War on the Short-Sellers?

Bloggersand regulatorsweigh in to debate what blame short-sellers should bear for the financial crisis

The past week's madness in the financial markets kicked off with the Lehman Brothers (LEH) bankruptcy. Then came the AIG (AIG) bailout. Now there's an apparent war against short-sellers.

After tense lobbying by financial company CEOs who blamed short-sellers for the massive drops in their stock prices, Christopher Cox, chairman of the Securities & Exchange Commission (SEC), announced on Sept. 17 new rules to curb "naked short-selling," which involves selling a stock without first borrowing it and is illegal. (A short sale is a bet that a stock price will fall by selling borrowed stock and then repurchasing it later at a lower price for a profit.) The same day, Morgan Stanley (MS) CEO John Mack sent a memo to employees: "We're in the midst of a market controlled by fear and rumors, and short-sellers are driving our stock down. You should know that the Management Committee and I are taking every step possible to stop this irresponsible action in the market."

Under the SEC's new rules, investors are prohibited from "naked shorting" by requiring shorted securities to be backed by borrowed securities. And for options traders, the SEC is "making it illegal for a customer to mislead a broker about having located stocks and then failing to deliver them," according to The Wall Street Journal. Lastly, hedge funds and large investors are now required to publish their short positions daily. The rules went into effect Sept. 18. That same day, New York State Attorney General Andrew Cuomo said he had begun a "wide-ranging investigation into short-selling in the financial market" related to companies under pressure over the past week, such as Lehman Brothers, American International Group, Morgan Stanley, and Goldman Sachs Group (GS). Cuomo said the SEC should temporarily freeze short-selling of financial stocks. "Short-selling is not illegal, but when combined with the spread of wrong information, that is illegal," he said in a conference call with reporters.

Urging the Return of the Uptick Rule

The battle against short-sellers spanned across the seas after Britain's markets regulator imposed a ban on short-selling of financial shares for the rest of the year and will require daily disclosure of existing short positions of more than 0.25% in financial companies.

Some pros cheered the SEC's move against naked short sales, but say it didn't do enough. They're urging the SEC to reinstate the "uptick rule," which said traders could place short sales only at a price that is higher than the price of the previous trade. This rule, which was eliminated by the SEC on July 6, 2007, is meant to prevent short-sellers from adding to the downward momentum when a stock is already falling.

"Kudos to the S.E.C. for its move [Sept. 17] to tighten the rules governing short-selling," wrote Thomas Brown, a bank analyst who runs the research and blog Web site BankStocks.com. "But…the moves aren't enough." Brown added: "The stock market worked just fine over the 70 or so years of the Uptick Rule's existence; reinstating it shouldn't place an unreasonable burden on stock investors now." Brown also said that along with reviving the uptick rule, the SEC should "look into how short-sellers might be manipulating the CDS [credit default swaps] market to manufacture [uncertainty] around the stocks they are short."

Even Senator John McCain (R-Ariz.) jumped on the bandwagon. He blamed Cox for the financial crisis and for eliminating the uptick rule. "The chairman of the SEC serves at the appointment of the President and has betrayed the public's trust," he said at a rally in Iowa. "If I were President today, I would fire him." McCain also said a new agency should be created and modeled after the Resolution Trust Corp. that handled the fallout from the savings and loan crisis. This idea helped fuel a recovery in the stock market on Sept. 18.

Some Question the Focus on Short-Sellers

Short-sellers, of course, fought back—especially against the requirement to disclose their short positions daily. "The consequences of a hasty or ill-considered rule in this environment could be extremely harmful to the capital markets," said longtime short-seller Jim Chanos, chairman of the Coalition of Private Investment Companies, which represents 20 funds with assets in excess of $120 billion. "Such a requirement is akin to the government suddenly requiring Coca-Cola (KO) to disclose their secret formula for free to all their competitors."

Some pundits wonder why the SEC is so focused on short-selling after the largest corporate bailouts in history, which failed mainly because of risky investment decisions by the firms and poor oversight and rules by U.S. regulators. "What's striking is that this is what the SEC is focusing on now," wrote Jonathan Weil in a column for Bloomberg News. "On the list of the commission's priorities, cracking down on naked shorting should be just ahead of investor-protection seminars for federal prison inmates."

Paul Kedrosky at Infectious Greed agrees. "The trouble is not with short-sellers," Kedrosky wrote. "The trouble is with an over-levered financial system built on a house of cards comprised of under-collateralized toxic paper that was applauded all the way up by 'housing is the American dream' nutters who couldn't see that vast expansions in thinly traded credit are a path to economic ruin." In the end, says Kedrosky: "Focusing on the short-sellers will lead to completely wrong and counterproductive nonsolutions to the current crisis."

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