Govt trading ban could have unintended results

The government's unprecedented move Friday to ban people from betting against financial stocks might be a salve for the market's turmoil but could also carry serious unintended consequences.

In a bid to shore up investor confidence in the face of the spiraling market crisis, the Securities and Exchange Commission temporarily banned all short-selling in the shares of 799 financial companies. Short selling is a time-honored method for profiting when a stock drops.

The ban took effect immediately Friday and extends through Oct. 2. The SEC said it might extend the ban - so that it would last for as many as 30 calendar days in total - if it deems that necessary.

That window could be enough time to calm the roiling financial markets, with the Bush administration's massive new programs to buy up Wall Street's toxic debt possibly starting to have a salutary effect by then.

The short-selling ban is "kind of a time-out," said John Coffee, a professor of securities law at Columbia University. "In a time of crisis, the dangers of doing too little are far greater than the dangers of doing too much."

But on Wall Street, professional short-sellers said they were being unfairly targeted by the SEC's prohibition. And some analysts warned of possible negative consequences, maintaining that banning short-selling could actually distort - not stabilize - edgy markets.

Indeed, hours after the new ban was announced, some of its details appeared to be a work in progress. The SEC said its staff was recommending exemptions from the ban for trades market professionals make to hedge their investments in stock options or futures.

"I don't think it's going to accomplish what they're after," said Jeff Tjornehoj, senior analyst at fund research firm Lipper Inc. Without short sellers, he said, investors will have a harder time gauging the true value of a stock.

"Most people want to be in a stock for the long run and want to see prices go up. Short sellers are useful for throwing water in their face and saying, 'Oh yeah? Think about this,'" Tjornehoj said. As a result, restricting the practice could inflate the value of some stocks, opening the door for a big downward correction later.

"Without offering a flip-side to the price-discovery mechanism, I think there's a pressure built up in stock prices that only gets relieved in a great cataclysm," he said.

Short selling involves borrowing a company's shares, selling them, and then buying them to return them to the lender later, when the stock falls. The short-seller pockets the difference in price.

Although the practice can make markets more efficient and bring in more capital, the government argues that it has widened the scope of the recent financial crisis and contributed to the collapsing values of investment and commercial bank stocks in particular.

Government officials on both sides of the Atlantic have been denouncing hedge funds and other short sellers they say have swarmed over the limp bodies of venerable investment banks and other big companies. New York Attorney General Andrew Cuomo likened them to "looters after a hurricane," and his office is investigating a possible conspiracy among short-sellers to spread negative rumors to pound down companies' stock prices.

The turmoil in recent weeks has swallowed some of the most storied names on Wall Street. Three of its five major investment banks - Bear Stearns, Lehman Brothers and Merrill Lynch - have either gone out of business or been driven into the arms of another bank. Many contend that short-selling played a key role in forcing the collapse of these institutions.

SEC Chairman Christopher Cox, who with Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke had met with lawmakers at the Capitol Thursday night, acknowledged that such extraordinary measures would not be necessary in a well-functioning market and said they are only temporary.

Cox said Friday his agency "is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets." He said the temporary ban "will restore equilibrium to markets."

The SEC also imposed a new requirement, also temporary, for investment managers to publicly report their new short sales of stocks. And the agency eased restrictions on the ability of companies to buy back their own shares, also through Oct. 2, another move aimed at helping restore liquidity to the distressed and volatile market.

Over the summer, the SEC imposed a 30-day emergency ban on "naked" short selling - where sellers don't actually borrow the shares they sell - in the stocks of mortgage finance giants Fannie Mae (FNM) and Freddie Mac (FRE) and 17 large investment banks. But Friday's ban expanded to all short selling, not just the more aggressive naked variety, and to a much wider universe of companies.

The 799 companies covered by the SEC ban are an A-to-Z of the nation's financial institutions, including the powerhouse investment banks such as Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) and commercial banks running the gamut from Bank of America Corp. (BAC) to Cape Fear Bank Corp. (CAPE) SLM Corp. (SLM), which is known as Sallie Mae and is the biggest U.S. student lender is on the list, as are Charles Schwab Corp. (SCHW), Berkshire Hathaway Inc. (BRKA) and Principal Financial Group Inc. (PFG)

Washington Mutual Inc., the nation's largest thrift, which has lost billions from subprime mortgage exposure and seen its shares plunge in recent weeks, also is on the SEC list. So is the NYSE Euronext, the biggest stock exchange, and foreign financial companies whose stock is traded on U.S. exchanges, such as Lloyds TSB Group PLC of Britain and China Life Insurance Co. Ltd.

However, investors still have ways to place bearish bets: by trading in options that turn profitable when a stock drops.

Jim Chanos, a prominent short seller and president of a $7 billion hedge fund, Kynikos Associates, called short-selling a "vital investment strategy" and said banning the practice "will not enhance long-term market integrity."

He argued that investment banks' bad bets on risky assets - not predatory short-sellers - were the true cause of the steep declines in the stock price of financial firms.

"Far from being the cause of the crisis, many short sellers were warning months and years ago about problems in this area," Chanos said in a statement.

The new SEC ban also touched smaller investors. Two popular funds that specialize in short selling and are traded on stock exchanges - ProShares' Short Financials and UltraShort Financials - were temporarily halted Friday due to the ban. Trading resumed later in the day, but ProShares said it has suspended creating new shares in the funds until further notice.

ProShares Chairman Michael Sapir called the ban "extraordinary" and said it remains to be seen whether it has the intended effect of calming the markets.

"I don't think anyone sees the action today as a long-term solution," Sapir said. "It's a way to calm things down, but it isn't consistent with a free and open market."

The SEC's ban came in concert with Britain's Financial Services Authority, which announced a similar ban there Thursday. Some British politicians had claimed that short-selling was partly responsible for HBOS PLC's abrupt takeover by banking rival Lloyds TSB PLC on Thursday. The ban there was met with a similar reaction as the SEC move - a mix of relief and skepticism.

"Banning short selling is just a part of a solution," said Nic Clarke, banking analyst at Charles Stanley Stockbrokers. "We view this as a side issue. It doesn't stop the underlying reason for the credit crunch and it doesn't get to the heart of the problem."