Selling Shorts…Short?

Shorts are, once again, in the sights of regulators, as they seek remedies—or, some would say, scapegoats—for recent market pain. The Securities Exchange Commission announced today that it is considering restricting short selling—again. The new rule would either take a market-wide approach or target individual securities that experienced a severe decline in price, and would include measures similar to the now defunct uptick rule and the Nasdaq’s old bid-test. (The proposals will be open to comment for 60 days.)

Shorts are, once again, in the sights of regulators, as they seek remedies—or, some would say, scapegoats—for recent market pain. The Securities Exchange Commission announced today that it is considering restricting short selling—again. The proposed new rule would either take a market-wide approach or target individual securities that experienced a severe decline in price, and would include measures similar to the now defunct uptick rule and the Nasdaq’s old bid-test. (The proposals will be open to comment for 60 days.)

In June, 2007, the SEC voted to eliminate all price restrictions on short selling, but it is revaluating the issue due to “extreme market conditions and a deterioration in investor confidence,” the SEC said in a release about the rule proposals.

Company executives have long complained that shorts, and particularly naked shorts, are behind violent drops in share prices, and in the recent market meltdown, many blamed naked short sellers for Lehman Brothers’ collapse—an argument that was repeated in a story on Bloomberg today. Some complain that short sellers, in fact, illegally spread negative rumors about the companies whose shares they sell short in order to ensure a profit. (In fact, former hedge fund manager James Cramer once copped to doing that very thing in a filmed interview with TheStreet.com TV, a clip that recently aired again during his visit to Comedy Central’s The Daily Show-- check frame 3:20.) Then again, one might consider negative rumor-mongering a just antidote to the giant hype machine that is Wall Street, which talks up stocks all day long as a matter of course.

The problem is, regulators conducted a study in 2004 to determine whether short-selling drives down stock prices or causes unhealthy volatility, and they found that it doesn’t, releasing their findings in February, 2007. As a result, the short pricing rules, first created after the crash of 1929, were eliminated in 2007. What’s more, when regulators briefly banned short selling on a list of vulnerable stocks in the fall of last year—including many financial services firms—those stocks declined anyway. Some, in fact, claim that short-selling keeps the market healthy, because it provides liquidity and helps uncover dubious business practices.

As for naked short sellers, it is very difficult to determine how widespread the practice is, but the SEC has stated publicly that it does not believe it is widely practiced. Naked shorts essentially sell a stock short without first borrowing the shares of the company they have shorted, or ensuring that they can be borrowed.

Certainly, short-selling seems almost beside the point when you consider all of the fundamental underlying problems with market regulation that need to be addressed—for instance, there is the simple fact that the rules currently on the books were created decades ago and the financial system has changed radically since then. What's more new rules have been heaped onto the old ones to address changes in the system, only to create a veritable regulatory quagmire.

Indeed, Peter Boockvar, on Barry Ritholz’s blog The Big Picture, issues this complaint about the the blame heaped on short sellers for the current market trouble: “Short sellers (SS) didn’t get people to buy homes with no money down, SS didn’t convince people to buy homes with teaser rates, SS didn’t convince people to lie about their income on their mortgage applications, SS didn’t tell banks/brokers to lever up to such huge levels, SS didn’t tell Greenspan to cut rates to 1 percent and leave it there, SS didn’t invent FNM and FRE, SS didn’t tell the OTS, OCC, FDIC, Fed, SEC, FFIEC, FTC, FHFA and all the state regulators to twiddle their thumbs all day, SS didn’t tell the rating agencies to rate AAA on anything that moved, SS didn’t tell banks to lend to commercial real estate investors on a property where the rent didn’t cover the mortgage payment, SS didn’t tell the average consumer to spend more money than they make and borrow difference.”

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