UPDATE 3-NY probes for illegal short-selling in financials

(Adds Goldman Sachs comment, hedge fund comment)

By Grant McCool

NEW YORK, Sept 18 (Reuters) - New York on Thursday began a probe into possible illegal short-selling in the stocks of Wall Street companies such as Goldman Sachs Group Inc (GS.N) and Morgan Stanley (MS.N), Attorney General Andrew Cuomo said.

Cuomo said on a conference call with reporters: "I want the short-sellers to know today that I am watching. If it is proper and legal then there is nothing to worry about."

He said his office was concerned about destabilization of financial markets, which are suffering their worst crisis since the Great Depression of the 1930s.

The New York State prosecutor said his office also would look back into illegal short-selling that may have occurred in stocks of Lehman Brothers Holdings Inc (LEHMQ.PK) and American International Group Inc (AIG.N), two companies at the heart of the crisis.

In the past week, Lehman has gone bankrupt and the insurance giant was rescued by the U.S. government.

"This investigation will not only encompass short-selling of Lehman Brothers and AIG but also short-selling in other companies that may be occurring, like Morgan Stanley and Goldman Sachs," Cuomo said.

The prosecutor said he believes the SEC should freeze short-selling of financial sector stocks on a temporary basis, perhaps for 30 days.

In a statement, Morgan Stanley welcomed the investigation to uncover improper short-selling of financial stocks.

"We also support his call for the SEC to impose a temporary freeze...given the extreme and unprecedented movements in the market that are unsupported by the fundamentals of individual stocks," the statement said.

Goldman Sachs spokesman Lucas van Praag said that "if stocks are in fact driven down by inappropriate activities then it is quite right they be investigated."

MANIPULATION

Short selling is a legitimate form of trading that can prevent stocks from being overvalued, but often blamed when a company's shares fall. Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making a profit when the price drops.

Harry Strunk, partner at Treflie Capital Management fund said: "Anyone who stops lending the stocks may be engaging in market interference in my mind, and that is worrisome."

Cuomo said he would use a New York securities fraud law called the Martin Act, which gives the office both criminal and civil jurisdiction.

"The markets need to be stabilized and the only way to help bring about that stability is to root out and deter short-selling that is based on false information," Cuomo said.

From Thursday, U.S. securities regulators tightened rules on traders who profit from stock declines.

UK securities regulators imposed a ban from Thursday through Jan. 16 on the short-selling of financial-sector stocks to help stabilize the market.

A "naked" short sale occurs when an investor sells stock that has not yet been borrowed. Broker-dealers will sometimes accidentally fail to deliver stock to investors who have arranged to borrow it. If this is done intentionally it is already illegal. (Additional reporting by Svea Herbst-Bayliss; editing by Carol Bishopric)