Friday, September 19, 2008

Setup for a Crash (BJ Lawson)

BJ Lawson comments on the SEC's disastrous decision to ban short selling of certain financial stocks:

Nothing like a midnight press release from the SEC to let us know that all is well:
SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets


Commission Also Takes Steps to Increase Market Transparency and Liquidity

Washington, D.C., Sept. 19, 2008 — The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. The U.K. FSA took similar action yesterday.

Additional Materials

The Commission’s action will apply to the securities of 799 financial companies. The action is immediately effective.

SEC Chairman Christopher Cox said, “The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets. The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets. This action, which would not be necessary in a well-functioning market, is temporary in nature and part of the comprehensive set of steps being taken by the Federal Reserve, the Treasury, and the Congress.”

I visited China in the summer of 2007 while everything was bubbly and beautiful in their equities markets. Our group met with a representative of the Shenzhen stock exchange, who told us how the Chinese government had taken steps to ensure that China’s markets would always be stable and prosperous. The government knows who is buying and selling every position, so they can identify “market manipulators.” Most importantly, the government has outlawed short selling.

How has this transparency and forbidding short selling helped the Chinese market over the past year?

It’s lost over 60% from its peak. Without any short sellers.

Short sellers simply borrow existing shares, paying for the privilege, and sell them in the open market. They have carrying costs, and must eventually buy the shares back. The fact that they must buy to complete the transaction means that they provide support for stocks during declines — when stocks are going down, short sellers are often the ones buying back to close their positions.

Without short sellers looking to close their positions, declines can be precipitous. In moments of panic, short sellers are the only buyers — so without them, markets can simply crash with no bids offered.

There is a form of short selling, termed “naked” short selling, that is and should be illegal. Naked short sellers don’t actually borrow shares to sell — they literally sell something that they don’t own, without actually borrowing “real” shares. In that case, they are simply counterfeiting stock and dumping it on the market. That’s fraudulent, and must be prosecuted.

The SEC should be prosecuting naked short selling, not eliminating short selling.

This step by the SEC may cause a pop as short sellers rush to close their positions, but it will not prevent insolvent financial firms from facing their ultimate judgment as stockholders eager to exit sell into any strength.

When judgment comes, it will be precipitous.

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