SEC Says Naked Shorts Are Out of Style

On July 21, the Securities and Exchange Commission instituted an emergency order requiring that the shorting of stocks of 19 U.S.-based financial institutions be contingent on a “pre-borrow requirement.” Last week, the SEC allowed the stopgap measure to prevent naked short-selling to expire.

Short selling, the sale of securities that a trader does not own but hopes to buy back later at a lower price, is a legitimate and lawful tactic that may temper speculative excess as shares in highflying stocks are sold short, and brace the fall of a damaged stock as the short sales are “covered,” or bought back. But the short sale of shares that do not necessarily exist, known as “naked shorting,” violates stock exchange and SEC rules, and, if coupled with the spreading of malicious rumors, is illegal and manipulative and can damage companies and stock markets.

The SEC is considering implementing more permanent changes this week to curb naked shorting, including a “circuit breaker,” as MarketWatch calls it, that would halt short sales  when a given stock falls by a certain percentage within a particular time  period.

Between July 21 and 30, 10 of the stocks protected by the SEC’s stopgap measure gained in price per share, including Credit Suisse and Bank of America, while nine fell, including Merrill Lynch, Lehman Brothers, UBS and the mortgage companies.

But the protection against naked shorting may be more bane than boon. A study directed by Arturo Bris, a professor of finance at Lausanne, Switzerland’s IMD business school, showed that the SEC’s emergency order “contributed to a decline in share prices for the 19 stocks,” for a total of some $60 billion in losses, reported The Wall Street Journal.

The SEC’s effect on ETFs
Trading in options on ETFs, or exchange-traded funds, surged over the 23-day period, however. The options market “allows investors to bet against stocks without going through the process of borrowing them first,” The Wall Street Journal explains.

Seeking Alpha’s Greg Newton described in an Aug. 1 article on Seeking Alpha the performance of leveraged/inverse ETF provider Pro Shares’ fund SKF in light of rumors about, and the later implementation of the SEC’s new rule. Between July 15 and July 25, the fund’s worth increased from $2 billion to $3.4 billion. But Pro Shares’ double-long financial ETF UKG fell 20 percent over the same period, “when financials ripped higher after SEC chairman Christopher Cox’s announcement of an emergency order.”

The Pro Shares Trust Ultra Short Financials ETF tries to earn double the inverse of the Dow Jones’ showing on a given day—so the fund does twice as well if the markets drop.

The Wall Street Journal cites data from OptionMonster showing Pro Shares’ average daily trading volume had almost quadrupled since July 15.

Good start, but not good enough
Former SEC commissioner Roel Campos wrote in Forbes on July 31 that the SEC’s stopgap measure against short selling was “commendable,” although it should be extended to all banks rather than major Wall Street players. “In the current market environment, the failure of many small companies on America’s Main Streets can just as easily threaten the U.S. economy,” he argues.

Edward Yingling, the president of the American Bankers Association, had views paralleling those of Campos, saying in a statement quoted in a July 30 MarketWatch article that any bank not part of the elite 19 was a likely target for naked shorting.

Another SEC move
Last month’s decree was not the only recent move by the SEC to combat naked short selling. The SEC instituted Regulation SHO in 2005, which stipulated that stock brokers cannot take an order to sell short without verifying the existence of a stock.

But The Motley Fool’s Karl Thiel wrote in March 2005 that the guidelines were inadequate: “The result of the SEC’s effort so far has arguably been to turn rampant abuse into a spectator sport by simply providing a list of stocks being most abused, and doing little else.” 

The rise of the Internet and the subsequent advent of instantaneous communication “have made it easier to spread false rumors, but traders also know, or should also know, that the risk in flogging false information is also greater than ever,” writes The Wall Street Journal’s L. Gordon Crovitz.

Naked short sellers allegedly helped spark the downfall of Bear Stearns, the onetime investment banking stalwart that as Vanity Fair put it, was Wall Street’s “tough-guy loner” who was “wearing its beat-up leather jacket and nursing a cigarette.”  The bank saw its stock tumble to a stunningly low price, apparently the result of a “bear raid,” or a pack attack by naked short sellers betting against the stock and spreading rumors that the bank would fail.

In the SEC’s statement on its measure, it directly mentioned the case of Bear Stearns as motivation: “During the week of March 10, 2008, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. As Bear Stearns’ stock price fell, its counterparties became concerned, and a crisis of confidence occurred.”

An unnamed investment bank executive told Vanity Fair, “I don’t know of any firm, no matter the capital, that could have withstood that kind of bombardment by the shorts. This was not about capital. It was about people losing confidence, spurred on by rumors fueled by people who had an interest in the fall of Bear Stearns.”

Naked shorting has also been alluded to as one reason for Fannie Mae and Freddie Mac’s recent stumble.