Short sale bans seen a risky game by regulators

By Emily Chasan and Rachelle Younglai - Analysis

NEW YORK/WASHINGTON (Reuters) - The world may be about to find out if short sellers really are the scoundrels they are accused of being for exacerbating the current financial crisis.

In the past few days, regulators in the United States, Britain, Canada and Germany have imposed unprecedented temporary bans on the short selling of financial shares as they seek to head off what is threatening to be the worst financial turmoil since the Great Depression.

They blamed short sellers for the rapid decline in major banks, such as Morgan Stanley, last week. For financial markets already reeling from the collapse of Bear Stearns and Lehman Brothers, the declines triggered questions about whether more big banks would falter and worsen a credit markets freeze that threatens the broader economy.

At first, the short sales crackdown, combined with an unprecedented $700 billion proposed U.S. government bailout of toxic mortgage assets owned by the banks and others, helped to drive stocks higher.

But after rising more than a combined 700 points on Thursday and Friday, the Dow Jones industrial average sank 372.75 points, or 3.3 percent, on Monday. Banking stocks, supposedly protected from short selling, took a particular hammering, with Bank of America Corp down almost 9 percent and JPMorgan Chase & Co losing more than 13 percent.

Although far from conclusive, the drop illustrates there can be very bearish days without short selling being allowed across a big part of the market.

The ban "will result in the exactly the opposite in what they want to achieve," said Doug Kass, founder and president of hedge fund Seabreeze Partners Management, who is also a short seller. "It will scare the longs into selling, exacerbating stock price declines."

Short sellers have been blamed for nearly every financial meltdown since the 1929 crash, but it has often been debated whether this is because they were either smart or lucky enough to profit while others struggled, or because they spread malicious rumors and sparked bear raids on quality companies.

Now, the short sellers are being targeted again.

The emergency order in the U.S. halted short selling in nearly 800 financial stocks was issued early on Friday and effective immediately. The order runs through October 2 and may be extended further if the agency deems it necessary. The order can only last a total of 30 calendar days.

And since the SEC issued the order, nearly 100 companies, including General Electric Co, have been added to the temporary ban.

But there are concerns regulators are playing with fire and do not fully understand what they have unleashed.

Critics say they are interfering with the basic functioning of the markets, including taking away liquidity provided by the shorts, at a time when things are already enormously shaky.

"My concern is that a total ban really does not comport with free market principles and I also think it leads to very potential dislocations in our markets that don't need to have been created this way," said Harvey Pitt, who was the chairman of the SEC when U.S. markets plunged after the September 11, 2001 attacks.

Pitt said at that time U.S. companies pressured the SEC to ban short selling but he refused.