SEC should ban hedge funds from pulling out their money, then shorting

Posted Sep 19th 2008 9:15AM by Peter Cohan
Filed under: Goldman Sachs Group (GS), Morgan Stanley (MS)

It looks like SEC Chairman Chris Cox still has his job -- this despite John McCain's call to fire Cox. And what has Cox done for us lately? He's banned short selling on 799 financial stocks for the next 10 days, according to the Wall Street Journal [subscription required]. The SEC's temporary ban on short selling won't help deal with the underlying problems causing this 100 Year Crash -- but it won't make them any worse.

Short selling is one way to bet against the decline in a stock's share price. A short seller borrows shares from a broker and sells them at that market price. SEC rules give the short seller three days to obtain custody of those shares. The short seller profits by buying back the shares at a lower market price to repay that stock loan. So-called "naked shorting" -- when the short seller never obtains custody of the shares -- is considered abusive. By banning short selling, the SEC is trying to interrupt a negative feedback loop about which I posted yesterday.

This loop helped shorts profit from a decline in investment bank shares. How so? All the bad news has been driving down their shares so much that ratings agencies downgraded the investment banks' debt. Since that debt was insured through the $62 trillion Credit Default Swap (CDS) market, the downgrade threat boosted CDS premiums requiring the investment bank to post collateral in the billions. This put even more pressure on the investment bank to raise capital, driving down its shares even more.

But the shorts have been pushing down the shares of these investment banks in another way -- a way which in my humble opinion should be illegal. As I posted, in the case of Bear Stearns, hedge funds ganged up to withdraw their money -- from the bank's very profitable Prime Brokerage unit -- and then sold the stock short. In other words, hedge funds may have colluded to damage the bank's business before getting together to short the stock.

This practice may still be going on. Bloomberg News reports that hedge funds have been withdrawing their money en masse from Morgan Stanley (NYSE: MS) -- I posted about this yesterday. No word on whether the same thing is happening with Goldman Sachs Group (NYSE: GS). Prime brokerage is a huge revenue source for these banks -- it could amount to $11.5 billion in global revenue by the end of 2008, according to Bloomberg. Could hedge funds have shorted these banks' shares before pulling out their money?

There's no telling whether banning this practice would have kept Bear Stearns, Merrill Lynch (NYSE: MER), and Lehman Brothers Holdings Inc. (NYSE: LEH) from their various ends. But if the SEC really wanted to do something useful, it would ban the practice of investors getting together to damage the business of a company before shorting its stock. Until that practice is made illegal, the hedge funds can continue to harm a bank's business and then profit from the decline in its shares in other ways -- such as buying puts or selling calls.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the other securities mentioned.

Tags: Banks, CDOS, Christopher cox, ChristopherCox, featured, Financial stocks, FinancialStocks, Investmetn banks, InvestmetnBanks, john mccain, JohnMccain, SEC, short selling, ShortSelling, Wall Street, Walll Street bailout, WalllStreetBailout, WallStreet

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Reader Comments (Page 1 of 1)

9-19-2008 @ 10:17AM

Mike Sanders said...

"100 year crash?" Obviously, someone who wasn't around in October of 1987, or was too young to remember. I had some comments about short-selling, but I'll post them elsewhere.