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Emergency rules against naked shorting end

August 13th, 2008 · No Comments

So, what do we know from the installation of those emergency rules against naked shorting?

For those who are not quite sure what we’re talking about:

  • Shorting is borrowing shares to sell them and buy them back at a lower price, giving the lender back his shares and pocketing the difference
  • Naked shorting is doing the same without first borrowing them, this can lead to delivery problems when the shares are sold
  • Shares for which delivery still hasn’t materialized after the statutory three days end up on the regulation SHO list. (InterOil is on that list for close to 500 consecutive trading days, for instance)
  • The SEC instituted a requirement  that shorters should borrow shares for 19 financial companies first before shorting them.

It has expired. Has that rule been a success? It seems so. From Bloomberg:

  • Bank of America Corp. and Morgan Stanley’s month long rally, propelled by an emergency limit on short-selling, may end as the rule’s expiration lets investors redouble bets that losses will mount.
  • Mortgage underwriters Freddie Mac and Fannie Mae and 17 brokerages resume trading today freed from the Securities and Exchange Commission’s restriction aimed at preventing stock manipulation. The group’s shares rose by an average of 17 percent since the SEC’s action on July 15.
  • Analysts including Oppenheimer & Co.’s Meredith Whitney and Deutsche Bank AG’s Mike Mayo this week cut profit estimates and forecast further writedowns on mortgage-related bonds. Bets in the options market against gains in the Standard & Poor’s 500 Financials Index are within 2.3 percent of a record, Bloomberg data show.
  • “You are going to see stresses continue for financial institutions,” said Stephen Wood, who helps manage $213 billion at Russell Investments in New York. “You’re beginning to see that macro-economic slowdown ripple through.”
  • JPMorgan Chase & Co., the second-biggest bank by market value behind Citigroup Inc., on Monday reported a $1.5 billion loss on mortgage-backed assets since the start of the third quarter, less than two months ago. JPMorgan shares dropped 9 percent yesterday, the steepest decline in six years, as Ladenburg Thalmann & Co. analyst Richard Bove called the stock “dead money.”
  • Bear Stearns Probe. Lehman Brothers Holdings Inc. led declines yesterday among shares of 19 companies covered by the SEC’s temporary rule. Lehman tumbled 12 percent to $16.21, paring its advance since July 15 to 23 percent. Bank of America, based in Charlotte, North Carolina, fell 6.7 percent yesterday to trim its gains since July 15 to 68 percent.
  • The SEC is investigating whether trading abuses contributed to the collapse of Bear Stearns Cos. in March and the 75 percent drop in Lehman shares this year. Fannie Mae and Freddie Mac each lost more than 80 percent of their value amid speculation the two largest U.S. mortgage buyers may not have enough capital to cover losses from the deepest housing slump since the Great Depression.
  • In traditional short selling, traders borrow shares and sell them. If the price drops, they profit by repaying the loan and pocketing the difference. The SEC’s temporary rule, which went into effect July 21, aimed to make it harder for investors to complete so-called naked short sales. The Washington-based agency hadn’t seen an increase in such trades, Chairman Christopher Cox told  reporters July 16.
  • Short Sales Plummet. The SEC required brokers to arrange a loan before selling short shares of the 19 companies. In the first week, short sales plummeted 78 percent compared with the number of trades on July 14, the day before the rule was announced, according to S3 Matching Technologies, an Austin, Texas-based firm that processes transactions for brokerages.
  • Short interest, or the number of securities that have been sold short and not yet repurchased, in the 19 companies fell by an average of 13 percent in the two weeks ended July 31, New York Stock Exchange data show. Overall, short interest at the NYSE dropped 1.5 percent during that period.
  • The drop contrasts with increased pessimism among investors for financial companies. Short interest for an exchange-traded fund tracking the 88 bank and brokerage stocks in the S&P 500 rose 13 percent during the period, NYSE data shows. Open interest in put options on the XLF, as the Financial Select Sector SPDR Fund is known, climbed to 4.61 million contracts yesterday, just shy of the 4.71 million record reached July 18.
  • `All-Time Lows’ Analysts have also turned pessimistic, according to First Coverage Inc., a Toronto company that tracks recommendations from 250 different brokerages. Analysts were the most bearish on financial stocks than any other industry group in the S&P 500 last week, down from a two-month high in optimism during the first week of July.
  • “Financials find themselves back firmly entrenched in last place, nearing all-time bearish lows,” First Coverage Chief Executive Officer Randy Cass said in an interview yesterday.
  • Oppenheimer’s Whitney and Deutsche Bank’s Mayo yesterday cut their profit estimates for Goldman Sachs Group Inc., citing weaker revenue from underwriting and equity capital markets. Mayo also reduced his earnings projections for Morgan Stanley. In addition, Lehman analyst Jason Goldberg cut his earnings projection for JPMorgan.
  • Goldman declined 6 percent in NYSE composite trading, for its biggest drop since February 2007, while Morgan Stanley fell 6.4 percent. That eroded their gains since July 15 to 6 percent for Goldman, and 37 percent for Morgan Stanley. JPMorgan has climbed 22 percent since July 15.
  • “Banks have to reinvent themselves and find new ways to make money, and that doesn’t happen overnight,” said Tim Ghriskey, who helps manage $2 billion as chief investment officer at Bedford Hills, New York-based Solaris Asset Management. “The strong performance we’ve seen off the bottom may be a bit premature.”

So: the shorting in those 19 companies went down a lot, while their stock prices went up a lot, despite increasing gloom about their fundamentals. We’d say the rule was a success. It needs to be extended to the whole market.

Tags: The Markets