July 21, 2008 / 11:06 PM / 11 years ago

New U.S. borrowing rules hit short sellers

NEW YORK, July 21 (Reuters) - The emergency U.S. rules to clamp down on short selling has driven up the cost of borrowing financial stocks, short sellers said on Monday, prompting some bearish investors to look for alternative trading strategies.

The rule is the latest effort by the Securities and Exchange Commission to clamp down on market manipulation that some blame for the sharp declines in financial stocks, including mortgage lenders Fannie Mae FNM.N and Freddie Mac FRE.N.

“Clearly borrowing the shares in Fannie and Freddie has gotten more difficult and dealers seem to be clearly hoarding borrowed shares,” said Brad Golding, managing director at private money management firm Christofferson, Robb and Co in New York, who shorts financial stocks.

The new rule has increased the cost of borrowing “considerably,” said a second short seller, who spoke on condition of anonymity.

Financial stocks, which rallied last Wednesday, Thursday and Friday, rose early on Monday but headed lower in the afternoon to close down 0.85 percent as measured by the S&P Financial .GSPF index.

Options dealers said the controversial rule — which also covers some other financial institutions, including Citigroup (C.N) and Lehman Brothers LEH.N — would push traders into options.

But on Monday, it was difficult to determine what direct effect the rule had on options trading because July options expired on Friday and companies are reporting earnings, option participants said.

The emergency rule, brought in to relieve downward pressure on banks and other financial institutions, require a short seller to borrow securities before executing the sale.

NEW MECHANICS

In short selling, the investor arranges to borrow securities they believe are overvalued, and sells them in hopes of profiting when the price drops. The rules specifically target naked short sellers, who sell stock that has not yet been borrowed. Naked short selling is illegal.

The second short seller said the new mechanics of locating shares have affected the number of shares brokers are providing investors.

Robert Francello, head of equity trading for Apex Capital Hedge Fund in San Francisco, said the rules have “made it more cumbersome for some of the large funds but it certainly hasn’t dampened their will to short.”

“I think those who may feel it would be the faster, smaller accounts,” Francello said.

Michael Schwartz, chief options strategist at Oppenheimer & Co Inc, said options volume will absorb “a good portion of” the diverted short volume.

“Give it time and it will probably start to pick up,” Schwartz said. “You’re going to use an option as a substitute for being short these stocks — this way you don’t have to be concerned about borrowing the day you put the trade on.”

One simple way to protect an existing stock position or to speculate on stock weakness is to buy a put option. A put allows an investor to sell the underlying stock at a preset price within a specified time period.

Shares of the 19 firms covered under the rule climbed strongly last week, when the rules were announced.

Jon Najarian, a founder of Web information site optionmonster.com, said the effectiveness of the rule will be much clearer at the end of the week.

“Some of the put (option) action we are seeing in the financials today looks to be people protecting the outlandish gains made in the past four sessions,” Najarian said. (Additional reporting by Kristina Cooke and Jennifer Alban in New York and Doris Frankel in Chicago; editing by Phil Berlowitz)

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