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July 18, 2008

The SEC Brings Back the 1930s

Charles Jones
Professor, Finance and Economics
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Earlier this week, the SEC issued an emergency order prohibiting naked short selling in 19 financial stocks, including Fannie Mae, Freddie Mac, Lehman Brothers and other names in the news. Beginning on Monday (July 21), it won’t be enough to make a good-faith effort to locate shares to borrow. Short sellers will have to have a formal agreement to borrow the shares in these stocks before they actually initiate a short position.

Emergency orders don’t happen every day, so you might think we are in uncharted waters. But when stocks go down sharply, it’s actually a fairly common response by regulators to try to throw sand in the gears and slow down the shorts. Perhaps the SEC was looking to the 1930s for guidance.

Back in September 1931, the world economy was spiraling downward into the depths of the Great Depression. U.S. stocks had fallen about 70 percent (!) from their 1929 peak, and short sellers were blamed. A number of commentators called for an outright ban on shorting. When Great Britain abandoned the gold standard on Sunday, September 21, 1931, the NYSE capitulated and issued an emergency order prohibiting all short selling. The gold standard news should’ve led to a sharp decline, but stocks advanced, mostly because specialists and other market-makers had no ability to provide liquidity on one side of the market. It was clear that the rise in prices was completely artificial, and after two days the NYSE repealed the ban.

An even closer analogy happened in early 1932. By then stocks had fallen even further. Opponents of short selling were encouraging stockholders to throttle short sellers by not lending shares to them. But like today, most brokerage customers held their shares in “street name,” and back then brokers could lend these shares without permission from the investor. On February 18, 1932, the NYSE announced that, effective April 1, brokers would need written authorization before lending an investor’s shares.

There was ample time for brokerage firms to secure the needed signatures, but they were apparently unable to do so in sufficient quantity. This wreaked havoc on the securities lending market. Share lenders were able to extract substantial concessions from borrowers. But the effect was completely temporary. Within two weeks, conditions in the share lending market had returned to normal. Stock prices rose on the announcement, but actually fell on April 1, because the market was expecting things to be worse. Ultimately there was only a short-term, temporary reduction in short interest.

I expect something similar here. None of the 19 stocks on the list are particularly hard to borrow. The vast majority have never been on the so-called threshold list, which identifies stocks with a significant amount of naked short selling. For these stocks, the SEC’s order really just adds more hoops for brokers. There could be a temporary effect if back offices can’t figure out right away how to jump through these hoops, but it will be very short-lived. Plus there are plenty of other ways for investors to take a bearish view. If a hedge fund can’t short, it can still buy puts. The options market-maker who sells the put will hedge by shorting the stock, and it looks like that options market-maker will be exempt from the naked shorting ban. At most, all we’ve done is add a middleman. So I suspect we won’t see much effect on Monday.

The pre-borrow requirement is actually a good idea. You can’t buy stocks unless you have the money or borrow it. You shouldn’t be able to sell stocks unless you have the shares or borrow them. I just think it won’t make much difference for these 19 stocks.

Comments

by Howard (Howie) Flinker | July 30, 2008 at 2:59 PM

Charlie, nice commonsensical reminder. It specifically and more gently points out what Theodore Burton warned us overall about financial panics and the reactions of politicians and regulators among others.

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