What the SEC Really Accomplished with Its New 'Short-Sell' Rule

by Eric Roseman

Bear markets tend to rear the government's ugly head. In my book, the less government intervenes, the better. Markets should be allowed to function freely, as long as market participants use transparent reporting.

Sometimes, however, the government has to intervene when investors are unfairly punished or defrauded. This was the case earlier this decade during the Enron, WorldCom, Tyco, and the Spitzer mutual fund-timing scandals. Millions of investors were victimized, defrauded, and CEOs were subsequently sentenced or heavily fined.

But now the rules are about to change. It looks like short-sellers are the new target in the United States, the United Kingdom, and Australia.

In an effort to curb speculation in financial services stocks, the United States Securities and Exchange Commission [SEC] have introduced new short-selling rules for the next 30 days. These changes bar institutions, mainly hedge funds, from shorting financial stocks. The government has issued a list of 19 commercial and investment banks that cannot be shorted.

The SEC, announced these new rules last Tuesday after financial stocks plummeted for the second day. This announcement triggered a massive 17% rally for the bank index on Wednesday. The new short-sale rule was probably the biggest single factor contributing to the rally.

So will this new rule help financial stocks and their devastated shareholders? The answer is probably not.

Though the government has identified 19 financial institutions to be protected, this leaves a few hundred more that remain even more vulnerable as a result of this legislation.

Also, hedge funds and other speculators will find alternative targets. If a financial stock deserves to be priced lower, then it should trade at a discount to other more profitable companies. By isolating 19 companies, the SEC has invited vultures to the party as hundreds more are now fresh targets that are not protected by the 30-day rule.

Don't blame the hedge funds for the woes afflicting the financials. The real blame falls on poor financial supervision, poor government regulation, and rogue CEOs that went absolutely wild issuing mortgages to sub-par applicants.

And don't forget Wall Street. Investment banks, the largest of which are now protected by the Feds with the new short-selling rules, where the largest issuers and innovators of mortgage-backed securities tied to synthetic derivatives.

Comments

[Ames Tiedeman:]

Well said. The best way to make short selling less of a threat on given companies is to have these companies improve their balance sheets. Well run companies with strong fundamentals do not see their stocks shorted to oblivion. Ever wonder why JNJ, and CAT are not n single digits like these banks? They are well managed.

2008 Jul 25 07:02 AM

[je:]

This could be more evidence of a sect few trying to gain control of most ofeh banking or at the very least providing an opportunity to buy the unprotected banks at a huge discount........

and why only thirty days....what is going to happen in the next thirty days that theyy need this sort of protection.....they have the keys to the vault.

2008 Jul 25 08:45 AM

[Mainer:]

This article is completely incorrect. The SEC has taken steps to limit "naked" short selling, which is illegal. Shorting these 19 stocks is still allowed, however the shares to short need to be borrowed first. These regs should be extended to all stocks, and Cox has indicated this may happen. Shorting is completely legitimate, legal and a necessary activity, IMO, but naked short selling leads to abusive practices and manipulation, and in its worst form leads to the counterfeiting of shares when more shares are shorted than can be borrowed or in some cases even exist.

2008 Jul 25 09:06 AM

[Mainer:]

"Short sellers sell borrowed shares which they hope to replace later at lower prices, profiting from stock price declines. The practice is legal, but has long been controversial. The SEC has put restrictions in place in recent years to curb abusive "naked" short sales, in which stocks are not borrowed before short sales. That effort was extended with the emergency order, which calls for borrowing or arranging to borrow shares in advance of short sales in the 19 targeted stocks." Again, they are NOT outlawing shorting, simply requiring that shares be located before doing so, to curb abuse.

money.cnn.com/news/new...

2008 Jul 25 09:25 AM

[Enes K.:]

CAT well-managed? That is a new one. It is not just short selling which they are trying to stop, it is also the false rumor spreading. And that's what makes bank runs. If one dumb Senator's sentence can cause that, what else can happen?

2008 Jul 25 10:16 AM

[jabez:]

Mainer has it exactly right. Evidently the authors do not know the difference between short-selling and NAKED shorting, or perhaps just want to tell a good story. No need to worry that shorting has been banned, or will be banned.

Besides, the marketmakers have been exempted from the rule...

2008 Jul 25 10:34 AM

[Jay Jay:]

The rumor is just the trigger, the mismanaged company is the real cause.

2008 Jul 25 11:11 AM

[maeve3333:]

Does anyone know what mm's are allowed to do besides trying to make a orderly market.Primarily OTC.Thank you.

2008 Jul 25 11:13 AM

[ajhough:]

Naked shorts do not borrow stocks, do not own stocks, and use extemely large leverage. This is the opposite of investing and is against the interest of investors. It provides "liquidity" since they borrow money, pay interest, move in and out of positions very rapidly, and at the end of the day simply clear the investment decks.

2008 Jul 25 11:27 AM

[taxmarc:]

I am sick and tired of the constant government interference. Where's the conservative party's outcry against this behavior? If anyone thinks we are in a free market economy you are deceived. Starting with Greenspan's precedent of the government bail out of Long Term Capital Management, which opened a Pandoras Box for the government to continue it's welfare to these mis-managed companies, to the present bailout of the financial sector. At least when Cyrsler was bailed out it was a loan and they paid it back. Where was the government to bail me out when I saw my Enron stock and dot com companies get blown away? Big deal the CEOs were fined. That didn't put money in my pocket. Those fines just continued to grease the wheels of more government. All welfare does is create a dis-insentive to be responsible. I thought playing the market meant having a strategy for making money. Shorting is part of that strategy. If an investor sees an opportunity to short based on a company's foundamentals why shouldn't they? But if the government interferes why consider a company's foundamentals? All smoke and mirrors. At least the former Soviet Union admitted they were communist.

2008 Jul 25 01:27 PM

[OldLimey:]

A couple of months back there were negative rumours in the London market about HBOS (for those of you unfamiliar with the stock, a grimly mismanaged UK bank with a lot of property exposure). The shares tanked and there was a witch-hunt for the wicked short-sellers supposed to be behind it all. This week there was a rumour of a bid for HBOS. The shares soared and there were smiley faces all around. The new Anglo-American game-rules are clear: negative rumours - bad; postive rumours - good; facts - best kept obscured for as long as possible.

2008 Jul 25 01:56 PM

[Phil Anthropy:]

There is nothing wrong with short selling. However, one must begin to ask where short selling stops and market manipulation begins. Orderly short selling is simply a bet against a stock, which is just as legitimate as buying a put option. However, if there is a sudden "run" on short sales which drives the price down, this is as suspicious as a sudden run which drives the price up.

The difference is that as prices rise, there is resistance, but as they fall, there is often less of a bottom, particularly in a bad economy. Therefore, non-orderly short selling, which destroys market cap (and therefore credit and business opportunity) in a hurry, must be limited by regulations.

It should come as no surprise to anyone that naked short selling is illegal. The surprise is that there is little or no enforcement, and one must wonder why.

There is nothing that stops brokers from programming their back office computers to match short sales requests with specific shares of that stock in margin accounts in street name. If this is not being done, and if naked shorts and "failures to deliver" are ordinary business practices, then the culprit is a much the SEC as the violators.

The limitation of enforcement protection to the Wall Street financial heavies is a travesty -- among other travesties in various markets which would not have come to pass if our regulators were doing their jobs of enforcement.

2008 Jul 25 03:31 PM

[carey_jim:]

The SEC is an elephant (pardon the Republican reference) sitting on a pressure cooker.

The explosion is going to spectacular.

2008 Jul 25 05:38 PM

[hrant:]

as a small investor ,I actually need this kind of government monitoring . Unlike you , i no longer TRUST that everyone in the market are acting within the lawe.;

2008 Jul 25 11:58 PM

[garsonvonah:]

Lets just make it simple. If ya like a stock buy it if you have the money. Then if you own the stock and you don't like it, sell it. No shorting, no anything if you dont have the money and buy it outright. No margines. Thats my plan for an honest, level playing field stock market.

2008 Jul 26 03:56 AM

[Giovanni di...:]

I agree with garsonvonah, play with what you have, either money to buy or stock to sell.
Those who rant about gov interference (=regulation) are either silly if they believe a fair market can exist without regulation or they have their own private interest to defend.
The millions of retail investors would have no chance to save their savings from the vultures otherwise.
Regulation is rather still to weak as the rules are not sufficient and don't really get enforced.
Even if one believes that one should be allowed to speculate with borrowed shares, this does not justify naked shorting except for very limited cases (i.e. mm's during a very short period in order to make a market when demand and supply do not match momentarily).
But even "regular" short selling is mostly based on abuse because brokers mostly do not ask the owners of the shares that they "borrow" whether they want to lend their shares. If I own stock X in a margin account (for which I pay interest!) who or what gives the broker the right to "borrow" my stock without even asking me? Forget about paying me for borrowing my property.
It is obviously against my interest to lend my stock (of which I am long because I believe it will go up) to someone who wants to drive it down by shorting it and (not so rarely) afterwards manipulates the market with rumours to make it go down more. If they want to sell short, ok, borrow the stock from a conscient (!) owner who knows that he lends it to a short seller.
This is what I mean when I say there is even too little regulation. Nobody should be allowed to use my long position to short sell without my consent.

And OF COURSE nobody should be allowed to sell stock that they don't own nor even borrowed. This not only "may lead to counterfeiting" as one comment says, this IS counterfeiting because it creates immediately (!) non existing shares (few or many, whatever) of the traded stock.
The stock that is naked short sold does not exist, the shares traded are counterfeited but the buyer does not know this and believes that they bought "real" stock. Indeed their account shows that they own this stock, but in reality it does not exist.

If you pay with a cheque that is not covered either by your money in your account or by a loan or credit margin of your bank, this is called fraud. Paying with a cheque that is not covered is like printing false money. Naked short selling is nothing else. Like a chque or a bank note the share of stock represents money. If you falsify bank notes or commit cheque fraud you go to jail.
Why not if you sell non existing stock?

2008 Jul 26 11:11 AM