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Borrow from Fed and you get protection against shorting

Section: Daily Dispatches

SEC Extends Ban on Shorting Fannie, Freddie

By David Scheer and Edgar Ortega
Bloomberg News Service
Wednesday, July 30, 2008

NEW YORK -- The U.S. Securities and Exchange Commission extended an emergency limit on short sales in shares of Freddie Mac, Fannie Mae, and 17 brokerages as it prepares broader rules to thwart stock manipulation.

The SEC pushed back expiration of its ban on so-called naked short sales of the firms' stocks to Aug. 12, the Washington-based agency said in a statement yesterday. The order aims to keep traders from driving down financial stocks after Bear Stearns Cos. and IndyMac Bancorp Inc. collapsed amid rumors they were faltering.

The emergency order, focused on companies whose collapse might expose the U.S. government to losses, gives regulators time to weigh wider restrictions. The SEC said yesterday it plans to collect data to measure the impact of the rule and will examine additional proposals to curb short sales.

"The commission will continue exploring other remedies for the broader marketplace to further protect investors from 'distort and short' artists," SEC Chairman Christopher Cox said in the statement. The agency doesn't plan to extend the temporary order again.

In traditional short selling, traders borrow shares and sell them. If the price drops, they profit by re-buying the stock, repaying the loan and pocketing the difference.

... Manipulative investors

Naked short sellers don't borrow shares before settling sales. The SEC is concerned manipulative investors may use the sales, legal under some conditions, to drive down prices by flooding the market with orders to sell shares they don't have. Investors, such as hedge funds, previously could start trades without an agreement to acquire shares.

The temporary order took effect July 21 and would have expired yesterday. It requires traders to at least arrange to borrow shares before selling short Freddie Mac and Fannie Mae, the government-sponsored mortgage buyers. The order also covers brokerages with access to the Federal Reserve's discount window, which was opened to investment banks after the March collapse of Bear Stearns.

Market makers have an exception under the SEC order that permits them to sell short to maintain liquidity.

The American Bankers Association had sought an expansion of the order to include all publicly traded banks and bank holding companies. The Managed Funds Association, the largest hedge fund industry group, asked regulators not to renew the order, saying it damps legitimate trading.

... Sales plummeted

Short sales, particularly among retail investors, plummeted after the SEC announced the ban, according to data from S3 Matching Technologies, which processes trades for three of the top five retail brokerages. The sales fell 78 percent on average among the companies covered by the order, compared with trades on July 14, the day before the SEC announced the measure, S3 data shows. The company handles about 15 billion transactions daily.

"I see no reason that will turn around," said John Standerfer, the Austin, Texas-based firm's vice president for financial services. "It seems like a pretty restrictive rule to put in place for the entire market."

For hedge funds, the costs of shorting the 19 stocks went up after the emergency rule, said Richard Baker, head of the Washington-based Managed Funds Association. If the rule is extended to the broader market, traders might stop shorting shares of smaller companies because of higher costs, he said.

"We'd like to be at the table and understand the SEC's concerns," said Baker. "We may have suggestions as to other remedies.''

... 'Serious' Challenge

The Securities Industry and Financial Markets Association, Wall Street's largest lobby group, said the SEC should also weigh suggestions from brokerages on new rules. Extending the borrowing requirement to all stocks would create a "serious" challenge for brokerages, Ira Hammerman, general counsel for the group, said in an e-mailed statement.

Penson Worldwide Inc., the Dallas-based company that clears trades for more than 250 firms, is introducing a system this week to help automate compliance with the order after employees were forced to work weekends manually reviewing short sales.

"I hope they don't go market-wide, because that would take six months to a year to implement," said Mike Johnson, head of global securities lending. "Capital has to be extended, systems have to be rebuilt and we're talking about months of infrastructure building."

The SEC will start drafting rules next month to safeguard investors against short sale abuses. Cox told Congress last week the agency may also force investors to disclose "substantial" bets on falling stocks and reinstate a version of the so-called uptick rule, which barred short sales of stocks when prices are falling.

The uptick rule, implemented after the Great Depression and scrapped last year, allowed short sales only if a preceding trade boosted the stock price. The SEC is studying whether increasing the uptick increment, such as to a nickel or dime, might be more effective, he said.

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