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Fox Business: Did the SEC’s Plan To Get Shorty Work?


https://emac.blogs.foxbusiness.com/2008/08/14/did-the-secs-plan-to-get-shorty-work/
August 14, 2008 7:33AM
Did the SEC’s Plan To Get Shorty Work?
By Elizabeth MacDonald
Did the SEC’s plan to stop naked short selling abuses in 19 stocks work?

The jury is still deliberating, the results so far are mixed.

Stocks in many of the companies on the list actually rose during the ban, but the stock market took shares down in others due to problematic balance sheets and poor risk management controls.

The Securities and Exchange Commission’s emergency move to outlaw naked short sales in shares of 19 financial stocks went into effect July 15 and expired Aug. 12. Short sellers were forced to actually have borrowed stock in hand before executing a short sale. https://www.sec.gov/rules/other/2008/34-58166.pdf

SEC Chairman Christopher Cox said that the agency wanted to stop certain stock price manipulations, as volatility in the financials is at historic levels.

SEC Moves to Make Ban Permanent

The SEC is moving to permanently outlaw naked short-selling for all stocks and has already begun work on the new rules so as to “extend this kind of procedural protection to the entire market”, Cox told Congress. “Very soon we will be in a position to issue a proposal on that.”

Short-sellers aim to profit from share declines, usually by borrowing a stock, selling it and buying the shares back after their price has decreased. In “naked” short-selling, the shares are sold without being borrowed first. The emergency rule requires investors to borrow the security first and deliver at settlement (see blogs “Get Shorty,” “The SEC Comes Up Short”).

Besides the ban, the SEC has also issued subpoenas to a raft of hedge funds to determine if rumor mongering helped cause Bear Stearns to collapse and shares in Lehman Bros. Holdings (LEH: 15.57, -0.64, -3.94%) to plunge–again despite the fact that their financial houses were clearly not in order due to their massive overleveraging.

Why the Temporary Ban Was Enacted

Aggressive short selling was blamed for aggravating the steep plunge in shares of Lehman, mortgage finance giants Fannie Mae (FNM: 7.69, -0.33, -4.11%) and Freddie Mac (FRE: 5.55, +0.18, +3.35%), who together hold or guarantee more than $5 tn in home mortgages, or about half the U.S. total.

The temporary ban was enacted despite the fact that these companies were under fire for poor risk management and questions over their accounting (see blogs “Why You Should be Worried About the Rescue of Fannie Mae and Freddie Mac,” “Fannie and Freddie on the Brink,” “Breaking Down Lehman’s Earnings,” “Questions About Lehman Brothers Continue to Mount” and “The Fire-Engine Red Flags at Lehman Brothers”).

The SEC initially announced the emergency order on July 15 after a dangerous drop in shares of Fannie and Freddie. Aggravating the drop was a Wall Street Journal report https://online.wsj.com/article/SB121564782376340951.html?mod=hps_us_whats_news that said the White House had begun contingency planning in the event the mortgage finance giants failed due to their potential insolvency, an insolvency raised by former St. Louis Federal Reserve president William Poole.

The 19 Gain in Strength-Despite the Ban

But, as Bloomberg reported, the 19 companies on the SEC’s list actually saw their market value climb 26% since July 15, with the companies adding $270 bn to their market capitalization. https://www.bloomberg.com/apps/news?pid=20601109&sid=ajtpSnlu9×0M&refer=home

Bloomberg adds that the companies’ gains in market cap put them back around where they stood on March 17, the St. Patrick’s Day shotgun wedding of the nearly bankrupt Bear Stearns and JPMorgan Chase, orchestrated by the Federal Reserve.

Shorting is Back With a Vengeance

However, Richard X. Bove, a top banking and brokerage analyst at Ladenburg Thalmann who is widely followed on Wall Street, says in a new report that “the anecdotal data I am receiving suggests that shorting these companies was resumed with a vengeance.”

Bove notes that bank stocks have plunged in the past two days, with the KBW Bank Index falling 11.8% from its high Monday to its close Wednesday, the S&P Bank index down by 10.8% and the American Exchange Broker index down by 9.4%.

Bove notes that two stocks on the SEC’s list, Goldman Sachs (GS: 164.90, -2.40, -1.43%) and JPMorgan Chase (JPM: 36.91, -1.01, -2.66%), fell in response to earnings estimate cuts, and that Lehman Brothers (LEH: 15.57, -0.64, -3.94%) “continued to give off negative vibrations relative to its balance sheet.”

However, Bove says “there may be another explanation, since a number of banking and brokerage stocks are not impacted by the negative developments affecting the targeted companies.”

Who Was on the List

BNP Paribas Securities Corp
Bank of America Corp
Barclays
Citigroup
Credit Suisse Group
Daiwa Securities Group
Deutsche Bank Group
Allianz SE
Goldman Sachs Group Inc
Royal Bank ADS
HSBC Holdings Plc ADS
JPMorgan Chase & Co
Lehman Brothers Holdings Inc
Merrill Lynch & Co Inc
Mizuho Financial Group Inc
Morgan Stanley
UBS AG
Freddie Mac
Fannie Mae

Regulatory Apartheid

Raising criticism of regulatory apartheid, the SEC did not include on the list companies whose stocks have been hammered, including Washington Mutual (WM: 4.12, -0.18, -4.18%), Wachovia (WB: 14.81, -1.19, -7.43%), MBIA (MBI: 8.75, +0.33, +3.91%), Ambac (ABK: 3.94, +0.02, +0.51%), National City (NCC: 4.88, -0.07, -1.41%), KeyCorp (KEY: 11.07, -0.68, -5.78%), Sovereign Bancorp (SOV: 9.92, -0.03, -0.30%), Corus Bank (CORS: 4.57, -0.18, -3.78%) and Bank United (BKUNA: 1.38, +0.10, +7.81%).

To get on the list, the SEC chose “precisely those financial firms” that the Federal Reserve “has designated as eligible for access to its liquidity facilities, and for which the taxpayer could be on the hook,” Cox explained.

But all US banks are eligible to access the Federal Reserve’s liquidity facilities, as even Fed Chairman Ben Bernanke noted in testimony before Congress recently that “all banks can borrow from the Fed’s discount window.” Wamu, Wachovia, KeyCorp and the other banks not on the list can go fail, too, leaving the taxpayer on the hook in a taxpayer-backed bailout.

Moreover, SEC chairman Cox recently said in a July 24th op-ed piece in The Wall Street Journal https://www.sec.gov/news/speech/2008/spch072408cc.htm that “the SEC’s emergency order is not a response to unbridled naked short selling, which so far has not occurred.”

So again why ban naked shorting for these 19 if it’s not occurring? In his editorial, Cox added rather flatly: “rather it is intended as a preventative step to help restore market confidence at a time when that is sorely needed.”

How Did the Companies’ Shares Perform During the Ban?

Fannie Mae’s stock stood at $7 the day the ban was enacted, rose to $14 in the interim, and shares closed at $8 the day the ban was lifted.

Similarly, Freddie Mac stood at $5 the day the ban was enacted, rose to nearly $11 in the interim, and closed at $5 when it was lifted.

S3 Matching Technologies, a stock market research firm, says that while short sales for the 19 stocks dropped by a sizable 63% during the ban, the firm says short sales didn’t determine the shares’ value, the markets did.

It also says that short sales actually increased in shares of Bank of America Corp. (BAC: 28.86, -2.27, -7.29%) while the ban was in effect, despite the fact that BofA’s stock price rose from about $19 to $31 during the blackout period.

Arturo Bris, a professor affiliated with the Yale International Center for Finance, analyzed short selling data from the Big Board in the 19 stocks on SEC’s list for the trading period from Jan. 1 to July 15, 2008 https://www.imd.ch/news/upload/Report.pdf and argues that the SEC didn’t need to enact the ban in the first place. Bris says that short-selling amounted to just 12% of the trades in the 19 stocks, versus 13% for comparable U.S. financial outfits.

A Curious Trade Off of the Ban

Bove also notes a curious trade off of the ban. “The theory is that the paired transaction, which was in place, had investors buying utilities and shorting financial,” he says. “When the SEC controls were put in place, the positions were reversed allowing the financials to recover in price and forcing the utilities to fall back. In the past two days, the positions may have been reversed, again, with devastating impacts on the financials and positive impacts on the utilities.”

The SEC has said that short sales do provide liquidity to the markets–and which analysts say stops certain shares from being inflated due to things like unlawful accounting moves.

Naked Shorting is Not Illegal

I’ve noted before, naked short selling is not illegal. The SEC’s rules on short selling, enacted in January 2005, said broker dealers and traders were not required to have a physical agreement to borrow the shares if they had “reasonable grounds” to believe that the shares can be borrowed.

The SEC itself has said in public statements that “naked short selling is not necessarily a violation of the federal securities laws or the Commission’s rules,” https://www.sec.gov/spotlight/keyregshoissues.htm and that in certain instances, it can replenish market liquidity. The New York Stock Exchange has also said it has found no evidence of widespread naked short selling.

Naked shorting can arise when a stock is so illiquid and there are such a small number of shares outstanding, that trying to find shares to borrow can be difficult to arrange.

Also, underwriters of initial public offerings or secondary stock offerings often have an over allotment of shares they place and trade that don’t technically yet exist in the offering, so they make the trades through naked short positions, Fox Business’s news director Ray Hennessey explains.

Traders often do naked short selling if they have reasonable grounds the shares in a short sale can be borrowed later on. If they see a financial cataclysm arising due to poor accounting, they have a right to do a naked short sale.

Reinstate the Uptick Rule

Again, it must be reiterated that the real problem is the SEC’s decision to remove the uptick rule in July 2007. The rule was an old stock market backstop, put in place in 1938. The SEC lifted this ban right when the subprime and credit crisis exploded.

The uptick rule said that traders can only short a stock if the last trade of a stock is at least a fraction, or an uptick, higher than the prior trade. The SEC says it has no intention of reinstating the uptick rule.