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December 8, 2008

2008 Review: Short Sellers Get the Blame (Once Again)

Turbulent Times

By Peter Chapman

In 1929, after stock prices were cut nearly in half over a two-month period, short sellers got some of the blame and the New York Stock Exchange banned short sales at prices lower than the last sale.

Despite the new rule, the market still managed to crash again in 1937. The Dow Jones Industrial Average dropped about 34 percent in the second half of the year. Once again many blamed short sellers. A three-year-old Securities and Exchange Commission responded by imposing Rule 10a-1, an "uptick" rule similar to the New York's.

Even with the two rules, the stock market still managed to crash in 1974, 1987 and 2002, shedding about 30 percent of its value each time. The SEC eventually decided the uptick rule was useless and repealed it last year, along with the price-test rules of the NYSE and Nasdaq.

Flash forward to this summer: Faced with crashing prices for bank stocks, politicians and editorialists were crying for the reinstatement of the uptick rule.

Under enormous political pressure, the SEC decided to go one step further by imposing a total ban on short selling. On Sept. 19, the Commission temporarily banned short selling on 799 financial stocks, a list that was later expanded to nearly 1,000 securities.

The purpose was to "restore equilibrium" to the markets in those names, the SEC said. The agency granted an exception to the rule for market makers in cash equities and options.

The move did take many of the shorts out of the market. Short interest declined on both Nasdaq and the New York in the latter half of September. The average number of days to cover short positions fell to 3.24 on Nasdaq by Sept. 30, from 5.22 days in mid-September. At the NYSE, short interest was equal to 3.88 percent of shares outstanding.

Still, despite an outright ban on short selling, the downward progression of bank stock prices continued. During the three-week period it was in effect, the targeted securities dropped 13 percent, according to a study by TFS Capital, a hedge fund based in suburban Philadelphia. That was better than the performance of the market as a whole. During the same time frame, the S&P 500 index dropped about 18 percent.

If the SEC's emergency order, which was lifted on Oct. 9, achieved some success in reducing the velocity of the stocks' freefall, it did not come without a price. Traders left the market. Liquidity dried up. Spreads widened. Volatility surged.

"The high-frequency players are turned off right now because of the SEC ban on short selling in financial stocks," Dan Mathisson, head of Advanced Execution Services at Credit Suisse, told Traders Magazine at the time.

The story may not be over. In October, the SEC asked executives from a group of exchanges, large broker-dealers and the Financial Industry Regulatory Authority to get together and ponder the efficacy of a new short-sale rule. The group told the SEC that a new price-test rule was unworkable, but that a circuit breaker, to be used only in times of panic, might be feasible.

A circuit breaker would kick in if an individual stock or index fell by some very large amount during the day, the executives proposed. Then short selling in the security or the market would be halted for a while.

Neither Bob Greifeld, president and CEO of Nasdaq OMX Group, nor Duncan Niederauer, CEO of NYSE Euronext, appear very enthusiastic about a new rule, though. "We [at Nasdaq] don't have any religion when it comes to circuit breakers or the uptick," Greifeld said at a Securities Industry and Financial Markets conference. "Our religion is to make sure we don't have to do a lot of work and that it doesn't affect the normal functioning of the market."

Niederauer told the crowd, "We may just have to take one for the team."

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