The SEC, the Ban on Short Sales, and A Vote of No Confidence in the Efficient Market

We were treated to the Feds (and Treasury's) decision to purchase 80% of AIG, an extraordinary intervention by the government into the private sector.  This morning we see an equally unprecedented regulatory step, the decision by the SEC to ban short selling in almost 800 companies.   The ban is only for 10 days although it may be extended.  But even with the short term nature of the step, it reflects both panic at the SEC and an extraordinary lack of faith in the market.  

The SEC suggests that short selling is essentially manipulation.  As the release notes:

• Given the importance of confidence in our financial markets as a whole, we have become concerned about recent sudden declines in the prices of a wide range of securities. Such price declines can give rise to questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence, without a fundamental underlying basis.  This crisis of confidence can impair the liquidity and ultimate viability of an issuer, with potentially broad market consequences.
  

Short sales are a bet that stock prices will go down.  For every short sale, there has to be someone else on the other side of the transaction who thinks the share prices will go up.  In other words, short sales help achieve more accurate price equilibrium.  The transactions are necessary in an efficient market.  When companies release information, some participants may think it will help the prospects of a company and others think it will hurt.  Short sales allow the market to adjust to the information and obtain an efficient price.

By banning all short sales (as opposed to efforts to combat naked short sales), the SEC is merely removing liquidity from the market and impeding the market's ability to set an efficient price for a company's shares.  In other words, it is tantamount to a judgment by the SEC that the market cannot be counted on to accurately set a price.  It is a remarkable vote of no confidence in the efficient market theory, something that has been at the core of the SEC's approach to regulation for a quarter of a century.   

Comments

[Michael F. Perlis]

SEC Ruling Proves the Need for Novel Leadership Through the U.S. Banking Crisis

As the former Assistant Director of Enforcement at the SEC, I applaud the fact that the SEC is at least doing something. Short-selling has, in fact, been a significant contributor to the recent downward spiral of U.S. banks, but there are so many other factors to consider. It’s high time our regulators begin to think a bit out of the box. This is what I’ve been saying all along: We need more ‘CEO type’ leadership from our federal institutions, and by that I mean that we need more innovative leadership willing to come to the table to find a way to go beyond the initial individual efforts to pump funds into the system. Our nation's leaders must form a team from all of the major financial regulatory institutions to find answers to the inherent problems in system.

Most banks are now having trouble raising new capital from investors, a key step to maintaining solvency when loan losses are rising. To add to this crisis, a weak economy is adding to loan defaults due to the enormous loan activity during the recent housing boom. This crisis may dwarf what happened in the early 1990's when savings and loans were also under-capitalized and the federal government had to bail out these private institutions.

Important issues need to be raised, such as what is the true size of potential losses on sub-prime mortgages and other loans. Some estimates put the total at about $1 trillion. Questions need to be asked about the next big unknown -- the large investment banks, are they too big to fail? The failure of Bear Stearns, Lehman Brothers has raised the question of whether US regulators now consider the largest investment banks at risk. Who could be next and are there systems in place to address the failure of a major investment bank? These large institutions play a much larger role than ever before in our financial system by issuing securities, packaging mortgage and credit-card loans, and other financial packages. The preparation for this can only come through a high level management team that can offer the leadership that is currently lacking within our federal institutions.

We must also ask what level of taxpayer dollars may or may not be needed before the crisis is over. The Federal Reserve has been loaning banks money with the expectation of repayment, taking collateral as a way to protect itself. There is discussion of creating another Resolution Trust Corporation, but we don't really know the extent to which this will continue. So, we must hope that a new and focused leadership will drive trust in the system and begin to define the limits of exposure for all of us. I am suggesting that we look at creating three fundamental strategies/approaches in order to restore confidence, build greater strength in the market and propel new growth. They are:

- Federal Economic Task Force: Rather than having all the various financial regulators, such as the Federal Reserve, SEC, Treasury and others all acting individually, we need to pull together all these organizations and have them act in unison, much the way President Franklin Roosevelt unified or created these organizations to dig out of the depression of the 1930's.

- Transparency: We still need to know the real depth of this crisis, who is at risk, and where the next big problem may be, and the public must be educated as to the risks.

- Leadership: Lastly, we need new fresh leadership. We must look beyond the ranks of the financial industry and the traditional economic advisory panels to find new ideas and individuals willing to make hard decisions.

These are elements of a transition towards solving this deepening crisis and defining how our financial markets will and must be structured in the future. We cannot afford business as usual, we need to act now.

Michael F. Perlis
Partner
Stroock & Stroock & Lavan, LLP