No pain, no gain

The actions of the Securities and Exchange Commission and Treasury Department yesterday are unfathomable. Imagine if the Federal Drug Administration, upon learning that a cold-medicine manufacturer was selling a defective run of its product, recalled all cold medicine on the market from all manufacturers.

That’s what the SEC and Treasury did in effect yesterday. Rather than police the marketplace by enforcing existing laws regarding naked short-selling and rumor-mongering in the financial markets, the federal agency has basically banned certain short investments altogether.

The Wall Street Journal reported this morning,

"In a dramatic emergency order, the SEC said it would immediately move to curb improper short selling in the stocks of struggling mortgage giants Fannie Mae and Freddie Mac, as well as those of 17 financial firms, including Goldman Sachs Group Inc., Lehman Brothers Holdings Inc., Morgan Stanley and Merrill Lynch & Co.

The plan, which is expected to go into effect on Monday, will expire in 30 days. But the SEC will also begin considering whether to extend the new requirements to all stocks traded in the U.S. The actions represent one of the most extensive attempts by a government agency in recent years to control short selling.

It’s far from clear whether the move, which sparked a barrage of criticism, will curb the activity of short sellers. While its aim is to curb abuses, it also would add an additional layer of bureaucracy to legitimate transactions."

To me, it is interesting how the big financial firms – two of them government-chartered and semi-public – are basically being given extensive protection from the ravages of the market, when there are other companies that are also struggling, like General Motors, that are not being protected at all. Regulators are picking and choosing who to save (and have done so too late for Bear Stearns in any case). Of course, I am not unaware that these institutions operate as lynchpins for the go-go global economy; however, shielding them from legitimate short-sell transactions is, well, just plain bizarre.

Why does shorting these stocks scare the Feds and the banks so much?

Aside from the grave damage that a failed Wall Street bank could wreak on the global markets, these financial firms operate in a cloud. There is zero transparency and very little faith in the marketplace that banks and others have come clean regarding their financial obligations and liabilities. Small write-downs have become big ones; off-sheet conduits weren’t really off the balance sheet at all; and debt and derivatives formerly deemed safe are increasingly toxic. This is the kind of atmosphere in which short sellers thrive, with or without rumor.

But, in this atmosphere, even defining the line between rumor and theory can be difficult, which is why the regulators’ actions yesterday are so pernicious. Without touching the proximate cause of the problem, they have chosen to treat symptoms, and in the course of doing so, made a grievous error in judgment. What investors need now more than ever is more information, not less, and calling every piece of unsubstantiated information a ‘rumor’ can only turn the opacity of the banks’ balance sheets to a nice charcoal color. There will be less talk, less theorizing, less thinking.

There is so much wrong with today’s financial system that it is difficult to know where to begin, but lynching short-sellers is surely not the place, or as MarketBeat’s David Gaffen opined,

"The move may, ultimately, satisfy the bigwigs among major financial executives who recently discovered that the bilge being held on their balance sheets is not the cause of their problems but the terror of short-sellers. But it’s detrimental in the long-term, as it gives people yet one more reason to excuse the market’s condition as the figment of someone else’s nefarious plan."

The irony is that many folks on Wall Street suspect the most actively malign traders vis-à-vis short-selling are resident at – you guessed it – a Wall Street bank.

This emergency order is about one thing in my estimation: protecting Wall Street from its own incompetence. It could also signal to those of us on the outside that things are moving from bad to worse in the financial markets rather quickly.