New York – News that the SEC is considering the implementation of stiffer rules on short selling is not really a surprise. The fact that the rules are temporary and apply to a subset of stocks should be. Clearly, the SEC is seeking to specifically target short sellers in the financials, with additional emphasis on the shares of Fannie and Freddie. While short sellers are generally maligned in times like this, it is the naked shorts that are targeted.
Existing rules state that the brokers for the client must have a general idea that the shares that are being borrowed are available. The new rules to be instituted for a period of 30 days (extensions are possible) will make clear that the brokers must have the shares identified and must deliver them within the 3 day time period, or be in violation of securities laws.
The rules seek to limit naked short selling, but also are designed to send a message to those that would attempt to manipulate share prices. Rumors are a part of Wall Street, always were and always will be. The issue is not rumors, but the malicious spreading of false information. Some market tracking news and analysis systems report market chattered to their clients. These groups have a responsibility to check the rumors. However, it is adding information to know that a rumor is “in the market”, so some of these groups simply confirm this by hearing it from multiple sources before publishing it. As a result, it is not the facts that are checked, but the existence of a wide spread rumor.
Whether the short sellers are attempting to manipulate the market or simply rationally assessing the value of the shares and the balance sheet strength of the company is not readily apparent.
What is clear is that the preponderance of the hedge funds—all generating alpha for their clients—and the extremely lax credit conditions in recent years has produced the need for a serious correction in the markets. As Michael Goldstein of Empirical Research has often said, there is simply not enough alpha in the markets to pay the hedge funds’ fees that are chasing it. The natural implication for hedge funds is to leverage up in smaller spreads to increase profitability. This works, until the credit cycle begins to wane.