The New SEC Illegal Short Selling Law: Does it Really Do Anything to Help Solve our Financial Crisis?

September 19, 2008

Today, before market open, the SEC announced that all short selling on U.S. financial stocks will be illegal for an indefinite and unqualified period of time (Update: actually the SEC has now qualified the period as ending on October 2, 2008 since I first wrote this article, though they have declared that they may extend this date beyond October 2nd if necessary. I believe that there is a strong possibility that the SEC will extend this expiration date at least one more time after October 2nd until at least after the U.S. Presidential election passes.- editor’s note). In a nutshell, the Securities Exchange Commission, because the free market is not cooperating with their wish of having the U.S. stock market rally, has forced all short sellers to immediately cover all short positions on all U.S. financial stocks. If you’re shorting a U.S. regional banking ETF like the KBE, expect to be hammered again today, but don’t expect Friday’s market action to be indicative of reality. U.S. financial stocks across the board are experiencing a forced but illogical massive short-covering rally that should be a temporary phenomenon.

Short sellers of financial stocks were given no choice but were forced collectively by the SEC to make all financial stocks appreciate in price considerably. This action was tantamount to passing a law that would set a forced temporary floor for all U.S. financial stocks. For example, if a U.S. financial stock was trading at $14 a share last week due to supposed free-market efficiencies of all available information about that company, the SEC’s actions were almost the same as putting a law on the book stating that it is now illegal for this share to trade any lower than $18 a share. It’s forced and it won’t last. I’m not saying that steps shouldn’t be taken to fix the U.S. financial sector because they must be taken immediately. But this is not a proper nor effective solution by any means.

After this weekend, on Monday, the U.S. Federal Reserve, the U.S. Treasury and other U.S. regulatory agencies are expected to make another bombshell of an announcement that discusses the spin off of all U.S. financial companies’ bad debt into separate companies, and the consequent declaration that all U.S. financial companies are now healthy because their bad debt has disappeared. Of course, the bad debt will not have disappeared at all, as one could spin off all the debt of any bankrupt or financially ill company, and it really does nothing to address nor solve the problem. Still, these proposed actions will fool most of the people most of the time and the announcement that is coming on Monday probably will. If so, we really could receive a 100% irrational financial sector rally that will only collapse into ashes six months from now.

The following is the statement the SEC posted on their website today:

“Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.”

This explanation is comical and 100% deceitful because short selling now is revealing the true health of stocks in the U.S. financial sector. It is the truth and price efficiency that the SEC wishes to obliterate and destroy through this new law.Further deceitful comments from industry executives also mislead investors. For example, Phil Orlando, New York-based chief equity strategist at Federated Investors Inc, which oversees $334 billion, stated in response to the new SEC law: “You had a lot of the hedge funds ganging up on these financial companies and putting them out of business.” What put these financial companies out of business is not short selling. To claim so is ludicrous. The enormous risk appetite of these companies for derivative products that created massive short-term profits and fat paychecks for executives, but are now imploding today, is what put the financial companies that have failed out of business. It is the very arrogance of executives like Phil Orlando to recognize true fault and to assign true responsibility for this crisis that is guaranteed to make the crisis worse instead of solving it.

Why didn’t people like Phil Orlando call for a ban to call options and a ban on buying of additional shares on financial stocks (I’m being sarcastic here) when all financial stocks were being bid up to ridiculous valuations based upon risky but highly profitable (back then) investment derivative products that had an extremely high probability of being deemed worthless a few years down the road? If they had declared, “these valuations are madness given all the toxic waste we have on our balance sheets!”, then perhaps investors would have understood the crisis better a few years ago, share prices of financials would have dropped significantly, and the madness would have been stopped as financial companies would have been forced to halt their risky practices and start repairing their balance sheets years earlier. More importantly, had this happened, the average investor would not have suffered any huge losses that resulted from the deception of these executives.

They were silent because the executives at the highest level of banking and Wall Street institutions were making money hand over fist even though they knew that hiding the risk of these derivative products would lead to the debacle we are experiencing today. How do I know that those on Wall Street knew that today’s situation was inevitable given their foolish greed and risk appetite over the last decade? Because I had been calling for this event to happen since October of 2006 on my investment blog and so had a handful of others. If, as outsiders we were able to see this coming years ago, then I have no doubt all Wall Street insiders knew the grave implications of their greed as well. However, just as a ban on buying financial stocks would not really have been the solution back then, this ban on short selling is equally foolish. Besides artificially creating grossly distorted share prices for all financial stocks, does the ban on short selling fix any of the problems that led to this crisis? No. Oh, I’m sure that it will fool some investors into buying financial stocks of companies, but that is called deceit, not a solution.

Short selling actually exposes hidden and covered-up weakness of companies that are real. If they are not real, then the fundamentals of a stock would lead the stock higher and the short sellers would be wiped out. Short sellers can not force the price of a financial stock lower in the event of record earnings and profits or in the event that a financial company is truly healthy as the SEC ridiculously claims. But short selling can force the price of a financial stock much lower if losses keep piling up as has been the case for the U.S. financial sector. There is no reason for short sellers to be short other than the fact that they see the true position of a company and know that the company stinks, period. This not only provides important information to other investors that may own a lot of this stock but it also can alert an investor that a company is not as healthy as he or she believes and therefore will prompt the investor to conduct more research on the company that otherwise he or she would not have been undertaken. Thus, the process of short selling actually helps investors get out of a precarious stock position BEFORE a stock tanks, helps them save money and provides invaluable information to possess in the workings of a free market.

With this new law, every single financial stock’s price will have ZERO bearing on their financial soundness. Every single financial stock’s share price will be massively and grossly distorted and have no representation at all upon their financial health. I guess the SEC believes that if they pass laws that force the price of financial stocks higher without actually doing anything to solve the massive problems that have so far led to the failures of Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, and that will eventually cause the failures of hundreds of smaller banks and most probably at least one colossal U.S. bank, that they can fool the world into thinking the financial crisis is over when it is just getting started. The only thing this new rule does is now prevent an investor from having access to a valuable tool that would warn them to sell a stock before its share price takes a precipitous dive.

The average investor has again been severely handicapped by this massive free-market intervention and now instead of a financial stock tanking from $85 a share to $4 a share over several months when short selling was legal, a financial stock may actually tank from $85 a share to $4 a share in two weeks without any warning. Massively bad surprises in share prices will now become commonplace as industry insiders most likely secretly offload their shares at these higher forced prices (and don’t think that there is a way for you to know if insiders are offloading shares because again the SEC has granted executives so many loopholes in their regulations that insiders can offload massive blocks of shares in secretive manners that are never reported on the insider selling reports that most investors track.) The SEC, the U.S. Treasury and the U.S. Federal Reserve, and the CFTC are the biggest manipulators of them all. Do we have any precedent for the likely long-term outcome of this new law?

Of course. The SEC’s actions today are similar to the forced rally last July in financials when they passed a law that outlawed naked shorting of Fannie Mae and other select financial institutions. Back then, that temporary law manufactured a “false” rally in Fannie Mae stock of the magnitude of an incredible 153% gain in share price in just a six day trading period. Unheard of, but when a share price is forced higher by forced short covering, anything is possible. What happened next? Less than 12 trading days later, Fannie Mae lost 98% of its value and rightfully so as it was and had been bankrupt for all intents and purposes for at least six months.

If the argument the SEC has made is valid – the one that all short selling is manipulative rather than helpful in determining a fair market price for a stock, why would they not ban short selling on all stocks across all sectors in the United States? All of their hot air about such laws as necessary to save the economy is easily exposed as seriously flawed when you consider that they chose only one sector to ban short selling – the financial sector (the UK also passed similar laws in their stock markets banning short selling only in the financial sector as well). My questions to SEC Chairman Christopher Cox are the following: Are not automobile companies being hurt by short selling? Are not mining stocks hurt by short selling? Is not the retail sector being hurt, or in the SEC’s words, “manipulated” grossly by short selling? The reason that the SEC has chosen to only help out Wall Street and U.S. financial institutions is driven by their highly improper relationships with the financial sector and the fact that a former Goldman Sachs CEO heads the U.S. Treasury. If the former General Motors CEO headed the U.S. Treasury, it would be no stretch of anyone’s intellect to assume that all short sales on the automobile sector would be illegal right now as well.

So know that ZERO has been fixed in the U.S. financial sector and even with their “surprise” announcements after the weekend and declarations that all problems in the U.S. financial sector are fixed, don’t believe the hype. I guarantee you that their non-solutions are only delaying the crisis and making it worse. Grade this move, Foolishness – 1; Real Solutions – 0.

[tags]illegal short selling of financials, SEC, U.S. financial crisis[/tags]

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