Fly SwatterSwatting an Imaginary Fly
By THOMAS G. DONLAN
Memo to the SEC: Short-sellers aren't to blame.
THE STOCK MARKET WAS A SAFER PLACE last week and the financial system was somewhat less endangered. How do we know? The Securities and Exchange Commission ordained it.
"The SEC's mission to protect investors, maintain orderly markets and promote capital formation is more important now than it has ever been," Chairman Christopher Cox declared on July 15, as the commission took action to "stop unlawful manipulation through 'naked' short-selling that threatens the stability of financial institutions."
We pause for the obligatory definition: Short-selling is a trading tactic intended to provide profits if assets decline in price. The short-seller borrows the assets, such as shares of stock, and sells them in the usual way. As the great 19th-century market shark Daniel Drew declared, "He who sells what isn't his'n, buys it back or goes to prison." So the short-seller later buys replacement shares in the open market and gives them to whoever lent them in the first place. If the replacement shares can be purchased for less than the original shares were sold for, the short-seller keeps the difference, and is happy. The owners of shares are not so happy.
We also pause to mention to new readers that Barron's, sometimes known on the Street as "Bear-ons," prides itself on offering accurate negative news about companies as much as it does about passing on accurate good news. Good news is plentiful, and therefore cheap. Bad news has to be dug up, and indeed there are many who try to keep it buried, or bury those who make it known. Short-sellers read Barron's with special interest, and they also make good sources of information that our reporters can check and publish if true.
Mission Not Accomplished
Now back to the SEC. It is obvious that honest treatment of investors and orderly markets are important factors in capital formation, and that a capitalist society must have a government that enforces contracts. What isn't obvious from the news or from the historical record is whether the SEC understands its mission.
Does the SEC have its eye on the ball? Hardly. It is the agency that preserved and protected the shared incompetence of a few favored "nationally recognized" credit-rating agencies. It is the agency that watched while auditors became corporate consultants, selling the kind of services that audits should detect and report and eliminate, and even selling methods of hiding deleterious facts from auditors. It is an agency that attempts to regulate speech because it's easier than detecting and prosecuting fraud.
Rather than fixing any of the real problems with the agency and its mission, Cox and his fellow commissioners waved a newspaper and swatted the imaginary fly of naked short-selling. It made a big noise, but there's no dead bug.
Aggressive short-selling isn't a crime. Even naked short-selling -- selling shares before borrowing them -- hasn't been against the rules. Until last week, a short-seller could enter a naked trade in almost any stock if his broker had reasonable grounds to expect that an adequate number of shares could be borrowed by the day of settlement.
For now, the commission has applied its new discipline only to trading in shares of 19 large financial companies, of course including Fannie Mae and Freddie Mac, which were the last two companies listed -- as if they were of the least importance.
Yelling "Fire"
The SEC also denounced false rumors and undertook to fish through traders' e-mails and phone records in search of rumor-mongers. Its reasoning was simple:
"False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by "naked" short-selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price-discovery process. If significant financial institutions are involved, this chain of events can threaten disruption of our markets."
The SEC cited the example of Bear Stearns: "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 late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms."
Talk about putting the cart before the horse: The SEC has formally declared that false rumors drove Bear Stearns over the edge. In fact, as even the commission's version of the sorry tale makes clear, the rumors were true. The falsehoods were told by Bear Stearns spokesmen, who declared that everything was hunky-dory.
The new investigations and regulations aren't designed to protect investors, but to deceive them. The SEC decided to support the market reputations of 19 banks and other financial institutions in the face of well-warranted criticism.
Yelling "fire" in a crowded theater is a terrible thing to do -- unless there's a fire.
Encouraging Caution
Markets can be dangerous, and investors should be aware of the dangers. Protecting the proverbial widows and orphans has a cost, because markets efficiently relate returns to risks. No risks, no returns.
Placid, protected markets where no news is good news aren't safe anyway. They will seize up in the face of new information. They will not evaluate truth or falsity and they will not clear the changed market with changed prices. Investors will have less security because of the effort to swaddle them.
While the SEC was considering its rules about short-selling, another declining stock market was facing an extreme reaction to its lessons about risk and reward. The Pakistani markets, neither deep as a well nor wide as a barn door in the best of times, has fallen substantially in the past few months. Some punters who like risk and reward, but not risk and ruin, burned piles of old tires in front of the Karachi and Islamabad exchanges, trying to shut down trading to avoid further losses.
That's not the kind of market America needs, but the SEC is working to create it: 19 stocks affected now; how many next week?