SEC Bans Short Selling Financial Stocks The Securities and Exchange Commission has announced a temporary ban on certain types of short selling or betting that a stock's price will fall. Wall Streeter Barry Ritholtz argues that the SEC action reverses 1,000 years of theory about how free markets should work.

SEC Bans Short Selling Financial Stocks

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Some people on Wall Street think this ban on short-selling is short-sighted. One of them, Barry Ritholtz, is an investment-research strategist. He runs a very lively blog called The Big Picture. Hi, Barry.

Mr. BARRY RITHOLTZ (Chief Executive Officer and Director, Equity Research, Fusion IQ): Hi. Thanks for having me.

BRAND: OK. So, you're against it, I understand.

Mr. RITHOLTZ: Yes, yes, to say the least.


Mr. RITHOLTZ: Well, you know, when you look at the role of short-sellers in the market, they actually are not cheerleaders, like most of Wall Street, and they've identified a tremendous amount of fraud and bad activity. If you look at all the major disasters of the past 10 years - Enron, WorldCom, Tyco, and now Bear Stearns - the short-sellers were first ones to say, hey, this is a problem with their books. There's something funny going on here.

BRAND: OK, well, now there's criticism that these short-sellers may be contributing to the funny business in terms of, you know, driving prices down for these big investment banks.

Mr. RITHOLTZ: You know, there's a ton of funds out there. There's a lot of cash out there. If the short-sellers are really driving prices to the point where stocks and companies are mispriced, there should be the countervailing, hey, this is a bargain, let's rush in and buy it. That hasn't happened, and in fact, if you look at the companies that have gone belly up in the past year, every one of them was either insolvent or had some major problem. Again, the short-sellers are the one who identified this.

BRAND: Hm. Well, also, in some of those banks, you have traders, actually, you know - have what is the accusation out there that they contributed to the problem by short-selling these derivatives and by driving prices down across the board.

Mr. RITHOLTZ: Well, there's two issues. One is short-selling in general, and then the other issue is naked short-selling, which - I'll give you the real short version of it. When you short-sell, you're doing the opposite of buying. You borrow stock and you sell it, and you hope to buy it cheaper and return it. Short-selling is legal. Naked short-selling has been illegal for many years. The only reason we have so much of it is the SEC has not enforced the rules against it, because there was a ton of money made by the biggest brokerage firms.

BRAND: OK. Tell us what naked short-selling is.

Mr. RITHOLTZ: Naked short-selling is, instead of borrowing a stock and selling it, you just sell it. And you know, under the rules, you have three days to actually deliver the shares. You're supposed to only sell what you own or what you can borrow. By failing to deliver, you put yourself in violation of the SEC rules, and the penalty for that is your clearing firm - be it Bear Stearns or Merrill or Goldman - they get to charge you a pretty aggressive interest rate.

BRAND: So, naked short-selling is illegal, and yet, you're saying these banks have been doing it.

Mr. RITHOLTZ: Morgan Stanley and Goldman Sachs, the two remaining independent brokerage firms, they're screaming about short-selling now. I could tell you both from anecdotal stories and actual data that when Bear Stearns was going down, the two biggest shorting houses of the stock was Goldman and Morgan.

BRAND: What do you think the government should do, then?

Mr. RITHOLTZ: There are rules on the books that do not allow banks and brokers to get leveraged up any more than 12 to one. And in 2004, the SEC granted a special exemption to five companies, Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman and Bear Stearns. Well, three of those companies are now toast. The reason all these things are taking place - all this leverage on top of a tiny capital base means that a little bit of a pullback in asset value wipes them out, and so, that's the problem with 30 and 40 to one. I believe Bear Sterns, at their peak, was 37 to one. For every dollar of assets, they actually went out and bought 37 dollars worth of various products. And what that means is, you see a three- or a four-percent pullback, you're completely wiped out.

BRAND: Barry Ritholtz, CEO of Fusion IQ - that's an investment research company - and his blog is called The Big Picture. Barry, thank you.

Mr. RITHOLTZ: Thanks for having me.

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