UPDATE 5-US SEC issues emergency rule to curb short sales

(Adds list of affected securities at bottom of story)

By Rachelle Younglai and Emily Chasan

WASHINGTON/NEW YORK, July 15 (Reuters) - U.S. securities regulators issued an emergency rule on Tuesday to limit certain types of short selling in major financial firms, including Fannie Mae (FNM.N) and Freddie Mac (FRE.N).

The rule is the latest effort by the U.S. Securities and Exchange Commission to clamp down on market manipulation that some blame for the sharp declines in financial stocks and the demise of investment bank Bear Stearns in March.

The rule will go into effect on Monday, July 21, and last through July 29, although it could be extended to last up to 30 days. The SEC said it will consider rules to address short selling issues across the entire stock market.

The emergency rule applies to 19 financial firms including Lehman Brothers LEH.N, Goldman Sachs (GS.N), Merrill Lynch MER.N, Morgan Stanley (MS.N), JPMorgan Chase & Co (JPM.N) and Citigroup Inc (C.N).

The SEC said that a loss of confidence in markets can lead to panic selling, which may be further exacerbated by certain types of 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," the SEC said. "If significant financial institutions are involved, this chain of events can threaten disruption of our markets."

Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making profit when the price drops.

With financial stocks dropping dramatically over the year, lawmakers have been calling on the SEC to investigate whether short sellers and speculators are behind the move.

Over the weekend, the SEC announced plans to crack down on false rumors and said it is examining whether broker dealers and investment advisers have controls in place to prevent market manipulation.

The agency's rule change would prevent investors from making "naked" short sales of the biggest financial stocks. A "naked" short sale occurs when an investor sells stock that has not yet been borrowed.

Broker-dealers will sometimes accidentally fail to deliver stocks to investors who have arranged to borrow a stock. If it is done intentionally, it is illegal.

"Today's commission action aims to stop unlawful manipulation through naked short selling that threatens the stability of financial institutions," SEC Chairman Christopher Cox said in a statement.

The emergency rule would require a short seller to borrow the securities before executing the sale. It would also require the investor to deliver the securities on the settlement date.

"The new rule will benefit the investment community and help bring more stability to the market," said Dylan Wetherill, president and founder of short interest tracking service ShortSqueeze.com.