(Globe & Mail StreetWise) For years, U.S. regulators have turned a blind eye to abusive short selling.
Now the SEC, along with European market watchdogs, are having to over-compensate for their negligence by putting a temporary ban on short sellers, halting what should be a healthy facet of capital markets.
The outright ban on shorting bank stocks comes after years of giving a pass when they engaged in naked short selling, a practice that is supposed to be prohibited.
The outright bans on all short-selling of announced over the last two days are nothing more than a Band-Aid, meant to buy time for a larger bailout of the American banking system. Canadian market regulators have no reason to join this intervention, because our financial institutions are clearly sound.
But this whole nightmare could have been avoided. The fact that short selling now demands global attention is an indictment of the SEC's leadership - Republican Presidential candidate John McCain is entirely justified in calling for the head of SEC chairman Christopher Cox.
A quick lesson in the market's plumbing: Short sellers are supposed to borrow shares, which they then sell, on expectations of buying the stock back at a lower price to return to its rightful owners, while pocketing the difference in price as a profit.
Naked shorts simply eliminate the borrowing part of that process. They sell shares they don't own. They take advantage of the fact that stock trades don't settle for three days. A naked short seller would sell early in the morning at $100, buy the stock back at noon for $95, and pocket that 5 per cent gain without every going to the trouble and expense of borrowing shares.
There are all sorts of rules against naked shorting, but the SEC didn't bother to enforce them. The result is the free-for-all seen in recent days. When the forensic audit of recent trading is done, I suspect we'll find all sorts of evidence of naked shorting, done by big-name funds and abetted by iconic .
Let's be clear: Short selling is not the real problem here. The U.S. investment banks aren't in the soup because a handful of deep-pocketed hedge fund wagered that shares of banks, insurers and brokers will fall.
The U.S. financial system is in peril because the Wall Street community, its regulators and its credit rating agencies, collectively let go of sound risk management when it came to real estate prices, mortgage-backed securities and derivative exposure. Those problems will take years to fix.
Short seller just helped deflate the real estate bubble quickly, and that's the way a market should work. The U.S. Conference Board actually praised activist short sellers in a report this week, for their role in spotting value plays. The draconian steps take by regulators Friday are reaction to naked short sellers, who should never have become entrenched forces in the market.