SEC to Expand Trading Probes
Derivatives Now Under Scrutiny

By Heather Landy
Special to The Washington Post
Saturday, September 20, 2008

NEW YORK, Sept. 19 -- Regulators investigating the recent wreckage in financial stocks expanded their probes Friday and will examine whether investors manipulated the markets to profit from derivatives trades, in addition to short selling.

This would be the Securities and Exchange Commission's first sweeping investigation into credit default swaps, derivatives that act as insurance policies against defaults by bond issuers.

The SEC said it will require hedge-fund managers, broker-dealers and institutional investors with significant trading activity in financial stocks or positions in credit default swaps to disclose their investments under oath to the agency. SEC enforcement staff members also plan to subpoena documents and testimony.

The SEC's investigation will focus on traders who might have used credit default swaps, short selling and other investment tools to profit illegally from the big hits that financial companies suffered this week in the markets.

The SEC on Friday also banned short sales of financial stocks for at least 10 days.

Morgan Stanley chief executive John J. Mack and the heads of other financial companies have complained that the value of their companies' shares has plummeted because of attacks by short sellers.

In a short sale, which is a bet that a stock will fall, shares are borrowed on the open market and then sold to another investor. To repay the lender, the short seller buys the stock later at what he hopes is a lower price than where he sold it. The short seller profits from the difference.

Credit default swaps trade on an unregulated market that has grown tremendously in the past decade. Some investors have suggested that short sellers could be pushing up the prices of such swaps to cause stock prices to tumble. Others have suggested the reverse, saying hedge funds might have loaded up on the swaps and then tried to manipulate stocks lower so that the swaps, insurance-like instruments designed to protect against a default by a bond issuer, would increase in value.

"To get a complete picture of what market participants are doing, we feel it's important to look at all those areas," said Scott Friestad, deputy director of the SEC's enforcement division. Traders might have manipulated one market to profit in another, a strategy Friestad said was akin to "investing in insurance while other things you might do could be burning down the house."

The SEC has announced the inquiries and regulations this week to try to pull the plug on trading strategies that have been widely blamed for the recent panic that hastened Lehman Brothers' tailspin into Chapter 11 and temporarily crushed shares of Morgan Stanley.

Earlier this week, the SEC reinstated temporary rules meant to protect financial firms from "abusive naked short selling," which is when a short seller sells stock before it is borrowed and has no intention of completing the second step of the transaction. Friday's ban went much further, halting all short sales -- naked or otherwise -- in about 800 financial issues.

In a typical market, a legally transacted short sale should not push down the share price any more than a plain-vanilla stock purchase would push up the price.

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."