The Securities and Exchange Commission took the dramatic step of banning for ten days short-selling on 799 financial stocks.

And of course with any hastily planned regulatory intervention, potholes have opened. And ironically, the SEC's new ban giving shelter to the 799 financial companies is also protecting famous short-seller David Einhorn from the shorts.

The SEC's ban could be extended for up to 30 days, and comes after Wall Street executives say short sellers have caused catastrophic declines in stock prices that have led to the downfall of Bear Stearns, Lehman Bros, and American International Group.

The SEC's moves follows close on the heels of Great Britain's decision to ban short selling in 29 stocks until the end of the year. U.K. investors have accused short sellers of causing shares in HBOS Plc to plunge before it entered into a $18.9 bn takeover by Lloyds TSB Group Plc.

Short-sellers profit from falling share prices. They borrow shares from brokers and then sell them. When the price declines, they turn back the shares at the lower price and pocket the difference. In a naked short sale, the short seller does not borrow the shares and physically have them in hand.  

Some $3 tn was wiped from stocks globally this week as financial shares plunged, causing the SEC to go on the offensive.

The fear is that shorts are causing massive price plunges, triggering credit downgrades, slamming capital and forcing companies to sell assets at garage-sale prices. (See "Get Shorty," "Did the SEC's Plan to Get Shorty Work?," and "Still Trying to Get Shorty.")

The SEC acted after it met with heated entreaties to intervene from Wall Street executives including Goldman Sachs Group (GS) chief executive Lloyd Blankfein and John Mack, chief executive of Morgan Stanley (MS).

A stock price plunge in recent days could still force Morgan into the arms of a commercial bank like Wachovia (WB). Short interest in Morgan Stanley is triple the levels of a year ago. Both Mack and Blankfein have discussed short sellers five or six times in the last week, Mack told employees.

In taking the emergency action, the SEC says it wants to "prohibit short selling in financial companies" to protect the integrity of the securities market and boost investor confidence.

Who is on the List?

Wall Street titans Morgan Stanley, Merrill Lynch (MER), Citigroup (C), JPMorgan Chase (JPM) are on the SEC's new list, as are Washington Mutual (WM) and Wachovia (WB). The SEC had met with criticism in mid summer when it initially banned a form of short selling in 19 financial stocks and left off the list Wamu and Wachovia. 

Damaged bond insurers Ambac Financial (ABK) and MBIA (MBI) also made the list, which couldn't have come too soon as Moody's Investors Service once again just placed the ratings of Ambac and MBIA on review for possible downgrade.

Warren Buffett's Berkshire Hathaway (BRK) is on the list, Blackstone Group (BX) is on it, as are beaten-up companies E*Trade Financial (EFTC), Dollar Financial (DLLR) and Conseco (CNO).

SEC Protects Famous Short Einhorn From the Shorts

Even Greenlight Capital (GLRE), the reinsurance company that is a wing of famous short David Einhorn's hedge fund Greenlight Capital, is on the list. Einhorn earlier this year made his case for shorting Lehman Bros., arguing the now-collapsed firm was engaging in questionable accounting ("What to Watch Out for at Lehman Brothers," "The Fire-Engine Red Flags at Lehman Brothers," and "Questions About Lehman Brothers Continue to Mount").

Not on the list: CIT Group (CIT), now asking the SEC to be put on the list.

Market analyst Paul Kedrosky, who writes for the website SeekingAlpha.com, notes ironically that Lehman is on the list, though it is in bankruptcy status, that the SEC has Silver State Bancorp on the list, though it's a failed bank already seized by the FDIC, and that the SEC is blocking shorting of NAHC. That ticker doesn't exist, unless it stands for the Nigerian Aviation Holding Company, Kedrosky says wryly.

The Crackdown

The Securities and Exchange Commission is also clamping down on "naked" short-selling, where the underlying stock in a short sale is neither borrowed nor delivered by the short-seller. The SEC is not outlawing the practice.

Instead, short sellers and 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 moves comes fast on the news this week that the SEC has subpoenaed 50 hedge funds to find out if they were engaging in rumor mongering in order to drive down shares in 19 financial companies they had shorted in naked short sales to book a profit.

Hedge Funds Must Confess

The SEC now wants to force hedge funds to make disclosures of daily short positions, a move that would let regulators assess the impact of short-selling at funds with $100 mn or more.

Currently shorts file forms with the SEC that disclose their long positions and options on a quarterly basis. In the past, the hedge fund industry has gone so far as to sue the SEC to stop any regulation of the industry, litigation which could arise again.

The disclosures may help, though famous short James Chanos, who blew the whistle on Enron, says it would be the equivalent of forcing Coca-Cola to reveal its secret formula.

Check out the most recent filing from Greenlight Capital, run by David Einhorn, who raised serious questions about accounting problems at Lehman. Einhorn gave speeches and went on t.v. with his criticism, but his latest filingonly shows about 581,000 in put options on Lehman, with little else detail.

Other Moves to Get Shorty are Underway.

After writing to 60 other pension funds asking them to follow its lead, the largest U.S. public pension fund Calpers, the California Public Employees' Retirement System, said it is no longer lending out shares of financials like Goldman, Morgan Stanley or Wachovia to short. New York State and Texas pension funds are considering similar moves.

And New York Attorney General Andrew Cuomo said he was opening investigations into short sellers who he believes are engaging in false rumor mongering to manipulate stocks down in order to take profits. Cuomo went so far to say he'll use the state securities-fraud law to go after short sellers, the Martin Act, which permits criminal and civil actions.

Marking to Taxpayers

The SEC's emergency ban on shorting coincides with the US government's announcement that it will set up a Resolution Trust-type entity, harking back to the S&L crisis, that would act as an assisted living facility for financial companies across the country, a mega-dumpster for their toxic subprime waste.

Now Wall Street and other banks would not have to pricetag these toxic assets and record losses on their own, an accounting endeavor called "marking to market," which lately is the equivalent of sticking a finger in the wind.

Instead the government is "marking to taxpayers" these assets.

A so-called mega bad bank structure for thousands of banks around the country, a structure that Lehman desperately clung to in its final hours. An entity far different from the RTC structure of the S&L crisis, where the government got assets dumped on it from insured thrifts that had bellyflopped, then liquidated them.

The new entity would buy frozen solid assets from banks and then sell them, likely at auction, into the market.

The move might entail an $800 bn fund to purchase these so-called failed assets and a separate $50 bn pool at the Federal Deposit Insurance Corp. to insure investors in money-market funds, as a mini-run on these funds is now underway.

Takes the Pressure off the Federal Reserve

Setting up this government warehouse would take the pressure off of the Fed's discount window, now strained with record bank borrowing.  The Treasury in the past two days announced $200 bn in special bill sales to help the Fed expand its balance sheet.

Already banks around the world have taken more than $510 bn in writedowns and losses from the housing and credit crisis. Wall Street created about $1.2 tn of subprime mortgage-backed securities, some $200 bn to $300 bn are now thought to be sitting at FDIC-insured banks and thrifts.

It's estimated that Citigroup, JPMorgan Chase (JPM), Bank of America Corp. (BAC), Goldman Sachs Group Inc., Merrill Lynch & Co. (MER) and Lehman Brothers had more than $500 bn of the most illiquid, toxic stuff, the so-called Level 3 assets as of June 30, according to research firm CreditSights Inc.

Markets Soar on the News

The governments' moves have sent the markets soaring. Shorts now are racing to cover their positions, helping to send stocks higher as well.

Volatility is hitting record levels. The closely watched CBOE Volatility Index, the VIX or the Fear Index, has easily blown through the 30 ceiling in recent days,  and briefly rose higher than 42.

The Potholes in the SEC's Moves

A heated debate is now underway over the SEC's ban, namely, that the companies under attack were rightfully shorted as they are insolvent, reflected in their stock prices.

An insolvency some say may have been inadvertently created by the SEC itself, as the agency did not do enough to force Wall Street firms who shoved debt into off-balance sheet vehicles that many thought went the way of Enron. The agency also is being criticized for not doing enough to get Wall Street firms to bolster their capital cushions, and instead let five firms weaken their capital positions (see blog "Still Trying to Get Shorty").

The question too is when the SEC is going to pursue executives of defunct companies, or companies now on life support, when they've walked away with lucrative compensation packages they won after their companies essentially reported artificially higher profits from their management decisions.

Another irony, too, is that shorting selling has fueled the profit engines at the very Wall Street firms now complaining about the practice, including the big, bulge-bracket broker dealers like Morgan, Goldman and Merrill. The SEC's move too would ban the investing strategies used by hundreds of mutual funds, hedge funds, pension funds, endowments and governments.

Also, short sellers can still short synthetically, via puts, exchange traded funds that carry many of the names on the SEC's list of 799 companies via the option market. And market analyst David Merkel warns that the SEC's move could hurt in the interim merger arbitrage funds, statistical arbitrage funds and other quant funds. He also warns that the implied volatility for put options would go up.

It's unclear now whether the collapse of Bear Sterns, Lehman Bros. and AIG, and the near demise of Merrill Lynch, Fannie Mae and Freddie Mac were caused largely by short sellers. Gut-clenching price declines on a daily basis of 40% in companies thought to be healthy should give you pause.   

Crisis of Confidence

Our equity and credit markets are suffering from a crisis of confidence that touches all securities and all investors across the country.

It is a crisis of confidence exacerbated by the news that Lehman Brothers wanted to suddenly double the dollar amount of its Kryptonite assets shoved into a bad bank structure in a matter of days, from $40 bn to $80 bn.

It is a crisis of confidence aggravated by the news that American International Group can now borrow up to $85 bn in a credit facility from the Fed, more than double in a matter of days what it said it needed, $40 bn.

It is a crisis of confidence worsened by the news that Congress had to hire Morgan Stanley to go find out what landfill was sitting on the books of Fannie Mae and Freddie Mac.

It is a crisis of confidence over solvency.

And over the fact that our nation's financial chieftains really don't know what they are doing.