As part of a wide-ranging effort to contain Wall Street's worst financial crisis since the Great Depression, the Securities and Exchange Commission (SEC) took the unprecedented step Friday of banning short sales of stock in 799 financial companies.
WASHINGTON — As part of a wide-ranging effort to contain Wall Street’s worst financial crisis since the Great Depression, the Securities and Exchange Commission (SEC) took the unprecedented step Friday of banning short sales of stock in 799 financial companies.
Here are some questions and answers about the government’s decision:
Q. What is short selling?
A. While it can involve lots of behavior that sounds dubious, such as “covering your shorts” and “naked shorting,” the practice of selling stock short is pretty straightforward.
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Investors “sell short” if they think the shares of a particular company are going to decline and they want to profit from the drop.
To do this, an investor borrows shares of Company X, usually from a broker, and then immediately sells the shares at their market price, say $100 per share.
If the share price falls, let’s say to $80, the investor buys back the shares and returns them to the broker. The investor pockets the difference — in this case, $20 per share.
The practice can be risky: If the shares increase in value, the investor has to buy them back at a higher price and loses money.
Q. Why did the SEC temporarily ban the practice?
A. The government and some money managers blame widespread short selling by hedge funds for contributing to the collapse of Lehman Brothers, American International Group (AIG) and other troubled companies by driving down their share prices.
Shares of the two surviving independent investment banks, Goldman Sachs and Morgan Stanley, saw sharp price drops this week. On Wednesday, Morgan Stanley shares fell 24.2 percent while Goldman’s dropped 13.9 percent.
Such sharp drops erode the market’s confidence, which makes it harder for the companies to raise capital and could scare away clients, further weakening the companies.
The SEC’s ban gives financial companies time to stabilize “without the daily drumbeat of hedge funds shorting them on a coordinated basis,” said Phil Orlando, chief equity-market strategist for Federated Investors, which manages $330 billion in assets.
New York Attorney General Andrew Cuomo said Friday his office will investigate whether some short sellers spread negative information to drive down the share prices of Lehman, AIG, Goldman and other firms.
Q. What’s naked shorting?
A. Naked shorting involves selling shares without actually borrowing them, a practice that critics say is particularly prone to abuse, because it potentially enables more shares to be sold into the market than actually exist.
The SEC temporarily banned naked shorting of 19 financial companies in July.
On Wednesday, it restricted the practice but did not ban it outright.
Some money managers have called for the SEC to prohibit naked shorting.
Q. How much are short sellers really to blame for the mess we’re in?
A. That’s a hotly disputed question. The SEC said that in normal times “shorts” can make markets more efficient and bring in more capital, but added that a “time out” is needed.
Richard Baker, president of the Managed Funds Association, a trade group for hedge funds, said shorting is “an essential risk-management tool.”
Q. Will the SEC’s move work?
A. It certainly helped reverse the slide in financial companies’ shares Friday. Goldman and Morgan Stanley each jumped about 20 percent.
The hope is that by the time the ban is lifted, the rest of the government’s rescue plan, which includes acquiring some bad mortgage-related assets from large banks, will kick in and the market will stabilize on its own.
But Baker pointed out that by the time this summer’s temporary ban on naked shorting was lifted, the shares of the 19 covered companies had dropped anyway.