Market nervously eyes return of short sellers

By Rachelle Younglai and Kristina Cooke - Analysis

WASHINGTON/NEW YORK (Reuters) - At midnight on Wednesday, U.S. regulators will restore investors' rights to make bearish bets on financial stocks but few expect it to put an end to wild swings in the market.

For nearly three weeks, investors who bet on falling stock prices have been prohibited from short selling more than 950 companies under an experiment by securities regulators to restore equilibrium to a fragile financial system.

Short sellers arrange to borrow shares they consider overvalued and sell them. If the price drops, they repurchase shares, return them and pocket the difference.

It's questionable whether the U.S. Securities and Exchange Commission's temporary ban worked. S3 Matching Technologies, a market data firm, said it found no statistically significant differences between stocks covered under the ban and those that were not.

The S&P financial stocks sub-index .GSPF dropped 23.6 percent over the length of the ban, hitting its lowest level in more than a decade on Tuesday. Financial stalwarts like Bank of America (BAC.N) saw its stock lose 27.7 percent and Citigroup (C.N) fell 14 percent amid fears of a global financial meltdown. The stock of Morgan Stanley (MS.N), whose chief executive John Mack lobbied for short-selling relief from regulators, lost 25.5 percent over the three-week period.

"It would appear that the prohibition against shorting was not the Band-Aid the markets required," said Ron Geffner, a partner at law firm Sadis & Goldberg who represents broker dealers and hedge funds.

Although the ban will be lifted, the SEC plans to craft a permanent disclosure rule requiring big short-sellers to report their trades to the agency. It remains unclear if the data will be kept secret by regulators or eventually made public.

Fear of regulators may keep hedge funds on the sidelines at first, said Ken McGee, head execution trader at Topos, LLC in Stamford, Connecticut.

If selling in financial stocks accelerates on Thursday, McGee added, it may not be in fact because of an increase in bearish bets. Instead, it may be that those investors who hold the shares on hopes they will rise, or "longs", will dump their holdings in fear that the return of the short sellers will force shares lower, he said.

On September 19, the SEC imposed an emergency ban on short selling of nearly 800 financial services sector stocks. After other firms clamored to be included, the list eventually grew to more than 950 stocks with some additions that raised eyebrows such as drug store chain CVS Caremark Corp (CVS.N).

But rather than stabilizing prices, U.S. stocks continued to swing wildly on fears Congress would fail to pass a $700 billion bailout law to help choked credit markets. Since the bill was signed into law last Friday, stocks have tumbled lower.

The Dow Jones industrial average .DJI is down 16 percent over the three week period. The Standard & Poor's 500 Index .SPX has lost 18 percent since the rule went into effect.

"The ban didn't stop the free spirit of the market and it ultimately caused more of these shares to be sold as opposed to just hedged," said Matt McCormick, portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel in Cincinnati, Ohio.

Robert Francello, head of equity trading for APEX Capital hedge fund in San Francisco noted that some funds refrained from buying shares during the ban as they were not able to short to hedge their positions.

"I think the lifting of the ban will have a net positive impact. You are bringing back huge amount of liquidity and there are going to be more active participants and you will get prices that are more stable."