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Did It Help to Curb Short Sales?

Date: Wednesday, August 13, 2008
Author: Floyd Norris, The New York Times

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A rule that made it harder to short some financial stocks — and that may have helped raise prices and reduce the volume of shorting in those stocks — expired Tuesday, as the Securities and Exchange Commission considers whether to tighten the rules on all short selling.

It may be a coincidence, but the announcement of the rule on July 15 coincided with the bottom of the bear market for financial stocks, which leaped that day and are now well above where they were. And the final day proved to be a very bad day for those shares.

But individual performance varied widely, as would be expected given the variation in news on the companies involved. The period included passage of legislation to let the government bail out two of the companies — Fannie Mae and Freddie Mac — and take other steps to ease the mortgage crisis. Tuesday’s fall came after JPMorgan Chase warned of continuing losses.

The S.E.C.’s temporary order tightened the short-selling rules for 19 stocks, only 12 of which have major markets in the United States rather than overseas. On average, those 12 rose 23 percent from the time of the announcement through Tuesday, about the same as the overall market for financial stocks. The Standard & Poor’s index of all financial stocks in the S.& P. 500 rose 22 percent.

But many banks did even better. The 10 largest banks and brokerage firms that were not on the S.E.C. list rose 40 percent over the same period.

All or most of the gains for stocks on both lists came before the rule actually took effect, on July 21. Since then, the average stock subject to the rule is down 8 percent, while the 10 other companies have gained 9 percent on average.

The S.E.C. promised to study the impact of the rule, but it has not made any data available. The exchanges collect short-selling data twice a month, making it possible to see how many shares of each company were shorted through a given date.

In the period from the end of June through July 15 — the period just before the S.E.C. acted — short positions on the 12 companies covered by the rule that have major American markets rose by an average of 19.3 percent. By the end of the month, the average had fallen by 8.4 percent.

By contrast, short positions on the 10 stocks not on the S.E.C. list rose by a smaller 5.8 percent before the rule was announced, and rose by 7.2 percent more in the next period. That could be taken as an indication that the rule curbed short selling in the stocks affected by it, but it also could indicate that short sellers were intimidated by signs that the government was determined to keep many of the companies in business.

Or it could mean nothing. The range of the changes in short position was very wide among both groups, as might be expected as traders weigh the various prospects of the companies.

Short sellers, traders who bet against a company’s share price, are supposed to borrow shares and then sell them, leaving themselves in a position to profit if the share price falls.

Short sellers have often been blamed when share prices fall, and the criticism was especially strong this year when stocks of financial companies — including those that governments feel are vital to the financial system — began to fall sharply amid disclosures of losses brought on by the widening credit crisis.

The S.E.C.’s action required that traders in certain stocks — Fannie Mae, Freddie Mac and 17 primary dealers in Treasury securities — could not sell them short without having arranged to borrow the stock.

Under normal rules, traders must identify shares available for borrowing, but need not actually arrange the loan until after they place the order.

In some companies, that practice, called naked shorting, is thought to be widespread. There, shares are sold short without actually borrowing them. The short seller faces the same potential losses if the stock rises, but can save the costs of borrowing the stock.

In announcing the S.E.C. action on July 15, the commission chairman, Christopher Cox, said it was needed to protect investors and banks. “Today’s commission action aims to stop unlawful manipulation through naked short selling that threatens the stability of financial institutions,” he said.

But there is no evidence that there had been a lot of naked shorting in those stocks. The exchanges publish lists of stocks in which there were large numbers of failures to deliver shares at settlement, a situation that can be caused by naked short selling or by a number of other factors.

Of the S.E.C. list of 19 companies, only Deutsche Bank, the German company, has recently been on the exchange’s lists of companies with large failures to deliver. Even that listing is misleading, because the number of failures is being measured against the relatively small number of shares registered to trade on the New York Stock Exchange, rather than the total number of outstanding shares.

For major investors, including hedge funds, naked short selling of most stocks would be stupid, as well as against the rules. Normally, when a stock is borrowed, both the borrower and the institution or brokerage firm that lent the shares make money, because they split the profits that come from investing the proceeds of the short sale. In heavily shorted stocks, however, the cost of borrowing sometimes exceeds those profits, giving traders a financial incentive to sell short without borrowing.

Mr. Cox has said that the S.E.C. is considering tightening rules on short selling, perhaps extending to all stocks the temporary requirement to arrange the borrowing beforehand. He has also said that the commission might revive the so-called uptick rule, which required that short sale orders be entered at a price that is higher than the most recent trade at a different price.

That rule was supposed to keep shorts from driving prices down, but some argued it became irrelevant after prices were allowed to move in penny increments, rather than increments of 12.5 cents, or an eighth of a dollar. The change meant that a short seller would suffer little harm even if the price did edge up by a penny before the trade was made.

The S.E.C.’s list of stocks included nine American companies — Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, Freddie Mac and Fannie Mae. It also included two Swiss banks, Credit Suisse and UBS, whose shares are frequently traded in the United States and were included in the performance calculations.

The fact that 10 of the 17 primary dealers in Treasury securities are headquartered outside the United States provided one sign of how global the financial markets have become. They are no longer dominated by American firms, as they were a generation ago.

The other companies, which were not included in the calculations, included three banks based in Britain, Barclays, HSBC and Royal Bank of Scotland; two Japanese firms, Daiwa and Mizuho Financial; two German ones, Deutsche Bank and Allianz; and one French bank, BNP Paribas.

The 10 American firms used in the comparison were Wells Fargo, US Bancorp, Bank of New York Mellon, Wachovia, State Street, PNC, Charles Schwab, BB&T, Capital One and SunTrust Banks.