There's been a lot of information and misinformation about short selling recently. Please allow me to bring you up to speed and bust some myths along the way.

Myth No. 1: Shorts should be shot
Many investors love to hate short-sellers because they see them as people who are rooting for others (companies and investors) to fail. What they're missing is that short selling is an integral part of a well-functioning market, since it allows market participants to express their view that a stock is overpriced. Without short sellers, the market would be inherently positively biased, and stocks would be priced less efficiently.

On top of that, some short sellers are outstanding stock analysts who have a good eye for fraud, mismanagement, or aggressive accounting. Take Jim Chanos of Kynikos Associates, for example, who was one of the first (and only) investors to call Enron out for its fuzzy accounting. If only more investors had listened to his arguments instead of those of Ken Lay and Jeff Skilling.

With that out of the way, now we can make progress.

Naked Short Selling 101
If you read a finance textbook, it will tell you that in order to sell a stock short, you borrow shares and sell them on, with the understanding that you must replace the loaned shares by purchase in the open market at a later date (hopefully, at a lower price).

That's the theory.

In practice, things are a little more fluid. Investors are not required to borrow the shares first before selling them, but they must have a reasonable expectation that they will able to locate shares they can borrow in order to be able to deliver on them to the buyer on settlement. Investment banks (remember those institutions?) have stock loan desks that specialize in going out into the market and locating shares for investors that want to go short. In fact, lending shares to hedge funds is a very big, very lucrative activity for the banks.

Selling shares that you haven't borrowed is known as a "naked short selling." You might have heard the term being bandied about in the press, since the practice has elicited much controversy and disinformation during the current crisis.

Myth No. 2: All naked short selling is illegal
This myth is unfortunately widespread, but it's simply false.

Nonetheless, critics argue the tactic allows hedge funds to launch speculative "attacks" on a stock, unfairly manipulating prices downward to profit from their drop. According to this line of thought, short sellers were instrumental in bringing down Bear Stearns (acquired by JPMorgan Chase (NYSE:JPM) in March) and Lehman Brothers (NYSE:LEH) (filing forbankruptcy).

What the critics are actually referring to is what the SEC describes as "abusive naked short selling," in which (a) short sellers sell shares they have not borrowed, and (b) are unable to deliver those shares on the settlement date of their sale. The SEC wants to eliminate abusive naked short selling through a series of measures that took effect on Thursday, which penalize failures to deliver borrowed shares at settlement. In addition, on Friday, the SEC banned all short sales of 799 financial stocks until Oct. 2, and increased the reporting burden for short sellers.

George Soros' principle of reflexivity and financial stocks
Why the comprehensive ban with respect to financials? Because those stocks may be particularly vulnerable to short selling. Why? George Soros' principle of reflexivity is at work here; Soros argues that a feedback loop enables investors' perception of a financial stock's intrinsic value to ultimately affect that intrinsic value. That might sound a bit "loopy," so I'll explain.

For companies outside the financial-services industry, a sharp and sustained drop in share price may reflect the market's negative outlook regarding a company's future prospects, but it is doesn't threaten the viability of the company in and of itself.

The same can't be said for many financial institutions, because they are highly leveraged and -- in the case of investment banks, for example -- they rely on short-term funding to do business. Under those circumstances, a massive drop in share price can irreparably damage the confidence of a firm's lenders and its customers, eventually producing a run on the bank.

We have watched that phenomenon raze the financial landscape in dramatic fashion. The most recent victims were Merrill Lynch (NYSE:MER), which fell into the arms of Bank of America (NYSE:BAC) last weekend, and Fannie Mae, Freddie Mac and AIG (NYSE:AIG), all three of which were nationalized to avoid failure. Finally, the fear of a run on the bank pushed Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) to become bank holding companies.

Abusive naked short selling should be eliminated, but…
Abusive naked short selling is not a normal or healthy part of a properly functioning market. Still, I'm a little uneasy with the ban of all short sales of financial stocks, which looks a bit heavy-handed. More importantly, regulators (and investors) shouldn't let the issue of short selling blind them to the fact that the massive credit problems that banks, broker-dealers and mortgage companies are dealing with are self-inflicted. Short-sellers didn't cause the credit crisis.

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Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.