The Short-Sale Ban Is a Fiction

Red herrings are common literary devices used to distract readers from a story's true plotline. SEC Chairman Christopher Cox just employed a whipper when he issued a two-week ban on short sales of around 800 financial stocks. By barring the perfectly legal practice of shorting a stock, Cox is setting investors up to believe that the shorts have caused of the market's current malaise. In fact, the true culprit is the market's rapidly dwindling confidence in the financial shell game that banking institutions have been running.

It was a dark and stormy night ...
A short seller borrows a company’s shares, sells them, and then buys them back later. If correct, the seller pockets a profit; if wrong, he or she could face limitless losses. A stock can go higher much longer than you can stay solvent, and such a "short squeeze" has wiped out plenty of short sellers. Hedge fund manager David Einhorn has famously railed that Allied Capital (NYSE: ALD  ) shares have stayed buoyant far longer than his short position thought they should.

One of the other concerns being addressed by the two-week ban is that of "naked shorting," shorting a stock without actually borrowing it. Overstock.com (Nasdaq: OSTK  ) CEO Patrick Byrne has been railing for several years against naked short sellers who have attacked the online closeout retailer's share price. However, some smart Fools think he's just been employing red herrings of his own to divert attention from a broken business model.

Meanwhile, back at the ranch …
The short ban ignores the SEC's own complicity in the market's fall. Last year, it did away with the so-called "uptick rule," which required a stock's price to move up first before a short is permitted. If the short sellers are responsible for driving the stock market down, then the SEC was sitting behind the wheel.

Yet betting against a company is still possible. Investors can still trade options that turn profitable when shares drop, or buy credit default swaps to protect against a company's demise. Such swaps have grown from a $133 billion market three years ago to more than $2 trillion in 2007, and they could be the next shoe to fall.

A real page-turner
This story ultimately won't have a happy ending. The SEC is abetting the Treasury and the Fed in artificially inflating share prices, creating a void beneath their value. Since nature abhors a vacuum, it's quite likely that once the ban is lifted and trading resumes, these protected stocks will collapse once again.

It won't happen, you say? Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) were among the 19 stocks "protected" by a temporary shorting ban in July, and we know how that tale turned out. Also on the list were Lehman Brothers and Merrill Lynch (NYSE: MER  ) , both of which are disappearing, and Morgan Stanley (NYSE: MS  ) , which is negotiating a merger with Wachovia (NYSE: WB  ) .

A fairy-tale ending
The short-sale ban is a fable that fails to address the bad loans the banks made, the mortgages handed to borrowers with no means to repay them, and the ever more complex and risky assets they piled onto their balance sheets. In effect, it was the short sellers who were saying the loudest that something was amiss at these companies, only no one wanted to listen. Rather than vilifying the short sellers, perhaps they ought to be praised for calling out the irrational exuberance of management. Now that's a story I'd like to read.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 23, 2008, at 3:51 PM, TMFLomax wrote:

    Good article, Rich. It has struck me as scapegoating, witch hunting... a distraction from the real core reasons things have gone awry, as you describe here. And the worst part is I suspect some people are buying the fiction (it's a lot simpler after all, and of course, nobody likes shorts!). I'm glad you wrote this.

  • Report this Comment On September 23, 2008, at 4:16 PM, surfish wrote:

    Shorts like Einhorn are notorious liars, cheats and thieves who have inflicted great damage on our market.

    Your argument sounds like the NRA dunderheads who say , "Guns don't kill people...".

    The SEC and the public find your argument lacking.

  • Report this Comment On September 23, 2008, at 4:31 PM, Brettze wrote:

    Rich

    You ate too much pizza and you are thinking too cheesy1?

  • Report this Comment On September 23, 2008, at 6:15 PM, BHNashville wrote:

    Mostly OK with your comments Rich but surely you didn't intend to rubberstamp NAKED shorting. Absolutely the most glaring example of trading practices that should be banned without exception.

    Nobody would let me do that when I saw housing prices at levels that the vast majority of folks could never afford. I tried to sell a few houses that I didn't own or have a mortgage on but those darn folks wouldn't let me do that even though I could buy them back now at really great prices.

    Ponzi schemes are Ponzis no matter what the commodity. Naked shorting is not helpful to market efficiency. Borrowing shares and selling short - no problem at all.

  • Report this Comment On September 24, 2008, at 10:13 AM, RRGY2K wrote:

    Funny how nobody cares about the destructive impact of shorting until it's applied to the companies Wall Street cares about.

    Borrowing shares and selling short means sales by people with no interest in the company. Their buyers are acquiring non-existent shares (until the position is covered, which would be "never" in the ideal circumstance). One share shorted is a trader's speculation. One million shares shorted is a market manipulation. Naked short selling needs to be prosecuted for the felonious theft that it is.

    Short selling offers no economic benefit to anyone other than the people making money from the trades. But, short sighted short selling has killed many businesses simply by denying them capital at their time of critical need. Unemployed Wall Streeters, welcome to your own club!

  • Report this Comment On September 25, 2008, at 8:37 PM, irjsi wrote:

    The Fox, sent 'watch-over' the Hen House . . . was expected to consume a few eggs . . . such is the Nature of the Fox!

    Not satisfied with a few 'eggs', Wall Street 'Watch Patrol', wants to eat "ALL" the Chickens!

    Severely myopic souls,

    cannot comprehend an 'ever-expanding' "Pie-of-Wealth"!

    Those myopicists' want to devour the Pie, not 'Grow the Pie'!

    The cure for Poverty is to 'expand Wealth'!

    When the Fox eats fewer eggs; the numbers of both Eggs and Chickens is increased, creating the

    Eventuality for need of services of another 'Fox'!

    So groweth Wealth!

    Roy Stewart,

    Phoenix AZ

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