SEC Bans Shorting of Financial Stocks

Within hours after U.S. presidential candidate John McCain threatened to fire SEC chairman Christopher Cox for not enforcing the rules against naked shorting, the SEC has banned all shorting of financial stocks. (Will this ban, too, go unenforced?) From CNN:

The U.S. Securities and Exchange Commission took what it called "emergency action" on Friday and temporarily banned investors from short-selling 799 financial companies.

The temporary ban, aimed at helping restore falling stock prices that have shattered confidence in the financial markets, takes effect immediately.

Short sellers borrow stock with the aim of selling it, then buy it back at a lower price, hoping to pocket the difference. The commission said short sellers add liquidity to the markets during normal conditions, but recent unbridled short selling has contributed to the recent tailspin in the stock market. ...

Cox said the action "would not be necessary in a well-functioning market," ...

Some market observers, including top bank executives, have also blamed short sellers for the punishing declines in bank stock prices over the past few days.

The shorting of stocks provides a valuable service in a market where most actors have an incentive to promote bubbles. Company managements have a vested interest in overstating the company's earnings and fund managers have a vested interest in 'talking up' the stocks they own. In such a market, short sellers often end up as the only voice of dissent. (Meredith Whitney excepted.)

The banning of shorting during a financial panic seems reasonable, but I will point out that there is no counterpart during a bubble. Too many people have an "only up" mentality, which attempts to defy the laws of mathematics.

This new outright ban on shorting financials raises the question of what will happen to mutual funds and ETFs, such as UltraShort Financials ProShares, which exist solely for the purpose of shorting financial stocks. Can they avoid the new rule by relying on options, rather than shares of stock? Are ordinary investors who own these ETFs suddenly criminals?

If the Fed had stepped in to restrain the housing bubble five years ago, none if this would have been necessary.