Short-Sellers Add Balance to Market Speculation

Once again, global governments are trying to tamper with capital markets in an attempt to deter speculators and restore order to the battered financial sector.

Bear markets tend to rear the government’s ugly head. In my book, the less government intervenes, the better. Markets should be allowed to function freely provided participants are regulated and transparent in their reporting.

Sometimes, however, the government has to intervene as investors are unfairly punished or defrauded; this was the case earlier this decade with Enron, Worldcom, Tyco and the Spitzer mutual fund-timing scandals. Millions of investors were victimized, defrauded and CEOs were subsequently sentenced or heavily fined.

But now the rules are about to change as short-sellers are targeted by the United States, the United Kingdom and Australia.

In an effort to curb speculation in financial services stocks, the United States Securities and Exchange Commission (SEC) have introduced new short-selling rules for the next 30 days. These changes bar institutions, mainly hedge funds, from shorting financial stocks. The government has issued a list of 19 banks and investment banks which cannot be shorted.

Australia is also mulling a similar law -- only it’s far broader in scale. Lawmakers in Australia want to include all stocks and not just financials; the stock market in Sydney is down more than 23% this year and the government is now taking aim at all short-sellers. The United Kingdom is debating a similar law.

The SEC, which announced these new rules last Tuesday following a second day of financial stock pummeling, triggered a massive 17% rally for the bank index on Wednesday. Better-than-expected corporate earnings also boosted financial shares but most companies continued to report challenging economic circumstances this year. The new short-sale rule was probably the biggest single factor contributing to the rally combined with a flurry of hedge fund short-sale covering or closing positions that bet against further declines in financial stocks.

So will this new rule help financial stocks and their devastated shareholders?

The answer is probably not.

Though the government has identified 19 financial institutions to be protected, this leaves a few hundred more that remain even more vulnerable as a result of this legislation.

Hedge funds and other speculators will find alternative targets. If a financial stock deserves to be priced lower, then it should trade at a discount to other more profitable companies. By isolating 19 companies, the SEC has invited vultures to the party as hundreds more are now fresh targets that are not protected by the 30-day rule.

Don’t blame the hedge funds for the woes afflicting the financials. The real blame falls on poor financial supervision, poor government regulation and rogue CEOs that went absolutely wild issuing mortgages to sub-par applicants. And don’t forget Wall Street. Investment banks, the largest of whom are now protected by the Feds with the new short-selling rules, were the largest issuers and innovators of mortgage-backed securities tied to synthetic derivatives.

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