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.
“There are a lot of people who are engaging in entirely appropriate short selling activities and I think that this may cause untold economic injury to people who have done nothing to warrant that from taking place ... There can be some serious fallout from this,” Pitt added.
And it isn’t only the bans -- there are also curbs on some kinds of shorting and demands for more disclosure from investors who are shorting.
The potential harm, short selling experts say, comes from discouraging shorting overall. Because short sellers borrow shares and have to buy them back later, they represent forced buying in the market, purchasing shares when no one else will.
“We are very concerned that these emergency orders will not enhance long term market integrity, nor will they address the fundamental economic issues that have been afflicting our financial sector,” said James Chanos, a well known short seller and president of hedge fund Kynikos Associates.
“Simply put, short selling is a vital investment strategy that responds to market fundamentals and contributes to the integrity of stock prices,” added Chanos, who was one of the first to point out concerns about the accounting at now defunct energy trader Enron.
In sophisticated markets such as the United States, there rarely have been restrictions on short sellers such as the ones taken this week.
The Malaysian government banned short selling in 1998 after the Asian Financial Crisis and struggled to attract liquidity to its markets while it was in effect. But until the SEC revoked it last year, in the United States the principal restriction on short sellers had been the uptick rule, which was implemented in 1938 following the Great Depression and required short sellers to sell stock on a higher price move.
The SEC Chairman Christopher Cox justified the agency’s drastic actions by saying the ban would restore equilibrium to markets and that it would not be necessary in a well functioning market.
“Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets,” the SEC said in a statement. “At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation.”
Banks and U.S. lawmakers welcomed the move.
“Extraordinary times call for extraordinary measures,” said the American Bankers Association, which represents banks of all sizes. The group leaned heavily on the SEC to crack down on illegal naked short selling.
Some short sellers say they don’t mind cracking down on the abuses to some extent, such as preventing the spreading of malicious rumors, or tightening up a bit on certain types of naked short selling. But they feel they are being unfairly targeted, especially as they have been actually pretty good at locating overvalued companies.
A four-year study of short sales, published in The Journal of Finance in April, found that short sellers were “extremely well-informed” and able to correctly anticipate price declines in stocks.
And with the crackdown on naked short selling, some short sellers now worry a clerical error -- such as a broker mistakenly telling them they had stock when they did not -- could now land them in court. They wonder how they will prove they were not deceiving their broker.
“The SEC has done a fantastic job blaming short sellers for nearly every problem in the financial markets today,” said Eric Newman, a long-short portfolio manager at TFS Capital.
“Sure, there are exceptions. But it isn’t the fault of the short sellers that Morgan Stanley was leveraged 30 to 1.”
Reporting by Emily Chasan and Jennifer Alban in New York, Rachelle Younglai in Washington and Svea Herbst-Bayliss in Boston; Editing by Andre Grenon