“What the SEC Really Did on Short Selling”

“What the SEC Really Did on Short Selling” is the title of an op-ed piece written by SEC Chairman Christopher Cox appearing in today’s Wall Street Journal.

Cox explains that last week’s Emergency Order temporarily prohibiting naked short selling of 19 financial stocks (described in “The SEC’s Short Story”), was done “in close consultation with the Treasury and the Fed” to apply “to precisely those financial firms that the Fed has designated as eligible for access to its liquidity facilities – and for which the taxpayer could be on the hook.” By that reasoning, all bank stocks should be included on the SEC’s list. During his appearance before the House Financial Services Committee last week, Fed Chairman Bernanke under questioning by Representative McCarthy, said that “all banks can borrow from the Fed’s discount window.”

Cox explains that the purpose of the Emergency Order “is intended as a preventative step to help restore market confidence at a time when that is sorely needed” – not to stop short sellers from breaking the law. The “three musketeers” – Cox, Bernanke, and Paulson cannot grasp that the government’s involvement in strong-arming the fire sale of Bear Stearns to JPMorgan (JPM) to proudly proclaim “moral hazard” is a factor freaking the market out. Heck, every time these guys open their mouth it tends to freak the market out. Financials cannot raise capital until they first clean up the mess on their balance sheets. If the short sellers believe financial armageddon is here and want to trade on that conviction, they should have every right to do so. But it is the SEC’s job to ensure they are doing so within the law.

Cox talks about Regulation SHO which prohibits naked short selling unless “the broker has ‘reasonable grounds’ to believe the security can be borrowed.” Apparently a proposal to curb fraud in naked short selling has been collecting dust somewhere in the SEC’s office since March. Cox says Regulation SHO abuses “has led the commission to consider simply eliminating the ‘reasonable grounds’ alternative altogether,” and is why he “made clear my intention to ask the full commission to apply operational protections against abusive naked shorting to the broader market.” The SEC is also “exploring” other ideas to curb “naked short-selling abuses, such as the reporting of substantial short positions (akin to the long-standing requirement to disclose significant long positions.)” Cox did not mention reinstating the Uptick Rule.

Once again, Cox and the SEC commissioners are sending mixed messages to Wall Street and investors. For now, Wall Street appears to be playing it cautious as the entire financial sector is getting a lift from short covering. Cox writes, “Manipulative naked short selling is one worry investors shouldn’t have.” If that is truly the stance of the SEC, then the Emergency Order should immediately become a permanent order extended to all stocks. As Nike says, “just do it!”

Related Post: “Shorting Does Not Help Mutual Fund Shareholders”

UPDATE! The following was added July 25, 2008 at 8:17 PM:
The Financial Times is reporting tonight that Washington Mutual (WM) “revealed it had raised an extra $10bn in fresh capital since the end of June in an effort to quell continued speculation over its financial health. WaMu told the Financial Times the extra capital would bring the total amount of cash and liquid securities on its balance sheet to more than $50bn. The funds were borrowed from the Federal Reserve’s discount window, the Federal Home Loan Banking system – a network of local lenders – and open market operations.”

This goes back to my point that the SEC’s temporary prohibition on naked short selling should extend beyond the primary dealers. If WaMu or any other bank is accessing the discount window, then it is imperative that the SEC enforce their own rules to ensure taxpayer money is protected from illegal activities conspiring to take down the banks’ stock price. Taxpayers become at risk when a bank’s stock price is so low that it is unable to raise needed capital.

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