Short Selling Regulations

Welcome to the most crucial period in American financial history. And the only persons who warned us about it first are the very same our government just took out of commission: the short seller.

How’d they do it? Was it really an overnight blow? Nope, not at all. They eased us into it. Giving us comment periods only after they, the honorable Senators, in concert with the SEC and Hank Paulson, “acted.”

And what’s going to be accomplished? The short sellers will have to cover their positions on the short side, and they’ll do so by making sales on the other side of the market: the long side.

In fact, in a tanking market, the shorts do a great service. They’ve got to buy shares to close out their short positions…and they buy them exactly when the longs are ready to sell at any price. So, that sucking sound you hear, that’s liquidity being siphoned out of the market.

To see where we’re going next (Clue: It looks a lot like how China runs its banking system), let’s see where we’ve been since July 21.

What the Naked Shorts Revealed: America’s Most Toxic

Upon those plummeting financials were set a plague of speculations known as the naked shorts — or so we’re led to believe. We now know it was just a checkmate to shut down the shorting market altogether.

On July 21, the SEC first banned naked shorting until Aug. 12. (We’ll skip the details on naked shorting for the moment, but know that it is a way to make money when stocks fall.) But take a gander at the SEC’s experimental test population: 19 very suspicious financial stocks on the “do not naked short” list:


Now, why these 19 stocks? The fear was that these naked shorts were coming up short — that is, that they failed to secure the stocks they needed to deliver, known as “failures to deliver.” (When a short seller closes a position, he must buy back the stock he sold.)


Get this: Only Deutsche Bank had hit a high failure-to-deliver threshold. The others, well, they certainly made excellent short targets: overleveraged, undercapitalized, and often poorly managed. They were all in free fall.

In the case of Fannie and Freddie, this ban was like a big “pause” button. So did our government attempt to stave off the bigger, more uncertain intervention: taking the GSE dirt onto America’s balance sheet.

Today, we know that Hail Mary play didn’t cut it. Fannie’s progression from just before the ban to the day of ban expiration went from $7 to $14 and back down to $8. Freddie: $5-$11-$5. Problem was, the SEC couldn’t change the facts.

Fannie and Freddie’s $100 billion capital hole was still a hole. These sick GSEs clung to Moody’s last “investment grade” rating before junk bond status.

No wonder when Fannie and Freddie turned to the Sage of Omaha for help, Warren Buffett took a pass. “The scale of help is such that I don’t think it can come from the private sector,” he told CNBC. Meanwhile, China and South Korea’s sovereign wealth just said no to Lehman Brothers shareholders — because nothing had changed on the balance sheet.

But how about those shorts? Arturo Bris, a professor at Lausanne, Switzerland’s, IMD Business School, kept tabs on shorts from January-July 15. The difference in shorting activity between the protected and nonbanned financial companies: a measly one percent. 12 percent of trades on the 19 companies were shorts — actually less than shorts of all U.S. financials, which clocked in at 13 percent of all trades. That’s a real crackdown! If those were all the shorts, how much havoc did the naked shorts really cause? There was something else at stake.

Semper Speculator: Remember the Short Seller

The hazard of the naked short wasn’t the issue after all, SEC chair Chris Cox admits in an op-ed to The Wall Street Journal on July 24: “[The ban] is intended as a preventative step to help restore market confidence at a time when that is sorely needed.”

So it was about hampering the free market. It wasn’t being caught naked. It was the fact that speculators were betting with such heavy confidence on the downfall of these former financial darlings. After that little test, Chris Cox promised that naked shorting on all shares could be banned in as little as two months — after public comment, of course.

On Thursday, Sept. 18, fast-acting Cox put a “100% zero tolerance” total naked short ban in effect. Broker-dealers had a three-day window in which to find those shares after they sell short or face charges of fraud. Your 30-day period for comment begins now, but that doesn’t matter.

The ban didn’t go far enough, see. Obviously, shorting was the sole threat to the “integrity” of this market. We need a real “time-out” for financials — or so said the government. Sens. Charles Schumer and Hilary Clinton hit up Chris Cox for a total ban. And they got it.

Now 799 financial stocks are protected from all short selling activities. So now our market’s “integrity” is inviolate and our confidence is boosted, right?

How is it right to outlaw — to criminalize — one brand of “greed” to protect the most heinous greed in recent history? Balance sheet-wise, this fiasco puts the government’s tab from the savings and loans scandal to shame. Today’s most recent tally has us sopping up this liquidity crisis for at least $314 billion. That’s $1,029 from your pocket that your government didn’t ask you if it could borrow. Ultimately, said Congressman briefed by the Treasury on Sept. 18, we could be on the hook for $2 trillion. It cost us only $125 billion to bail out hundreds of savings and loans institutions.

If we string somebody up, let’s make it the hard target. I want to see some of these CEOs and CFOs, or, heck, just a few fixed-income and quant traders, wearing prison pajamas.

Or, if there’s too much presidential fund-raising money at stake, could we at least to this:


Yes, that’s right, an alternative from the era of John Adams. Let’s bring back the custom of tarring and feathering the real criminals…I’ll bring the tar, who among you will throw the first batch of feathers?

Instead, I see a former Fannie Mae CEO, Franklin Delano Raines (responsible for a $6 billion accounting boondoggle), taking up the post of adviser to Barack Obama. I see Phil Gramm of the Gramm-Leach-Bliley Act of 1999 standing behind John McCain. In case you don’t recall, Gramm’s act broke down the walls between investment and commercial banks, brokerages, and insurance companies. Such freedom gave birth to unions like Citigroup and the very disasters on our hands today. And yes, Gramm was the fella who called us “a nation of whiners.”

What a thing for a former bank lobbyist to say. Guess we’re just not whining loudly enough.

Keeping an eye on our government,
Samantha Buker
September 22, 2008

The Daily Reckoning