Big Sky Cairn

I won’t rehash what Dave Budge has said while doing a great job of covering the recent market woes.

Today’s move by the SEC to crack down on short selling of stocks has me a little skeptical that our regulators know what they are doing.

Short-selling has long had a bad name because an investor is essentially betting on the market to lose. However, short sellers serve an important role in that they act as a counter overly bullish investments. They were the first to blow the whistle on Enron, the subprime market, and the dotcoms of the late ’90s.

Unfortunately, with the recent economic downturn, the geniuses in Congress and regulatory agencies have chosen to go after boogeymen rather than the underlying economic problems. Whether it be blaming oil companies for colluding or now investors who are short-selling stocks.

Here is a thought, maybe instead of wasting time investigating a legal practice the SEC should go after individuals who leak internal financial data from banks causing them to collapse.

Brad,

What Cox is going after is kind of “inside baseball.” There used to be a rule that before someone could sell short the broker had to make sure that the shares were available to borrow. What has happened since that rule was lifted is that brokerage firms allow certain customers to to make the short and, if they don’t have the inventory in stock they buy it post facto to fill the order. This is called a “naked short.” The rule should never have been lifted in the first place.

Since stocks settle “regular way”, which means that the stock certificates are delivered in three days, this leaves all sorts of room for monkey business.

What this does is place more “inventory” in the system than actually exists. The broker can execute the buy against the sell and add “volume” to the tape thereby making the stock look like it has more action. This is kind of like what the regulators call “painting the tape.”

So look at it like this.

A short seller, such a a hedge fund” puts a huge order in to sell, say, 100,000 shares at $10.

The broker crosses the trade of 10,000 shares at $9.99.
Crosses the next 10,000 shares at $9.95.
Crosses the next 10,000 shares at $9.90
Etc.

This makes the tape look like there are multiple sellers all heading for the exits - which can cause more selling by others.

The rule should never have been lifted and Cox is right to put it back in place. But he should have put it back for all trades, not just primary dealers.

Combine this with the removal of the “uptick rule” where a stock had to trade at par or up before a short could be executed and what we have is a lot of inorganic volatility in the market.

I love short selling. I hate giving big traders advantages that us little guys don’t have.

As for Schumer, as Al D’Amato called him, he’s a putzhead that needs to learn to keep his yap shut. If the OTS had a couple more weeks they might have been able to find a buy for IMB. I think the OTS should bill him for the shortfall.

Dave,

Sorry for the delay in responding here. I initially thought about differentiating between naked shorts and short selling. Ultimately, I decided, in my mind, it does not matter in this case.

Why I did that is because the SEC has rules in place to investigate investors who spread false rumors on a company and use that to their advantage, which is what I think you are going after here. Yes, the SEC when determining who to investigate should look at the percentage of shares traded short.

Further, correct me if I am wrong here, but it is already illegal to short if the seller has no intention of delivering the stock. last year, I thought the SEC tried to crack down on those groups which had unusually high fail to deliver rates.

Using your example, while I do not doubt the herd mentality, that fund would be exposing itself to a lot of risk unless the stock had an already poor outlook. Which gets to the core of the issue. Short selling, even negative shorting, hurts those companies which have poor outlooks for one reason or another. These horror stories do not happen to financially sound enterprises because it would make little economic sense.

I realize I am in a minority defending the idea of naked shorting, but I really do not have a problem with it as long as the SEC uses the enforcement tools it already has to go after those who fraudulently move a stock price one way or another.