Tuesday, July 22, 2008

Short Sale Tale

A week ago the Securities and Exchange Commission (SEC) put into effect an emergency order relating to short selling activity. The emergency order applies to seventeen Wall Street firms and U.S. housing finance companies Fannie Mae and Freddie Mac. Short sellers must borrow the securities in these stocks before executing a short sale trade. They must also deliver the securities on the settlement date.

Mind you, this is not a new regulatory effort. The stipulation of the SEC’s July 14th emergency rule is already embodied in Regulation SHO that went into effect in January 2005. One of the primary goals of Regulations SHO is to prevent potential abuses such as “naked short selling” wherein shares are sold short without having first determined if there are shares available to borrow and then settle the trade.

All the SEC is doing now is actually enforcing the Reg SHO for those named seventeen stocks. How the list was cut off at seventeen financial stocks is as much a mystery as why the SEC was not enforcing Reg SHO in the first place.

Perhaps this is just another example of how the federal agencies that have been charged with protecting the public interest have been short themselves - short on their responsibilities.

We saw it when Hurricane Katrina went flying through, leaving devastation in her wake. Where was FEMA in the aftermath? No where to be found.

Then last summer we found out that mortgage companies had been making bad loans right and left. To compound the problem, Wall Street firms used those loans for exotic financial instruments and sort of neglected to make any kind of proper risk analysis vis-à-vis portfolio leverage. Where was the SEC? No where to be found - at least until Bear Stearns got caught in the cross current.

Now that government-sponsored enterprises are in trouble, we find that the SEC wants to enforce rules against naked short selling. Apparently, unscrupulous short selling in Fannie Mae and Freddie Mac would be a bit too close to home.

Over the last four years we watched the SEC fumble around with hearing after hearing on Regulation SHO and the old “uptick rule.” The SEC staff was convinced the uptick rule was no longer necessary and engaged in a lengthy pilot study to prove it. Ok, let that go. Now it seems beyond denial that naked short selling is a factor in the U.S. equity market in all sectors.

The SEC has promised a review of short selling activity and regulations. Such action can only be a positive for small capitalization stocks that are often the subject of targeted rumors by short sellers some of whom are engaging in naked short sales.

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