In a bid to stop a stock market in free-fall, the Securities and Exchange Commission released new rules aimed squarely at short sellers.
The rules come after heated talks between the SEC and Wall Street executives, who firmly believe short sellers are savaging their companies' stocks, helping to drive down the overall market.
Richard Fuld of Lehman Bros. (LEH) and John Mack of Morgan Stanley (MS) now join Bear Stearns executives in their accusations that short sellers buy short positions in their companies' stock and then engage in rumor mongering to cause the collapse in shares in order to profit.
Republican presidential candidate John McCain also has criticized the SEC for not doing enough to stop a certain type of short selling alleged to cause severe downturns in stock prices, among other things, going so far as to use this criticism to make his case that he would "fire" SEC chairman Christopher Cox if he were president.
Shorts are being held partly to blame for the dramatic plunge in the stock market. As their stock prices plunge, investment and commercial banks have been hamstrung in raising new capital as potential investors bolt from their shares--despite the fact that these very same firms profited mightily on their own short selling bets on other companies.
Short sellers profit off of a stock's fall in value. They borrow shares from a broker and then sell them. When the price drops, they buy the shares back at the lower price, return the borrowed shares to the broker within three business days of the sale, and pocket the difference.
"Millions of investors entrust their savings to our securities markets because they can be confident that our markets are orderly, liquid, efficient, and rational," said Chairman Cox in a statement about the new rules.
SEC Under Fire
Setting aside the idea that the stock markets were ever rational, which is like saying a gnat knows which direction to fly in a tornado, the SEC's moves raise other concerns.
Already the SEC is being criticized, not just for the ad hoc, after-the-fact refereeing nature of its actions, but for its seeming arbitrariness in protecting some companies with its initial ban on a type of short selling, while not outlawing this practice for other banks and companies.
More broadly, the agency is under fire for doing little to stop the enormous, imprudent and indefensible leverage that investment banks under its purview took on, much of it shoved in off-balance-sheet vehicles.
That debt load has now swamped Wall Street and caused an epic market crisis that is remaking the entire U.S. financial system.
The average leverage ratio on Wall Street when the credit crisis exploded in late summer 2007 stood at 27 to one, whereby for every $1 in assets, investment banks borrowed $27. The figures does not include off-balance sheet debt.
It's clear Wall Street did not have an overseer as the SEC left investment banks to their own devices, turning the free market into a free-for-all.
Senator John McCain, Republican presidential candidate, says the SEC's Cox "has betrayed the public's trust," adding "if I were president today, I would fire him."
And the SEC has only itself to blame, former SEC official Lee Pickard tells the New York Sun's Julie Satow. Specifically, the SEC relaxed the agency's net capital rules that limited ther debt to net capital ratios to 12 to 1 in 2004. The move was a concession made in which the firms let the SEC conduct more oversight of both a broker dealer and its holding company.
Pickard says the SEC let five investment firms--Bear Stearns, Lehman Bros., Merrill Lynch, Morgan Stanley and Goldman Sachs--more than double the leverage on their balance sheets, blowing out their debt to net capital ratios to unheard of levels, for instance, at Merrill Lynch to 40 to 1.
Meanwhile, there is much heated debate, too, over whether the SEC should reinstate the so-called "uptick-downtick" rule, an old stock market backstop, a Depression-era rule enacted in 1938 that put speed bumps in place to slow the pace of short sales.
The rule says that traders can only short shares if the last trade of the stock is at least a fraction, or an uptick, higher than the prior trade. The SEC lifted this ban right when the subprime and credit crisis exploded.
My read of it is that reinstating the uptick rule would not have any impact at all. See below.
Wall Street Complains Loudly
The SEC's latest move is an attempt to stop the sheer terror in the stock market, which has prompted a flight to the safety of Treasuries and has driven three-month rates down to levels not seen since President Franklin D. Roosevelt sat in the White House and World War II was raging.
Just this week Lehman Brothers, America's fourth-largest investment bank, filed for bankruptcy. Merrill Lynch (MER), a household name, was forced to sell itself to Bank of America (BAC), and the Federal Reserve announced it would loan up to $85 billion to American International Group (AIG) to bolster the damaged insurer, the world's biggest by assets.
Shares in Morgan Stanley (MS) and Goldman Sachs (GS) have been hitting fresh 52-week lows, threatening their viability as the last two independent investment banks left standing, with rumors flying that Morgan Stanley may sell itself to Wachovia Corp. (WB).
Morgan's Mack on the Offense
In a memo to employees yesterday, Morgan Stanley chief exec Mack wrote that he had contacted SEC chairman Christopher Cox and Treasury Secretary Henry Paulson about the problem with short selling.
"We're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down,'' Mack said. Mack also told workers he spoke to Goldman Sachs "five to six times" about the short-selling issue.
What the New Rules Dictate
In a bid to stop alleged false rumormongering, the SEC is now seeking approval, on an emergency basis, for a new rule that would force hedge funds, (private funds not required to disclose much trading information), as well as other large investors with more than $100 million invested in securities to disclose their short positions, potentially on a daily basis as opposed to periodically.
The hedge funds and large investors may have to file these reports noting daily trades on a weekly basis, though that decision is still in flux. Currently hedge funds file quarterly reports that only disclose securities held in long positions.
Wall Street's most famous short-seller, James Chanos, the investment manager renowned for calling Enron ahead of everyone else, now criticizes one plank of the SEC's rules forcing more hedge fund disclosures.
"Such a requirement is akin to the government suddenly requiring Coca-Cola to disclose their secret formula for free to all their competitors," Chanos says, calling the new rule "hasty" and ill-considered" as it "could be extremely harmful to the capital markets" (despite the fact that hedge funds cratering have in the past rocked publicly traded companies who have invested in them--more disclosure might have avoided that pain).
Also, in a bid to stop alleged false rumormongering thought to be driving down stocks, the SEC reportedly sent subpoenas to more than 50 hedge funds as well as other institutional traders believed to be engaging in naked short-selling trades in 19 financial companies, including the major investment banks and mortgage finance giants Fannie Mae and Freddie Mac.
The 19 had been previously protected by an emergency order against abusive "naked" short-selling (See my July blog "Get Shorty," and "Did the SEC's Plan to Get Shorty Work?")
In a "naked" short sale, sellers don't borrow the shares and thus do not have them physically in hand before selling them.
Now, in an attempt to curtail alleged trading abuses, the SEC released new rules against "naked" short-selling.
Short sellers and their broker-dealers must now actually deliver securities borrowed for short sales--or risk being accused of securities fraud and of being permanently barred from engaging in naked short selling.
The SEC's new rules apply to all stocks, beyond the 19 financial companies it had announced the initial naked short selling ban on in midsummer, which has since expired.
Arbitrary and Ad Hoc
The SEC initially instituted the ban on naked short sales in these 19 concerns because they had access to the Federal Reserve's primary dealer credit facility.
That decision met with a hailstorm of criticism accusing the SEC of regulatory apartheid, as the list of 19 excluded numerous beleaguered banks that have access to Fed borrowings, including Washington Mutual (WM) and Wachovia (WB).
Other Concerns Arise
"It seems particularly galling that many, many companies have asked for stricter short rules (Overstock.com, Bear Stearns, Lehman, a school bus-full of midcaps) and got nothing but ‘the market should be free to work on its own' from the SEC," says Fox Business news director Ray Hennessey. "Then Morgan and Goldman complain and all these new rules come" down.
Hennessey asks: "What do they [the new rules] accomplish? Does disclosing trades stop trading? And shouldn't the SEC have been looking for manipulation all along?"
Hennessey adds: "They [the agency] have subpoena power. If they feel a hedge fund is manipulating the market, they could easily get the trading records." He notes too that "asking every fund over $100 mn" to hand "over trading records seems draconian," noting it spells "more intervention in the markets."
Naked Short Selling Has Been Legal
Also, for years the SEC maintained that naked short selling was not illegal. SEC rules on short selling enacted in January 2005 said 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.
The SEC 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, naked short selling contributes to market liquidity."
The New York Stock Exchange has also said it has found no evidence of widespread naked short selling.
And after the initial ban was enacted on the 19 companies, SEC chairman Cox said in a July 24thop-ed piece in The Wall Street Journalthat "the SEC's emergency order is not a response to unbridled naked short selling, which so far has not occurred."
Does the Ban Work?
Some analysis suggests that the answer, so far, is yes.
As Bloomberg reported, the 19 companies on the SEC's initial list actually saw their market value climb 26% between July 15, the date the initial ban was enacted, up until the SEC let it lapse.
The companies added $270 billion to their market capitalization at the time, putting their market caps back to where they stood on March 17, the St. Patrick's Day shotgun wedding of the nearly bankrupt Bear Stearns and JPMorgan Chase, orchestrated by the Federal Reserve.
S3 Matching Technologies, a stock market research firm, has already reported that short sales for the 19 stocks dropped by a sizable 63% during the ban.
But it also says that short sales actually increased in shares of Bank of America while the initial ban was in effect, despite the fact that BofA's stock price rose from about $19 to $31 during the blackout period.
And Arturo Bris, a professor affiliated with the Yale International Center for Finance, analyzed short selling data from the Big Board in the 19 stocks on SEC's list for the trading period from Jan. 1 to July 15, 2008 and argues that the SEC didn't need to enact the ban in the first place.
Bris says that short-selling amounted to just 12% of the trades in the 19 stocks, versus 13% for comparable U.S. financial outfits.
Naked Shorting Can Be Called For
Naked shorting can arise when a stock is so illiquid and there are such a small number of shares outstanding, that trying to find shares to borrow can be difficult to arrange. Also, underwriters of initial public offerings or secondary stock offerings often have an over allotment of shares they place and trade that don't technically yet exist in the offering, so they make the trades through naked short positions, Fox Business's Hennessey explains.
Short-Selling Can Help the Stock Market
Short selling overall keeps potential hyperinflation in shares in check, due to, say, accounting abuses or the mania of momentum investors crowding in. Witness the dangerous bubble that has inflated in China's stock markets, as China has outlawed short selling.
And short sellers caught by Buzzsaw Ben Bernanke's dramatic slashing of the Fed funds rate can actually help the ensuing stock market rally even more when they cover their positions.
Remember, short selling occurs when traders have sold contracts that they didn't own, expecting prices to continue dropping. When prices start rising, traders must buy those contracts to cover their positions so as to keep a neutral position and stop their losses.
And as I've noted previously, corruption in the markets has been around since Adam. Rare is the critic of the Wall Street trader or analyst who crooks the buy trumpets and in turn is talking long his book, lining his wallet.
Reinstate the Uptick Rule?
Much criticism has been aimed at the SEC's decision to remove the uptick rule in July 2007 and not reinstate it since.
The so-called "uptick-downtick" rule said that traders can only short shares if the last trade of the stock is at least a fraction, or an uptick, higher than the prior trade. In other words, every short sale transaction had to be entered at a price that was higher than the price of the previous trade.
Traders say that rule tamped down volatility and prevented short sellers from adding to the downward momentum when shares are already experiencing sharp declines.
Much Ado About Nothing?
The fight over the uptick rule might be much ado about nothing.
The uptick rule never applied to certain financial instruments such as single stock futures, which tend to precede market movements anyway.
So even if the SEC reinstated the downtick rule for stocks, traders can still short the futures.
Other securities that were never covered by the uptick rule include currency trades or market exchange-traded funds like such as the Nasdaq 100 Trust (QQQQ), an ETF that trades on the Nasdaq or Select Sector SPDRs, ETF's that trade S&P 500 stocks.
The likely reason being, all of these securities can be shorted on a downtick as they are highly liquid and have enough buyers willing to enter into a long position, ensuring their values won't be driven into a ditch, market analysts note.
And even if the uptick rule was re-enacted, traders can synthetically short in the option market rather than shorting the stock.
Also, the SEC has conducted tests of the uptick rule on a sample of Russell 3000 stocks from May 2005 to August 2007 to see if it affected the level of short interest in these stocks. The SEC found that the restrictions "appear to have no effect on short interest" in these stocks.
In other words, the SEC found no evidence to reinstate the uptick rule.