Why The SEC Banned Short Selling in 800 Financial Stocks

The one question that keeps getting asked today is why the SEC took the draconian step to ban all short selling on 800 financial stocks.   Banning financial transactions in securities is something that happens in Russia and Malaysia, not the United States.  How could it have come to this?  There is a logical explanation. 

The short sellers sealed their own fate when they picked on Morgan Stanley (MS).  Despite constant claims by to the contrary, I am convinced that huge sums of hedge fund money were raiding "weak" financial institutions.  These bear raids were the exact reverse of the 1999 - 2000 NASDAQ bubble when hedge funds could mark stocks up by 5% - 10% a day because of the ebullient investment environment. 

In a panic environment, these funds could destroy weak companies, such as AIG, because the sellers far outnumber any potential buyers.  The cratering stock price destroyed confidence in the company’s core businesses and the ability to find funding in the capital markets.  The short raids essentially created a death spiral, not just for the stock but for the company as well.  Yes, many of these companies would have had to go under or merge eventually, but the short sellers essentially pushed the weak off the ledge.  They forced the hand of managements before they could come up with a credible plan to sell assets or negotiate mergers.

These bear raids were taken right out of the 1930 - 1932 playbooks of stock operators who could overwhelm the markets with their huge pools of money.  Out of that disaster came such regulation as the “uptick” rule and government offices to oversee the markets such as the Securities and Exchange Commission (SEC).  For reasons that I still do not understand, the rules and regulations in place were not enforced or were repealed, leading to the new era of bear raids.  

The game plan worked perfectly all year for the short sellers.  However, when the short sellers picked on Morgan Stanley, they overplayed their hand.  Morgan Stanley was essentially caught in the death spiral.  Despite reporting a good quarter, the stock sank 50% in less than a week.  The short sellers were piling on - the stock had dropped from $20 to $11 on Thursday afternoon.  Morgan Stanley was essentially being forced into a merger because the sinking stock price was creating a crisis of confidence which prevented it from accessing capital to fund their business – a business that just reported a $1.3 billion profit several days earlier.

Source: Bloomberg

The disappearance of Morgan Stanley (MS) and potentially Goldman Sachs (GS) was politically, patriotically and structurally impalpable for the Fed, the Treasury and Administration. 

It was politically impalpable because no Treasury, Fed, Congress or President wanted to be seen as doing nothing as Wall Street, and eventually the economy, essentially collapsed.  Despite the obvious shortcomings and greed of many of the players on Wall Street, the capital markets are what make America great.  They are more important than any government institution in making our economy grow, adjust and advance.  Without capital markets, capital flows less efficiently and companies cannot find money to grow their businesses.

It was patriotically impalpable because Morgan Stanley and Goldman Sachs represent American financial power across the globe.  Companies all over the world, including China and India, try to have Goldman Sachs or Morgan Stanley underwrite their offerings because their names represent credibility to the rest of the financial world.  If these companies had disappeared, America would have lost as much respect in the financial world as it has in the political world.

Finally, it was structurally impalpable for the Fed and Treasury to have no independent investment banks remaining.  Morgan Stanley and Goldman Sachs provide primary dealer services for the Fed in its open market operations.  The firms are almost inextricably tied with Fed and Treasury.  Having this link be broken or altered was inconceivable for Hank Paulson or Ben Bernanke. 

The short sellers pissed off Hank Paulson and he brought out the big guns.  Paulson essentially had to shut down part of the free market to save it from itself.   And while it was draconian and un-American, it was probably a necessary step to save Morgan Stanley and Goldman Sachs - the last two symbols of American financial power. 

Comments

[feeling massively guilty for making money this week]

Amen. Thank you for the post. And f*** off to the right-wing/tinfoil-hat crowd threatening to move out of America because their Ayn Rand-version of capitalism had to be saved from self-immolation by the big, bad US government.

PS, I forgot where I read it but someone in the blogosphere was saying that "a lot" of short-selling originated from London/Dubai via non-US-domiciled accounts. Sigh. Even if false....this will only add to the hysteria on Main Street. Just what this nation needs---another scapegoat to make us forget that in the end it was the overleveraging of the nation that really caused this calamity.

Great post.

[complacent panda]

Thank you for the post as well. Makes a point that emotion can take over and push the market in directions that are not necessarily beneficial.

PS: Ayn Rand is a pseudo-philosopher. Her work lacks that insight and creativity of greater minds, like Nietzsche (her main influence). I find her work tasteless and shallow; definitely not worthy of being on any top 100 book list (and they normally aren't unless the list is voted on by the public).

[Rand fan]

It's always funny to read the anti-Rand comments when the government is making one of the biggest power grabs of all time. Our system in no way resembles a free market. Duh. Fannie, Freddie, FHA, DPA--none of these silly things would exist in a free market. Silly skeptics. You guys are great. Must be MBAs on Wall Street.

[Dr. Duru]

So why not also prevent big money institutions from running up stocks? If, for example, the government had never "allowed" the tech bubble to spin out of control, we may not even be where we are today...given that the easy money that supported the credit bubble had its origins in policies that were designed to save the economy from fall-out from the dot-bomb.