Short-Sellers: Unfairly Targeted in the Market Crisis?

During the nearly three-week ban on shorting financial shares, the market sank 21.5%. Are regulators after the wrong parties?

by David Bogoslaw

As the panicked selling in equities markets around the world has accelerated over the past two weeks, there have been several attempts to slow the process, including the temporary suspension of trading on stock exchanges from Moscow to Milan. In the U.S., the Securities & Exchange Commission banned short-selling—bets that shares of certain companies would fall—on a list of more than 800 financial stocks whose balance sheets have exposure to risky mortgage-backed securities and other distressed products.

When the ban, which lasted 13 trading days, was lifted on Oct. 9, it signaled a return to business as usual for the financial sector. Shares of Morgan Stanley (MS), one of the last-standing investment banks, which recently became a bank holding company subject to tighter government regulation, sold off with a vengeance, finishing almost 26% lower on Oct. 9 and dropping an additional 24% on Oct. 10. Insurance stocks such as Prudential Financial (PRU) and Hartford Financial Services Group (HIG) were also among the biggest losers on Oct. 9.

Whether the ban had the intended effect remains open to debate, given the 21.5% drop in the Standard & Poor's 500-stock index from the market close on Sept. 19, before the ban took effect, through its last day, Oct. 8. And the nearly 33% plunge during the same period in the KBW Bank Index (BKX), which has a much closer correlation with the 800 names traders were prohibited from shorting, is enough to make one think regulators were trying to pin blame for the extended sell-off in financial stocks on the wrong people.

Cover for the SEC?

Some market strategists think the ban was nothing but political cover for the SEC to show it was paying attention. In reality, the regulator has been behind the curve in reining in dubious financial reporting practices by the major financial institutions, which helped create the current crisis. By preventing short-selling for two and a half weeks, the SEC disrupted "a legitimate way for investors to convey information to the market" about the pricing of stocks, says Gerald Buetow, managing director of Portfolio Management Consultants, the investment arm of Envestnet . If anything, the ban on selling short seems to have exacerbated market volatility by depressing trades in the options market and forcing investors who couldn't hedge their long stock positions to take offsetting options to sell their stocks.

The market-makers who provide much of the liquidity in the options market curtailed their selling of options on financial stocks during the ban because they couldn't cover themselves by selling short, says Peter Bottini, executive vice-president for trading at optionsXpress (OXPS) in Chicago. He thought they would jump right back in after the ban ended, but that hasn't occurred. That's probably because the key liquidity providers tend to be the options desks at the larger banks, whose shortage of cash isn't allowing them to play that role right now. That's one driver, he believes, of the unprecedented volatility in the equities market at the end of this week. The Chicago Board Options Exchange Volatility Index (VIX) soared 20%, to a record-high 76.94 on Oct. 10 before sliding back to close just under 70.

For those who are determined to drive down the price of a stock, there are far more effective and less costly ways to do so than by selling short, says Buetow at Portfolio Management Consultants.