Unintended Consequences of the SEC's Short-Selling Ban

Anyone who believes that the SEC's ban on short-selling was a positive development for the market should take a look at some compelling trading data from Friday.  While the US markets rallied over 3% on Friday, it was the result of a panic to cover shorts in financials, rather than renewed confidence in the US economy.  Some argued that Paulson's proposed RTC-like bailout of the banks was the reason behind the rally, but a look at price action in bank stocks tells a much different story.

Ordinarily staid bank stocks were behaving like internet stocks in 2000 with extraordinary trading ranges.  Zions Bancorporation (ZION) had a $92.44 trading range.  Yes, you read that right:  An ordinarily $50 stock ripped up to $131.20 before plummeting to $38.76 and then rallying back to $50.84.  Wachovia (WB) opened up 65% before selling off and closing up 30%.  Morgan Stanley opened up 50%, erased all of its gains, then rallied back to close up 20%.  What exactly is wrong with this kind of volatility?  You can ask the guy who paid $131.20 for ZION.  I guarantee that those trades weren't sent from hedge funds or mutual funds.  It was more than likely the result of some poor schmo retail investor that ordinarily sends market orders without suffering any real consequences.  This time he sent a market order and paid through the nose for it because there were not enough sell orders in the system to stop the stock from ripping higher.

A far better example of the dangers of manipulating stocks higher is exemplified by the Lloyd's Bank/HBOS merger in London.  After agreeing to purchase struggling HBOS the day before the short-selling ban was announced by the FSA in London, Lloyds took advantage of the artificial 20% rally in its stock by quickly issuing more stock to raise additional capital.  Any bank with half a brain will take advantage of the short-selling ban to raise new capital at these higher prices while only long investors can participate.  What do you think will happen to prices after the temporary short-sale ban is over?  Gee, I wonder.

Finally, banning options market makers from shorting stock shows a real ignorance of financial market function.  Options market makers carry tremendous inventories of options and stock that they constantly hedge in real time by buying and selling stock.  They rarely place directional bets on stocks and focus on risk management of their volatility positions.  They need to have the ability to short stocks in order to make markets for customers, otherwise they will have difficulty quoting options prices.  While regulators might believe they are preventing investors from expressing their bearish views through put-buying, they are also penalizing long investors who sell calls against long stock to juice returns (a practice referred to as buywriting.)  The options community is attempting to gain an exemption from the SEC.  If the SEC fails to grant an exemption, options markets in the 799 financial stocks on the list will be severely repriced, wreaking havoc on some market makers' ability to make markets in certain stocks.  Then maybe, someone can sit Mr. Cox down and explain to him how the market he is supposed to regulate actually works.

Frankly, all of the accusations that have been hurled at hedge funds and short-sellers blaming them for the collapse of Bear, Lehman, AIG etc. are absurd.  Mr. Cox continues to spout about the manipulation and malicious rumors that has led to these firms' demise.  Yet it has been six months since Bear Stearns collapsed, and the SEC has not filed a single charge against anyone for nakedly shorting Bear's stock, spreading malicious rumors, etc.  I have to ask what Mr. Cox has been doing this entire time?  If there were malicious rumors, I certainly would've found them by now.  How?  I'd go to every prime broker, subpoena the trading records, identify the buyers of credit default swaps, puts, naked-shorts in Bear Stearns, and then pull the tapes from the trading desks who talk to the hedge funds.  Every dealer is required to tape record their conversations and the SEC can simply ask for the tapes from every salesman at a Wall Street firm that had a hedge fund client that was shorting Bear through some bearish financial instrument.  Really, is that so hard?  The SEC should start punishing all of the manipulators and abusers if they exist.  Instead it has chosen to greatly distort financial markets by penalizing every player in the market.  Mr. Cox needs to be very careful that he doesn't ruin the integrity of the US financial markets in his quest to go after a few (if any?) bad apples.