Well, That Didn't Work

The temporary ban on short-selling was supposed to help prop up share prices of troubled financial companies until a fix to the system could be implemented. The SEC has determined that extending the ban for another two weeks will be necessary. However, if the $700 billion "bailout" plan gets passed first, the ban will expire three days later.

After all, it was supposedly the short-sellers who drove Bear Stearns and Lehman Brothers to extinction, and it was the shorts who were riding herd on Fannie Mae (NYSE: FNM  ) and Freddie Mac until they collapsed, exhausted, into the arms of Uncle Sam. A systemic fix is supposedly needed before we can let the finance industry face the short-sellers again.

So let's see, in the two weeks since the ban went into effect, FirstFed Financial (NYSE: FED  ) saw its stock fall as much as 60% and Sovereign Bancorp (NYSE: SOV  ) saw shares plummet almost 80%. Washington Mutual actually failed and Wachovia (NYSE: WB  ) sold itself to Citigroup (NYSE: C  ) .

Of course, there are the nonfinancial "financial stocks" that have extended coverage, too, like such well-known banking names as diamond purveyor Zale and assisted-living facility Sunrise Senior Living (NYSE: SRZ  ) , as well as carmakers Ford (NYSE: F  ) and General Motors. Zale got on the list last week, while Sunrise made the cut yesterday, and its stock is down almost 2% as I write.

In reality, the ban has been a failure at propping up stocks, protecting financials, or whatever else the argument was behind instituting it. In short, short-traders haven't been the problem, but rather the whipping boys. It was the risky maneuvers and investments that individual companies undertook that caused investors to bid down their stocks.

Even the SEC admits short-sellers are useful players in the markets. In its statement announcing the extension, the commission noted the important role shorts play "contributing to efficient price discovery, mitigating market bubbles, increasing market liquidity, promoting capital formation, facilitating hedging and other risk management activities, and importantly, limiting upward market manipulation." Despite that, the SEC decided to give the shorts a few more lashes for effect.

Even so, there have been a whole series of unintended consequences from the SEC's actions. Trading has gotten more volatile, with wild swings in prices, particularly at the market's close, and the bid-ask spread has nearly tripled, making it a lot more expensive for you to buy stocks. The convertible-bond market, used by faltering businesses for financing, has also been effectively shut down by the ban. The liquidity that short-sellers bring to the market, along with the efficient price discovery, has been cut off.

What little upside there is comes from the ban remaining in effect for only another two weeks. But that won't really help: The ban is slated to be lifted just as banks are readying their third-quarter financial reports. With expectations that the news will generally be horrible, October may live up to its reputation as one scary month.

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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.


Read/Post Comments (3) | Recommend This Article (5)

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  • Report this Comment On October 02, 2008, at 4:36 PM, jcdaris wrote:

    I find it hard to understand "short selling" versus "Naked short selling" ie: "phantom shares"...

    I've found a simple explanation of it on a BB , and if this is the case, I don't see why it should be allowed...

    If it can be so easily abused, to destroy share value,why allow it.

    TIA

    -----------------------------

    Is this right..naked Short sell example..

    My brother has a share of abc

    I ask him if I can sell it short and I'll get it off him when I have to deliver..

    My other ten brothers ask him if they can also short sell the share..

    Now we're eleven naked shorts selling ten shares that do not exist..

    When the share drops, we purchase (real shares) and we deliver the ten share that did not exist..

    And as long as we stay short with the share and we do not deliver, there are all these invisible non existent short shares (phantom shares) out there keeping the price down..

    for no apparent reason but to bring prices down with no relation what so ever to the fundamentals of the company...

    Close?

  • Report this Comment On October 02, 2008, at 6:17 PM, larn919 wrote:

    Who needs options. Hedge with options. Financials and energy are boucing better than Duncan yo-yos. I feel like a kodiak hitting a salmon run. Another great day for puts. Out this afternoon, back in by Tuesday or Wednesday.

    I LOVE THIS GAME!

    Let's hope Sara doesn't make a complete idiot of herself. As long as this race remains reasonably tight, we'll have at least another month of great trading opportunities.

  • Report this Comment On October 03, 2008, at 10:53 AM, theeconomicsguy wrote:

    jcdaris,

    Naked short selling is simply selling a share that you can't borrow. It is essentially selling nothing, and is currently illegal to begin with. Short selling itself is not illegal, as it involves borrowing a share, selling it, and repurchasing it at a later time to give back to the original owner.

    The ban stops the legitimate practice of short selling. By also saying that naked short selling is not allowed, it essentially says, "By the way, that thing we said was illegal, you can't do that." Not too much of an impact from that.

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