SEC Extends 'Short' Ban as Bailout
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By TOM LAURICELLA, KARA SCANNELL and TENNILLE TRACYArticle
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The Securities and Exchange Commission's decision two weeks ago to ban short selling of nearly 1,000 stocks failed to prevent big declines in share prices in some of the best-known financial companies, has made an already edgy stock market more volatile and has raised trading costs for investors.
The SEC extended the ban on short-selling rules until three days after the $700 billion financial rescue legislation is enacted into law. It won't extend beyond 11:59 p.m. on Oct. 17.
The SEC also said hedge-fund managers would need to disclose their short positions until Oct. 17 and the hedge-fund rule would subsequently be made permanent. The SEC's move came shortly before the Senate approved a revamped financial rescue bill, returning the measure to the House for a vote Friday.
The SEC said the extension was necessary "to allow time for completion of work on the anticipated passage of legislation."
The SEC's ban has been widely criticized as a clumsy effort to buoy shares of battered financial stocks and for signaling to regulators around the world that such market intervention was acceptable. Stock markets from Australia to the Netherlands restricted short selling in the days after the SEC's action.
The ban's most significant impact was to cut in half the trading volume in stocks on the list by removing a big class of buyers who look to hedge their investments, often using short sales. Fast-trading computer-driven hedge funds, which account for significant amounts of trading volume, curtailed their activity. The drop in trading appears to be resulting in wide price swings in stocks at crucial times such as the final minutes of trading.
In addition, the gap between the price at which a stock can be bought or sold at any moment has widened, an indication that markets are working less smoothly. The SEC's rule changes have also been felt in the market for stock options, a commonly used tool for investors looking to offset risks in a portfolio.
Short sellers seek to profit from a stock's decline by selling borrowed shares and replacing them at a lower price. Bank executives blamed short sellers for the declines in stocks, including Fannie Mae and Freddie Mac, which collapsed just before the ban went into effect.
Two weeks ago, the SEC surprised many by banning short-selling in 799 financial stocks and required hedge-fund managers to disclose their short positions to the agency. The no-short list has now been expanded to include unlikely names such as International Business Machines Corp. and CVS Caremark Corp. and now covers nearly one-fifth of regularly traded stocks listed on U.S. exchanges.
But in the two weeks of the ban's existence, stocks including National City Corp. and Sovereign Bancorp Inc. suffered declines that at certain points this week topped 70%. Washington Mutual Inc. failed and was taken over, and Wachovia Corp. was forced to sell itself to Citigroup Inc. Stocks such as Hartford Financial Services Group Inc. lost 25% in two days, and premier names such as Goldman Sachs Group Inc. and Morgan Stanley saw their shares take dramatic drops, which contributed to their decisions to seek approval to become banks.
SEC Chairman Christopher Cox has been under increasing pressure since the collapse of Bear Stearns on his watch. Wall Street firms were agitating for the SEC to address what they said were a combination of false rumors and short selling to manipulate their companies' stocks. Some executives wanted Mr. Cox to use the bully pulpit to let short sellers know the SEC enforcement staff was investigating.
Mr. Cox eventually did, in July, and followed that up with the emergency short-selling order on the 19 financial companies.
Despite the criticism, the SEC extended the ban but didn't respond to industry calls to narrow the contours, including carving out exemptions for hedging strategies for the convertible bond market, which has essentially been shut down since the rule.
Despite the finger-pointing, there were never that many shares sold short on most financial stocks. Credit Suisse analysts noted that a bigger percentage of shares were sold short in Wal-Mart Stores Inc. than in 625 of the stocks on the list. Short interest in Goldman Sachs was 3% of the tradable shares and 4% for Morgan Stanley.
The clearest impact was on trading volume. Between Sept. 22 and Sept. 29, overall trading volumes fell 41.1% from the week of Sept. 15-19, according to a Sandler O'Neill & Partners report. But volume in the restricted stocks is down 49.6%. That has made trading less efficient, participants say, which in turn makes it more costly for investors by lowering the prices at which they can sell and raising the prices at which they can buy.
With volume lower "there are fewer bids and offers in the market, which means less quote competition," said Credit Suisse analyst Ana Avramovic in a report released this week. "It seems that the temporary restriction on short selling has made it more costly, on average, to trade these names," she wrote.
The Credit Suisse analysis found that for the 950 stocks on the restricted list, the average gap between prices at which investors are willing to buy and sell -- known as a "bid-ask" spread -- is nearly 0.40 percentage points, up from about 0.15 percentage points in the first eight months of 2008.
That adds up over millions of transactions. For example, with IBM shares trading at $115, if the spread were 0.15 percentage points, an investor would forfeit roughly 17 cents to buy or sell a share of stock. At the nearly 0.40 percentage point spread, the cost to an investor would be roughly 46 cents a share.
Meanwhile, price swings have become more magnified. Over the course of the day, the volatility of individual stocks since the short-selling ban was enacted has often been twice that seen during a sample period in early August, Credit Suisse found.
End-of-day trading -- which is often volatile -- has been especially unpredictable for stocks on the list. On Tuesday shares of MetLife Inc. were trading at just over $50 a share at 3:55 p.m. In the final two minutes, however, the price spiked to $52 and then hit $56 on the final trade listed on the New York Stock Exchange.
The options market has been the scene of more disruptions, not just from the no-short rule, but also from a tightening of other short-selling restrictions announced by the SEC. The end result was that spreads between bids and offers widened considerably, options volume declined and several brokerage firms limited the types of transactions their customers could conduct.
All of this while the broad impact on stock prices has been minimal. The median decline suffered by stocks on the original restricted list is 2.5% since the ban was put in place through Tuesday night. The S&P 500, meanwhile, was down 3.5%.
Write to Tom Lauricella at tom.lauricella@wsj.com, Kara Scannell at kara.scannell@wsj.com and Tennille Tracy at tennille.tracy@dowjones.com
