Get Shorty

The Securities and Exchange Commission late yesterday announced it's extending its emergency ban on naked short selling in 19 financial companies through August 12, noting this will be the last extension of the rules.

That means the SEC will continue its regulatory apartheid by refusing to bend to requests by bankers associations to widen the rules to cover more financial concerns, with no further information from the agency on whether it believes those companies left off the list are potentially subject to market manipulation.

So that means companies whose stocks have been pounded into the sand remain off of the SEC's list, including Washington Mutual (WM), Wachovia (WB), MBIA (MBI), Ambac (ABK), National City (NCC), KeyCorp (KEY), Sovereign Bancorp (SOV), Corus Bank (CORS) and Bank United (BKUNA).

The SEC instituted the temporary ban after shares in Fannie Mae (FNM), Freddie Mac (FRE) and Lehman Bros. (LEH) were driven lower, allegedly by rumors started by short sellers, despite the fact that legitimate questions arose over the health of their balance sheets and their accounting practices (see blogs "The SEC Comes Up Short," "Why You Should be Worried About the Rescue of Fannie Mae and Freddie Mac," "Fannie and Freddie on the Brink," "Breaking Down Lehman's Earnings," "Questions About Lehman Brothers Continue to Mount" and "The Fire-Engine Red Flags at Lehman Brothers").

The SEC also enacted the temporary ban despite the fact that Fannie and Freddie really started to plunge rapidly after a New York Times report indicating the White House was drawing up contingency plans to rescue these mortgage giants due to their potential insolvency, a possible insolvency raised by former St. Louis Federal Reserve president William Poole.

Also, the SEC itself says naked short selling, which it's outlawed for these 19 companies, did not affect them to begin with.

The SEC has issued subpoenas to a raft of hedge funds to determine if rumor mongering helped cause Bear Stearns to collapse and Lehman's shares to plunge-again despite the fact that their financial houses were clearly not in order due to their massive overleveraging.

Short sellers profit off of a stock's fall in value. They borrow shares and then sell them, and when the price drops, they buy shares back at the lower price, returning the borrowed shares and pocketing the difference.

In a "naked" short sale, sellers don't borrow the shares before selling them. "For this reason, naked shorting can allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions," SEC chairman Christopher Cox said in an opinion piece in the Wall Street Journal.

The SEC's new order forces short sellers to show specific agreements to borrow shares in these 19 companies before selling them.

Reason: The SEC wants to stop what Cox calls "distort and short" manipulations, the thinking being that illegitimate rumors are driving naked short sales and causing these stocks to experience record volatility.

"False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by 'naked' short selling," Cox said when the initial ban was announced.

The SEC is examining the order's impact, before writing final rules to potentially stop naked short selling abuses, while keeping short sales, which the SEC says does provide liquidity to the markets-and which analysts say stops certain shares from being inflated--intact.

The thinking on Wall Street is that the SEC's ban ignited short covering in these 19 companies, helping to create a level of support for their share prices. Here are the 19 financial companies on the SEC's list:

BNP Paribas Securities Corp
Bank of America Corp
Barclays
Citigroup
Credit Suisse Group
Daiwa Securities Group
Deutsche Bank Group
Allianz SE
Goldman Sachs Group Inc
Royal Bank ADS
HSBC Holdings Plc ADS
JPMorgan Chase & Co
Lehman Brothers Holdings Inc
Merrill Lynch & Co Inc
Mizuho Financial Group Inc
Morgan Stanley
UBS AG
Freddie Mac
Fannie Mae

To get on the list, the SEC chose "precisely those financial firms" that the Federal Reserve "has designated as eligible for access to its liquidity facilities, and for which the taxpayer could be on the hook," Cox explained.

Ironies and questions abound, beyond the fact that many institutions on the list are helping hedge funds execute naked short sales, and that there are a large number of foreign institutions on this list (being primary dealers, they have access to the Fed window).

All US banks are eligible to access the Federal Reserve's liquidity facilities, as even Fed Chairman Ben Bernanke noted in testimony before Congress recently that "all banks can borrow from the Fed's discount window." Wamu, Wachovia, KeyCorp and the other banks not on the list can go fail, too, leaving the taxpayer on the hook in a taxpayer-backed bailout. "Those institutions should be part of the group that requires better documentation on short selling as well," says Frazier Rice, a private banker in New York City.

So why only these 19 financials?

Also SEC chairman Cox said in his WSJ op-ed piece "the SEC's emergency order is not a response to unbridled naked short selling, which so far has not occurred," in these 19 stocks.

So again why ban naked shorting for these 19 if it's not occurring? In his editorial, Cox added rather flatly: "rather it is intended as a preventative step to help restore market confidence at a time when that is sorely needed."

This approach is of a piece with this administration's doctrine of pre-emptive strikes, unilaterally stamping out problems before they crop up, as Treasury secretary Henry Paulson did when he announced his "bazookanomics" approach to an effectively open-ended taxpayer bailout of Fannie Mae and Freddie Mac.

The approach here was that if the US could show the world at large it will pull out the stops to save these two publicly traded companies, just knowing the full faith and credit of US government (taxpayers) will scare the bejeezus out of the shorts and cause their shares to stop plunging, so no taxpayer bailout of Fannie and Freddie would be needed.

"If you've got a squirt gun in your pocket, you may have to take it out. If you've got a bazooka, and people know you've got it...you're not likely to [have to] take it out," Paulson testified recently about the government's rescue plan for Fannie and Freddie.

Naked short selling is not illegal. The SEC's rules on short selling, enacted in January 2005, said broker dealers and traders were not required to have a physical agreement to borrow the shares if they had "reasonable grounds" to believe that the shares can be borrowed.  

The SEC itself has said in public statements that "naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules," and that in certain instances, it can replenish market liquidity. The New York Stock Exchange has also said it has found no evidence of widespread naked short selling.

Naked shorting can arise when a stock is so illiquid and there are such a small number of shares outstanding, that trying to find shares to borrow can be difficult to arrange. Also, underwriters of initial public offerings or secondary stock offerings often have an over allotment of shares they place and trade that don't technically yet exist in the offering, so they make the trades through naked short positions, Fox Business's news director Ray Hennessey explains.

Traders have a right to do naked short selling, if they have reasonable grounds the shares in a short sale can be borrowed later on. If they see a financial cataclysm arising due to poor accounting, they have a right to do a naked short sale.

Savvy investors know to watch short positions to do necessary trouble-shooting in their own portfolios--before they get zeroed out due to financial mismanagement. Short selling keeps potential hyperinflation in shares in check-witness the dangerous bubble that has inflated in China's stock markets, as China has outlawed short selling.

Corruption will always be with the markets, as corruption has been around since Adam. Rare is the critic of the Wall Street trader or analyst who crooks the buy trumpets and in turn is talking long his book, lining his wallet even further.

Again, it must be reiterated that the real problem is the SEC's decision to remove the uptick rule in July 2007. The rule was an old stock market backstop, put in place in 1938. The SEC lifted this ban right when the subprime and credit crisis exploded.

The uptick rule said that traders can only short a stock if the last trade of a stock is at least a fraction, or an uptick, higher than the prior trade. The SEC says it has no intention of reinstating the uptick rule.