Market rally due to short-selling ban: Sprott

Date: Friday, September 19, 2008
Author: John Partridge, Globe and Mail

Eric Sprott thinks most of the massive rally in world equity markets is due to temporary bans on short sales of financial services stocks already imposed by U.S. and European regulators.

“I suspect most of today's rally is because of the change in the short-sale rule,” the hedge fund manager said Friday in a telephone interview. Canada's key market regulator continued to deliberate whether to follow the lead of Britain's Financial Services Authority, the U.S. Securities & Exchange Commission and other regulators.

“You can see what stocks went up the most: they're financial stocks,” said Mr. Sprott, who heads Sprott Asset Management Inc. in Toronto, acknowledging that his firm has had “to take a bit of a hit here.”

Short-sellers borrow and then sell stocks in the belief that their prices will fall, enabling them to go back into the market later and replace the borrowed shares at lower cost and pocket the difference as profit.

However, the temporary bans have forced practitioners back into the market to cover their positions by buying up the stocks they have sold, thus driving up the prices demand for those shares.

Many market players and observers have blamed massive short-selling for decimating the stocks of several U.S. financial industry pillars, pushing them to the brink of insolvency.

In an emergency order issued late Thursday, the SEC said recent market conditions have made it concerned that short-selling of a wide range of financial stocks “may be causing sudden and excessive fluctuations of the prices of such securities in such a manner as to threaten fair and orderly markets.”

“Such price declines,” it added, “can give rise to questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence, without a fundamental underlying basis.”

The move against short-sellers is just one of an array of measures taken by the U.S. government and central banks and market regulators around the world as they seek to stave off the worst financial crisis since the Great Depression. Central banks have pumped tens of billions of dollars into the banking system and Washington has unveiled plans to help banks shift bad real-estate loans off their books as well as moving to protect the value of money-market funds.

Whether or not the Investment Industry Regulatory Organization of Canada (IIROC) plans also to impose a temporary ban on short sales was still unclear as Friday wore on.

The matter is still “under discussion,” Paul Bourque, IIROC's senior vice-president of enforcement, policy and registration, said in a mid-morning telephone interview, reiterating a statement he made before the opening bell.

Mr. Bourque's comment was echoed by Jean St-Gelais, the head of Quebec's securities regulator, the Autorité des marchés financiers. “We have to see if we have a problem in Canada, first,” he said after speaking to a conference on corporate governance and financial markets in Montreal.

The key is to co-ordinate efforts with the various regulatory organizations around the globe, he added. “Everyone right now is looking to take quick action but without improvising,” he said.

However, Mr. Sprott, who opposes the clampdown, figures Canadian regulators are almost sure to follow suit.

“They're on the team, aren't they, with the U.S. and the U.K.?,” he said. “The authorities are changing the rule book because the rules aren't working for them. I'm disappointed that they have had to go so far.”

“Legitimate” shorting of financial stocks is “a portfolio technique to support you in difficult financial markets, which we are in for sure,” Mr. Sprott added.

The hedge fund chief also said, however, that he firmly supports bringing back the so-called uptick rule, a 69-year-old regulation that the SEC dropped in July 2007.

Under this rule a short sale could be made only after an uptick, or rise, in the price of a stock, which meant that shorts could not pile into a stock in an unbroken freefall. The SEC felt the rule was a constraint on market liquidity and did little to prevent market manipulation. But critics say the removal of the rule has left the market a more volatile and risky place.

Mr. Sprott agreed. “I don't know why people got rid of that rule, it just seems ridiculous,” he said. “I'd like to see that enforced.”

As IIROC continued its deliberations, at least six Canadian banks and insurers whose shares trade in New York as well as in Toronto have already won at least partial protection against the shorts by being included on a list of about 800 financial services stocks covered by the 10-day ban imposed by the SEC. They are: Royal Bank of Canada, Bank of Nova Scotia, Manulife Financial Corp., Sun Life Financial Inc., Fairfax Financial Holdings Ltd. and Kingsway Financial Services Inc.

Meanwhile, Switzerland's stock exchange issued what it called “reminder” to its members Friday that so-called naked, or uncovered, short-selling is not allowed and said it will monitor the situation strictly. In a naked short transaction, a trader sells shares before actually borrowing them.

Mr. Sprott dismissed the rules against naked shorting most jurisdictions have long had on the books as a “joke,” because regulators have simply failed to enforce them. “I think the naked shorting of Canadian stocks has been quite significant,” he added.

The SWX also warned market players that “the spreading of rumours of a nature that violates the applicable rules of conduct is also forbidden.”

However, it also said that covered shorts, where the trader has actually borrowed the shares, “remain fundamentally permissible.”

As it happens, the volume of short-selling on the Toronto Stock Exchange has been declining since peaking at a total of just under 1.43 billion shares on March 31. As of Sept. 15, the total number of shares sold short on the exchange had fallen to just over 1.2 billion.

As well, fortnightly figures compiled by the exchange show that no bank or other financial services stock has cracked the list of the top 20 largest short positions on the exchange since July 31, when Canadian Imperial Bank of Commerce came in at No. 20.

The perennial leaders include such companies as Nortel Networks Corp., Rogers Communications Inc., Research in Motion Ltd. and Bombardier Inc.

However, I-Shares Canadian S&P/TSX 60 Index Fund took over the top spot with the largest short position as of Sept. 15, up from sixth largest at Aug. 31.

With files from reporters David Parkinson in Toronto and Bert Marotte in Montreal