SEC to Expand Trading Probes

But these are not typical markets, and the big investment houses like Lehman and Morgan Stanley, which depend on a constant flow of borrowing to stay afloat, are susceptible to any perceived loss of confidence among their lenders.

Some of the recent carnage in financial stocks probably was deserved, given the declining values of the mortgage-related assets on many of the firms' books, but eventually short sellers just seemed to be piling on to drive down the shares, said Charles Gradante, co-founder of the Hennessee Group, a hedge-fund advisory firm.

"It's almost like a shark frenzy. You drop some chum in the water, and you get 100 sharks, and they start biting even each other by accident. And when one shark bleeds, that brings out more sharks," Gradante said. "That's the picture I have in mind for how I see this market right now: a bunch of sharks swimming around, biting at everything, and a lot of innocent people are getting hurt."

The short-selling ban, which expires Oct. 2 but could be extended by the SEC for an additional 20 days, might help relieve the pressure financial firms are under to unwind their holdings of mortgage securities and other assets made toxic by the subprime meltdown, said Stephen Wood, senior portfolio manager for Russell Investments.

"It's kind of like a global time out," Wood said. "I don't think this is a good solution, but it may be better than the alternative."

Regulators already had been looking at trading activity surrounding the rapid fall of Bear Stearns, which suffered a classic run on the bank in March as its stock went into a freefall. Lehman never had the chance to find out if it might suffer the same fate. It filed for bankruptcy protection just days after long-percolating skepticism about the company's finances gave way late last week to a full-blown crisis in confidence among lenders and investors.

"Hedge funds really can't come up with the fundamentals that lead you to believe Lehman Brothers goes to zero. There's no analysis out there that says that," Gradante said. In the case of both Lehman and Bear Stearns, "what the hedge-fund managers were playing on was the inability of other banks to trust each others' balance sheets, and that's what was being shorted."

How much of that shorting was done illegally may be difficult to determine.

But a senior securities-lending executive at a major bank said naked short selling should not have been a problem at Morgan Stanley, which complained this week that it had been attacked by short sellers, because there were enough shares readily available for short sellers to repay their lenders.

"There is a big sense within the hedge-fund industry and the prime brokerage industry that this [emphasis on naked short selling] is all very political," said the executive, who spoke on condition of anonymity because he was not authorized to speak for the firm. "We haven't seen tremendous volumes of naked short selling."