Seeking Alpha

Naked Short Selling Ban

by: Mike Steinhardt

After the SEC ban against naked shorting of Fannie (FNM) and Freddie (FRE) and 17 other companies was allowed to expire on August 12th at midnight, FNM opened at $8.00/share the next day. From that Wednesday to Friday August 15th, FNM traded in a range of $7.55 to $8.62 and closed the week at $7.91. If you believe in the short ban, you might have thought that the shorting would have immediately crushed FNM, but it did not. Of course, the loudest supporters of the SEC’s attempts to limit shorting were mostly silent. That’s what happens when the facts get in the way of the bullish hype agenda. The way the anti-short crowd promoted things, you would assume that the SEC’s ban would be largely responsible for “stabilizing” Fannie and Freddie from July 21 to August 12 while the ban was in place. That’s interesting given that FNM opened at $15.25 on July 21 and closed at $8.02 on August 12. I wouldn’t call that stabilizing.

But when FNM started plummeting again during the week that began August 18th and hit its low of $3.53 on August 21, suddenly the removal of the naked shorting ban was used to explain why the stocks might be declining(in addition to the missing Uptick Rule). Of course, this is stupid. There happened to be a few other things going on than just the initiation, implementation and then removal of the SEC’s ban. It’s just really convenient for people pushing an agenda to ignore facts in opposition to their argument and then apply coincidences that support their claim. Never mind that FNM has advanced 80% since the August 21 low at a time when the short ban was not in place.

The naked short ban had some effect on the stocks because all market rules impact trading in some way. However, it is tough to identify what effects it really had and to what degree. We do know that it did not provide stability and it did not prevent selling of the stock and it did not guarantee that buyers would show up. During the naked short ban, the protected stocks went up and down. Without the naked short ban, the protected stocks went up and down.

Maybe it is unfair to place the success or failure of the naked short ban by just analyzing Fannie’s stock movements. Okay. Pull up the charts of the following 17 companies that were on the SEC’s list of 19 companies protected (I am excluding BNP Paribas and Daiwa since they do not trade on the NYSE)….AZ, BAC, BCS, C, CS, DB, FNM, FRE, GS, HBC, JPM, LEH, MER, MFG, MS, RBS, UBS). Do a price study of these stocks on the following dates…. July 15th close, July 21 open, August 12 close, and today’s close.

You’ll find the following performance:

  • From July 15 close to July 21 open - all 17 stocks appreciated with an average gain of +35.7%
  • From July 21 open to August 12 close - 11 of 17 stocks declined with an average loss of -17.5% and an average gain of +6.3%
  • From August 12 close to August 27 close - 15 of 17 stocks declined with an average loss of -7.9% and an average gain of +2.5%

Here’s my take…The announcement of the ban on naked short selling caused a short squeeze and speculative momentum play from the announcement date (midday on July 15) until the ban actually took effect starting with the open on July 21st. Regulators like the Fed and the SEC love to put temporary floors in markets and create bullish spikes by squeezing shorts and encouraging bullish speculative trading on the momentum that follows. Bernanke did that on several occasions since August 17, 2007 so I guess it is only fair that Cox had his day. I find it interesting that Cox tried to prevent manipulation by short sellers by manipulating short sellers. Good one! Is this the kind of thing that gives investors confidence in markets and regulators?

As for the price action during the naked shorting ban, it did not suggest that the ban had an identifiable effect. Just consider how many of the covered stocks declined during the ban period of July 21 to August 12.

Since the ban ended, most of the protected stocks have declined. If you have read this whole post and still believe that the removal of the ban and manipulative short selling was the primary reason for the declines, please don’t waste your time reading my crap. It will not help you.

Naked short selling has been, is, and should be illegal regardless of whether the regulators choose to enforce existing rules for all or some of the stocks.

When Cox announces his next attempt to limit the effects of shorting, either naked or otherwise, please realize that the implementation of these rules does not materially affect prices. However (and this is the important part), the announcement of rules provides the majority of the gains and those gains are very short lived.