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It's Not the Shorts

Let’s be honest, short sellers will never win any popularity contests on Wall Street. It’s hard to warm-up to traders who make a killing when stock prices tumble. So that’s why short sellers have become such an easy and inviting target for regulators in the current financial crisis.

But the Securities and Exchange’s Commission move to bank all short selling in some 800 financial stocks for the next 10 business day smacks of overill. That’s because the short interest—shares sold short in anticipation of a stock decline—in big financial stocks is really rather paltry compared to the number of outstanding shares in those securities. At the close of trading on Sept. 17, short interest as a percentage of shares outstanding was 2.5% in Goldman Sachs; 2.6% in Morgan Stanley and 1.3% in Citigroup, according to Bloomberg.

Indeed, statistics taken from Bloomberg reveal that one bank with the highest percentage of shares sold short was credit card firm Capital One—a company that hasn’t been a target of much recent criticism from short sellers. The short interest on Capital One accounted for a whopping 21% of the bank’s outstanding shares. That’s nearly twice as much as the percentage of shares sold short on Wachovia, a big bank that has in the firing squad for quite some time.

Now there’s nothing wrong with regulators targeting abusive short selling, such as so-called naked shorting. In a typical short sale, a trader must borrow the shares from a broker so he can return them to the broker when the stock actually drops in price. In a naked short sale, a trader bets against a stock without actually arranging to take possession of the necessary borrowed shares.

It probably wouldn’t have hurt if the SEC immediately reinstituted the so-called up tick rule, which says traders can only short a stock when the price is moving up. A little over a year ago, the SEC discarded the uptick rule after determining that it had no bearing on the direction of stock prices.

Needless to say, short sellers are hoping mad about the SEC’s emergency ban. But don’t look for many hedge fund managers to go public with their discontent. The sentiment on Wall Street is that challening the ban won’t do any good and may draw unwanted attention from regulators.

Another idea the SEC could have pursed, instead of focusing all its attention on the shorts, is demanding that Wall Street banks come clean on holdings of toxic investments. Even now, 13 months into the financial crisis, Wall Street firms are still reluctant to tell investors just what troubled securities they have sitting in their balance sheets. That’s a big reason why investors harbor so much distrust of Wall Street banks.

So if it’s not short sellers who are driving a bear raid in financial stocks, who is? Well, it’s probably plain vanilla money managers, looking to get out of positions. Fear is a powerful emotion on Wall Street—almost as powerful as greed. What we’ve probably seen the past few weeks is simply a situation in which money managers decided to sell first, and ask questions later.

Counting Up the Shorts

Bank/Broker Short Interest as % of Outstanding Shares

(Sept. 17) (Aug. 29)

Bank of America 1.7% 2.6%

JPMorganChase 1.0% 1.4%

Citigroup 1.3% 2.8%

Goldman Sachs 2.5% 3.1%

Merrill Lynch 3.7% 2.9%

Wachovia 11.5% 12.5%

Morgan Stanley 2.6% 4.1%

Blackstone Group 6.5% 12.5%

Capital One 21.2% 19.6%

Source: Bloomberg

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