July 23 (Bloomberg) -- Forget naked short sellers. The fellow who isn't wearing any clothes is Securities and Exchange Commission Chairman Christopher Cox.
The emergency order the SEC issued last week, to protect the nation's financial system from so-called naked shorts, is so full of mixed messages and contradictory twists that the agency's plan makes no sense. It does, however, deflect public attention from the government's own failures in the subprime-mortgage debacle.
The SEC says its order is aimed at restoring market confidence by making it harder to bet against the stocks of Fannie Mae, Freddie Mac and 17 other ``substantial financial firms,'' including Wall Street's largest investment banks. Look at how the plan works, though, and the SEC is signaling that the same banks' judgments can't be trusted. This isn't exactly a confidence builder.
In a short sale, an investor borrows shares and sells them, hoping to buy them back later at a lower price and pocket the difference. In naked short sales, which sometimes are legal and sometimes aren't, the investor sells short without having borrowed the securities to make delivery. There is no evidence to date that naked short sales were responsible for declines in any of the 19 protected companies' stocks.
The SEC's rules on short sales, adopted in 2004, generally prohibit broker-dealers from executing short-sale orders for customers or for their own accounts, unless they meet certain conditions. A broker must have ``borrowed the security, or entered into an arrangement to borrow'' it, or the broker must have ``reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due.''
Be Reasonable
Whether a broker has reasonable grounds to believe such things is, partly, a judgment call. And by writing this leeway into the rules, the SEC indicated it could rely on securities dealers to exercise such judgment responsibly. That has changed.
The SEC's emergency order, which took effect July 21 and might stay in place as long as 30 days, eliminated the ``reasonable grounds'' element. Now, generally speaking, when a customer wants to short one of the 19 protected companies, the stock must be in the vault already or on its way there.
Some of the dealers that lost their right to exercise such discretion are the same banks on the SEC's emergency list. So while they are deemed worthy of the commission's protection, the SEC's order makes them seem unworthy of the agency's trust, at least for the time being.
Subprime Losers
In addition to Fannie and Freddie, the protected banks include major subprime losers such as Citigroup Inc., Merrill Lynch & Co., Lehman Brothers Holdings Inc. and UBS AG. The agency might as well have issued its list under the headline: ``Beware! These are the financial firms we're worried about.''
Even so, the American Bankers Association and the Financial Services Roundtable last week sent letters to the SEC, asking it to broaden its list to include other banks. The roundtable said the SEC should cover all financial-services stocks.
They have a point: If the SEC's order was such a good idea, everyone should be allowed in on the racket. Still, if I were in charge at Goldman Sachs Group Inc. or JPMorgan Chase & Co., which are on the emergency list notwithstanding their strength, I would be upset at the SEC for including my bank with all the others.
Other logical inconsistencies abound. On July 18, to avoid hurting liquidity, the SEC amended its order to say the ``borrow and arrangement-to-borrow requirement of the order does not apply to certain bona fide market makers.''
I'm OK, You're Not
For instance, let's say a market maker at one of the protected banks wants to short another protected bank without arranging to borrow the stock first. That's fine. However, it's not OK for an ordinary investor to do the same.
What we have is a preemptive strike against an enemy that, by the SEC's own account, hasn't yet presented a serious threat. At least when the U.S. invaded Iraq, President George W. Bush seemed to believe Saddam Hussein had weapons of mass destruction.
Cox last week said the SEC's order ``is not a response to unbridled naked short selling in financial issues.'' So far, he said, ``that has not occurred.'' Yet he made it look like investors should fear naked shorts anyway.
``Who profits from intentionally false information in the marketplace? Those who are in on the scam and positioned to benefit from the predictable response of others who believe the fraudulent information to be true,'' Cox wrote in a July 18 op-ed for Investor's Business Daily, under the headline ``Naked Short Selling Is One Problem a Slumping Market Shouldn't Have.''
Creating Bogeymen
``The classic `pump and dump' scheme, in which a stock is inflated through false information and then dumped on unsuspecting investors when the perpetrators flee, is one example of how this works,'' he wrote. ```Distort and short' is the same thing in reverse. Naked short selling can turbocharge these `distort and short' schemes.''
In other words: Boo! The SEC has presented no facts suggesting that anything like this has happened at these 19 companies, or at any other major financial firm. Meanwhile, the SEC is spreading unsubstantiated rumors that gangs of undressed, short-selling bogeymen might conspire to hurt the investing public, if left unchecked.
This isn't inspiring confidence. It's fear-mongering.
(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Jonathan Weil in Boulder, Colorado, at jweil6@bloomberg.net Last Updated: July 23, 2008 03:10 EDT
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