[mrtaxx:]

Short sell stopped on 19 financial stocks, isn't that unjust, how about all the other stocks that are manipulated. Why do the financials get this break? Oh I know they control all the money. Another farce by the SEC, another useless government agency that doesn't know how to do their job or just keeps looking the other way.

2008 Jul 20 04:59 PM

[quetzalcoatl:]

All I can say is the market scares the hell out of me. A long term investment is about an hour and a half. Predatory opportunism is the name of the game.

2008 Jul 20 05:08 PM

[CLH:]

Turning back the clock is what congress is all about. They call themselves progressives but the opposite is true.

2008 Jul 20 06:06 PM

[Medici:]

Naked Short Selling as it is called has always been illegal, this will be a BOOM for clearing firms Stock Locate Dept. with borrowing stocks short interest premiums. A hard locate simply means that the "shorter" has to now have the shares of a stock they are shorting, solidly borrowed with interest paid to the lender of the shares, rather than a "best effort" with no interest paid to the specific shareholder. The interesting things are that the Bank Shares have NOT eliminated there dividend as expected and many people shorting at the currently low multiples and share prices also have to pay the dividend to the lending shareholder, and eventual deterent-

2008 Jul 20 07:21 PM

[naturalsol:]

bookie, in the short sale case, wouldn't the profit go to the stock issuing company, not the broker (who acts on commission)?

2008 Jul 20 08:08 PM

[fatcat:]

I think the market maker would get the profit from the short losses,but I suppose the broker could if he was somehow on the other side of the trade or matching positions..

2008 Jul 20 10:07 PM

[BM1087:]

quetzalcoatl - Agreed! Makes investing in real estate promising again. Who really wants to invest (buy and hold) when the market is tilted and played by very few hands? Very few have time or the will to trade full-time. God forbid you take your eyes of the market for an hour. Obviously the government had to step in as these power brokers were willing to collapse the entire financial system in the name of the dollar. With no regard to you and I. Those same ***** also ran commodities to the moon and only when Congress aggressively started to introduce restrictive legislation has the air start to bleed out; however, during the run up the carnage to businesses and the consumer was un-remorseful.

2008 Jul 20 11:30 PM

[Gaucho:]

How can I short a stock Naked. It is a great Idea I could become rich over night and pay myself 1 billion a year in bonuses and salary. Oh, I guess the edge fund managers are already doing that.

Well, I will set up a company in a country where there are no laws. Then I will short a million shares of x,y,x company. If it goes down I cover and make a bundle. If it goes up I file BK and keep the billion salary I paid myself and let the suckers hold the bag with fake shares. PLEASE someone TELL ME HOW TO GET STARTED. I wanna be rich and famous and buy my own politician to keep the SEC toothless and pay the media hacks to write great things about me. Isn't America wonderful?

2008 Jul 20 11:50 PM

[fxtrader07:]

The SEC ought to be abolished for this preferential treatment of wallstreet. They are banning naked short sales ON wallstreet's banks and brokers - but they are allowing any naked short BY them on any stock they desire to continue. Go figure.

2008 Jul 21 04:54 AM

[tipalia:]

MRTAXX i agree with most of what you said except one thing ,the SEC knows how to do their job ,which is to help the financials out of their mess at the expenses of all of us. I invite you to read Richard Wending s message that is so accurate,thanks by the way Richard for something that becomes clearer about the SEC s intentions. But is this really a surprise to the small investors and also to the taxpayers.

2008 Jul 21 10:28 AM

[TIGERSOFT w...:]

THE SEC CLEARLY AIDED THE 2007-2008 "BEAR RAID"

With the financial stocks up sharply for a fourth day in a row since the SEC banned naked short sales in leading financial stocks, one has to wonder how much of the size of the decline owed to hedge fund naked shorting of these stocks and why, if the SEC is at all concerned about excessive market volatility owing to bear raids, it does not ban naked short sales in all securities and enforce this
rule with real  penalties.  The answer is, of course,  the SEC is the client of Wall Street insiders, not the investing public.  I might not have said that, but for way at the end of June 2007 the SEC cleared the way for a bear market by suddenly, capriciously, illegally allowing short sales on down-ticks.  The SEC has not
begun a single action against anyone for driving a stock down by naked short-selling. We should watch the SEC.  They want financials to rally now.  There are two earlier cases, in 1931 and 1932, where the NYSE briefly banned short sales. The market rallied then, too, until the ban was lifted.
See seekingalpha.com/artic...

I have to mention the SEC's hypocrisy and Chairman Cox's misleading statements on CNBC, where he denied naked short selling was illegal.  Cramer hit COX pretty hard.  Wall Street is not a level playing field.  And the SEC is not even pretending now.   That suggests that they are rather desperately trying to bring a
recovery. This is as rank as Bush's connections to Enron's Ken Lay.
He denied being friends with this convicted swindler. But the truth was Lay provided Bush with more than a million dollars. Bush would likely not have become President without Lay's lavish support.
                      ... They are supposed to police insider trading.   Who police's the SEC?   It is clear from 
                      ... the high volume of trading in  finance stocks before the announcement, that they let
                      ... favored insiders know in advance. 
                      ... ( See - www.tigersoftware.com/...   )
  

                      ... Given their heavy weighting in the DJI - BAC, C and JPM, I would think
                      ... the DJI will move higher and reach the point of breakdown, 11700.  A 50%
                      ... retracement would take the DJI up to 12000.   It is back to its declining
                      ... 21-day ma. and the resistance of the hypothetical low of January.  The market
                      ... was very oversold.  A two week rally off a July low is typical even in a bear market.
                      ... That the DJI is moving up appreciably more than the  SP-500 or NASDAQ
                      ... makes the rally suspect. 
                      ...
                      ... V-Bottoms Are Not Common

                      ... Despite the 450 point rally, we have no major Peerless Buy.  So, the odds favor the
                      ... rally being short-lived and a re-test of 11,000,  unless you are accept the Bear Raid
                      ... hypothesis offered above, which then would suggest that the DJI has along way to
                      ... rally, now that insiders have accumulated so much stock at the bottom.   Looking
                      ... back to 1965, there are few "V" bottoms  and still fewer boittoma without major
                      ... Peerless Buys.  Three quarters  of the time, bottoms require at least another test.  

2008 Jul 21 11:54 AM

[Lilliana:]

NOTE WELL
Quote
He that sells what isnt his'en must pay his debts or go to prison..
( Long standing rule..which has stood the test of time.)

2008 Jul 21 01:25 PM

[pavlov:]

Cut to the chase and just ban selling!!!

2008 Jul 21 04:35 PM

[Ringoes_Man:]

Let me get this straight; I pay my broker to buy, hold and eventually sell my stock (street thingy) and meanwhile he is short selling my shares and others in huge quantities in order to manipulate the price to my disadvantage?

How is this legal? How did I give my broker the right to 'lend/sell' my shares?

2008 Jul 21 06:21 PM