Wall Street executives now expect the Securities and Exchange Commission to extend its temporary limits on a certain type of short selling beyond the 19 financial companies on its initial list, the Wall Street Journal says.

However, the crackdown was problematic from the start, because, in a curious bit of regulatory apartheid, the list of 19 excluded a range of other financials, and because the SEC itself says the brand of shorting it's outlawed for these 19 stocks did not affect them to begin with.

The limits are set to expire tomorrow, but executives, lobbyists and representatives of the Managed Funds Association have reportedly been talking to the SEC over the weekend about possible approaches to extending the rules another two months and expanding the rules to cover more companies, including insurance, housing-industry and a broader range of financial concerns, the WSJ says.

The talk now is whether the SEC's temporary crackdown stopped the death spiral in stocks of financial outfits such as Lehman Brothers (LEH), Fannie Mae (FNM) and Freddie Mac (FRE), as it's believed that traders conducting a certain type of short sale covered their positions, causing the shares to form a level of support.

But when you consider the SEC's moves here, you may rightfully ask yourself in all irony:

Doesn't it seem that the government's farflung and costly attempts to stop the financial crisis are of a piece with the administration's doctrine of pre-emptive strikes, unilaterally stamping out problems before they crop up?

For example, Treasury secretary Henry Paulson says he supports an effective, open-ended taxpayer bailout of Fannie Mae and Freddie Mac to show the stock market and the world at large the US means business and will pull out the stops to save these two publicly traded companies, the thinking being that the enormous backing of the US government (taxpayers), even if it's not used, will cause their shares to stop plunging.

"If you've got a squirt gun in your pocket, you may have to take it out. If you've got a bazooka, and people know you've got it...you're not likely to [have to] take it out," Paulson testified recently about the government's rescue plan for Fannie and Freddie.

The SEC's crackdown on naked shorting in 19 financial companies are of a piece with Paulson's bazookanomics--because the SEC says, get this, these 19 are not under attack from naked shorts at all. And to begin with, naked short selling is not illegal.

In a short sale, a trader sells borrowed stock in a bet the share's price will decline and the stock can be resold for a profit at a lower price; the trader then simply returns the stock to the entity it borrowed the shares from and pockets the difference.

But "in an abusive naked short transaction, the seller doesn't actually borrow the stock, and fails to deliver it to the buyer," SEC chairman Christopher Cox explained in an op-ed piece in the WSJ that defended the SEC's crackdown to protect the 19. "For this reason, naked shorting can allow manipulators to force prices down far lower than would be possible in legitimate short-selling conditions," he added.

However, Cox says "the SEC's emergency order is not a response to unbridled naked short selling, which so far has not occurred," in these 19 stocks, adding, "rather it is intended as a preventative step to help restore market confidence at a time when that is sorely needed."

Also, a score of banks and financial under siege by the shorts were not on the SEC's list to begin with, igniting a growing chorus of criticism that says the SEC was unfair to keep them off the list.

Not on the list are stocks that have been savagely beaten up, including Washington Mutual (WM), Wachovia (WB), MBIA (MBI), Ambac (ABK), National City (NCC), KeyCorp (KEY), Sovereign Bancorp (SOV), Corus Bank (CORS) and Bank United (BKUNA). Wamu, Ambac and MBIA have plunged to around the price of a gallon of milk or gasoline, off 80% or more over the past year.

To stop the naked shorts, the SEC's new rules forced traders to show specific agreements to borrow shares in these 19 companies before they actually started a short sale. The list includes:

BNP Paribas Securities Corp
Bank of America Corp
Credit Suisse Group
Daiwa Securities Group
Deutsche Bank Group
Allianz SE
Goldman Sachs Group Inc
Royal Bank ADS
HSBC Holdings Plc ADS
JPMorgan Chase & Co
Lehman Brothers Holdings Inc
Merrill Lynch & Co Inc
Mizuho Financial Group Inc
Morgan Stanley
Freddie Mac
Fannie Mae

To get on the list, the SEC chose "precisely those financial firms" that the Federal Reserve "has designated as eligible for access to its liquidity facilities, and for which the taxpayer could be on the hook," Cox explained.

The SEC's moves raise ironies and legitimate questions here, beyond the fact that hedge funds pounding these stocks borrowed tens of billions of dollars from the same Wall Street investment banks and commercial banks on the list to do their short sales, and that there are a large number of foreign institutions on its list.

The SEC chose these 19 because they now can borrow funds at the Federal Reserve's expanded discount window, borrowings for "which the American taxpayer is now on the line," Cox explained.

However, Wamu, Wachovia, KeyCorp and the other banks not on the list can go under, too, leaving the taxpayer on the hook for them in a taxpayer-backed bailout.

And as Mark McHugh writes on the financial analysis website Seeking Alpha, on July 11, 2008, Bespoke Investment Group reported that "the short interest of the S&P 500 was 6.0% (percentage of float)," yet, absent Freddie Mac and Fannie Mae, the other 17 stocks "have a cumulative short interest of just 1.18% (percentage of outstanding)." 

He adds: "Is that really cause for concern?  In my universe, 1.18% short interest is no great shakes." McHugh asks too why Goldman is on the list, "why are the "smartest guys on the street hiding under mom's apron?  They should just buy puts on themselves, make billions and squeeze these cretins until their eyeballs pop; they've pulled similar stunts, right?" (http://seekingalpha.com/article/85999-the-sec-s-sacred-cow-list-where-ar...)

The SEC's attempt to outlaw naked shorting was problematic from the start. In 2004, well-intentioned bureaucrats at the SEC tried to "attack the problem of naked shorting," Cox has said.

The new rules, enacted in January 2005, forced broker-dealers and traders "before they accept short sale orders or effectuate short sales in their own accounts, to first borrow the security to be shorted, or enter into a contract to borrow it," Cox said.

The problem was, the SEC wrote a loophole into that 2004 rule, saying broker dealers and traders were not required to have a physical agreement to borrow the shares if they had "reasonable grounds" to believe that the shares can be borrowed. "Opportunities for evasion of the rule's purpose" were born via the "reasonable grounds" loophole, Cox has noted, and the thinking is the naked shorts piled through.

So the belief is traders shorted stock in the 19 companies, including Citigroup (C), Lehman, Fannie Mae, and Bank of America (BAC) without borrowing the shares to deliver to buyers, even though the SEC's Cox says from the start that "has not occurred."

Short sales add liquidity to the market, and provide a needed correction to stop overheated trading. Shorts are often attacked for talking their books, despite the bullish bias on Wall Street and despite the fact that Wall Street tends to bruit about its long positions.

Shorts often do their homework poring through financial statements finding economic potholes that protect investors, and can provide a necessary reality check, a reality check that clearly bounced in this crisis. China has outlawed short selling, which has helped inflate the bubble in those markets.

Yes abuses occur. But the SEC itself has said in public statements that "naked short selling is not necessarily a violation of the federal securities laws or the Commission's rules," and that in certain instances, it can replenish market liquidity.

The New York Stock Exchange has already said that the Big Board has found no evidence of widespread naked short selling.

Also, naked shorting can arise if a stock is so illiquid or has a tiny number of shares outstanding, making the attempt to find shares to borrow difficult to arrange. And underwriters of IPOs or secondary stock offerings often have an overallotment of shares they place and trade that don't technically yet exist in the offering, so they make the trades through naked short positiosn, Fox Business's news director Ray Hennessey explains.

The real problem at the SEC is its mysterious decision to remove the uptick rule in July 2007, just as the crisis in the financials was about to explode.

The uptick rule said that traders can only short a stock if the last trade of a stock is at least a fraction, or an uptick, higher than the prior trade.

The rule was an old stock market backstop, put in place in 1938. When the SEC lifted this ban, the subprime and credit crisis blew up and the rule change helped whipsaw volatility in financial stocks faster than a tractor trailer on a bungee cord.