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.