SEC rule will limit short sales

By Rachelle Younglai and Emily Chasan

WASHINGTON/NEW YORK (Reuters) - U.S. securities regulators plan to issue an emergency rule later 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 demise of investment bank Bear Stearns in March.

The rule is expected to go into effect on Monday and last 30 days. It also applies to big financial firms such as Lehman Brothers LEH.N, Goldman Sachs (GS.N), Merrill Lynch MER.N and Morgan Stanley (MS.N), the SEC said.

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 crackdown 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.

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.

"This rule would help relieve the extreme downward pressure on stocks, that has helped fuel the market down to these levels," he said.

Broker-dealers will sometimes accidentally fail to deliver stocks to investors who have arranged to borrow a stock.

As of June 30, short sellers held about 14 percent of Fannie's outstanding stock, up from around 3 percent last August. For the same time period, shorts held almost 12 percent of Freddie's outstanding stock, up from about 2.7 percent. They also held about 10 percent of Lehman's stock, up from 4.5 percent.

Short sellers say they prevent stocks from becoming overvalued and are an essential feature of the market.

"While no one in Washington did their job, now they are trying to blame short sellers," said William Fleckenstein, president of Fleckenstein Capital, which manages a Seattle-based hedge fund.