The SEC, which has been watching this financial crisis mostly from the sidelines so far, is suddenly on the warpath. First it announced emergency rules meant to make it harder to short-sell certain financial stocks, among them Fannie Mae and Freddie Mac. Now it’s reportedly flinging subpoenas around the offices of Goldman Sachs, Deutsche Bank, Merrill Lynch and more than 50 hedge funds in an effort to find out if manipulators, whatever those are, were behind the collapse of Bear Stearns and the troubles of Lehman Brothers.
This sudden offensive has gotten a lot of criticism, mainly along the lines that it’s
a) political pandering to powerful bankers,
b) an exercise in shooting the messenger and
c) will interfere with the exchange of information and setting of prices in markets
I’m sympathetic to all three of these points. But let me defend SEC Chairman Chris Cox for a moment. First on the short-selling rule: Short selling, as we people who write about business for a general audience almost always feel necessitated to explain, is borrowing a share of stock, then selling it in hopes you can buy it back cheaper later. For several years a few people–most loudly Overstock.com CEO Patrick Byrne–have been claiming that some dastardly hedge fund managers take advantage of the ethereal nature of modern stock markets to sell shares that they never actually get around to borrowing. This practice is called naked shorting, and Byrne’s accounts of it are so over-the-top that I’ve always tended to dismiss them (I still do). But naked shorting is, in theory at least, problematic: If you could get away with selling 100 million shares of a company that only has 80 million shares outstanding, you could definitely drive the price down.
In response to these concerns, the SEC in 2005 adopted a rule (Regulation SHO) that says you have to “locate” the stock you plan to borrow before selling it. This spring it proposed penalties for lying about whether you located the stock. And now it’s saying that, for the stock of 19 financial companies, you actually have to have borrowed the stock before you can sell it. My own hunch is that naked shorting is not a major factor in the sharp stock price drops of banks and other financial firms (fear and bad loans are). If that’s the case, the SEC’s rule will silence the whiners who say naked shorts are a big problem. And if the whiners are right, well, this will have turned out to be a landmark piece of regulation.
As for the hunt for supposed spreaders of false rumors about Bear and Lehman, it has been depicted as an assault on free speech. Yeah, but it would be shouting-fire-in-a-crowded-theater speech. And the SEC already goes after people for pump-and-dump operations where scammers buy shares in some thinly traded company, send out a bunch of e-mails saying the stock’s about to pop, then sell. What we’re talking about here is essentially a dump-and-let-the-air-out. I get that it’s going to be really hard to parse what’s “false” (if you were whispering that Bear was going under you were right, after all). But it’s not as if this investigation is way out of line for the SEC.