Betting on Bad News

NEW RULES? Mary L. Schapiro's SEC will consider measures to curb short selling, including reinstating the
NEW RULES? Mary L. Schapiro's SEC will consider measures to curb short selling, including reinstating the "uptick rule." (By Jay Mallin -- Bloomberg News)
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By Binyamin Appelbaum and David Cho
Washington Post Staff Writers
Tuesday, March 17, 2009

As the stock prices of major financial companies plunged over the past year, in some cases helping to drive firms out of business, executives and government officials have repeatedly pointed a finger at short sellers, investors who make money from falling prices.

Some have called it a war between the government and short sellers over the fate of troubled firms.

Regulators briefly banned short selling of financial stocks in September, seeking to save firms from what they described as unfair and destructive attacks. That ban was ended after it was deemed to have done more harm than good. But with share prices still in a deep trough, the Securities and Exchange Commission in April plans to consider new measures to restrict short selling, including the restoration of a rule that the SEC eliminated in 2007.

Some financial experts regard the government's efforts as misguided. They note that short selling plays an important role in the marketplace, allowing investors to express skepticism about a company. They also note that short sellers succeed only when other investors are not interested in buying shares at a higher price.

"You'd think you'd find someone who wants to buy a massive number of shares when a stock price falls by 95 percent. You'd think it would be pretty easy," said Albert S. Kyle, a finance professor at the University of Maryland. "The fact that they can't really tells you something about these companies."

Furthermore, the share prices of many financial companies, including Bank of America and Citigroup, have fallen precipitously without a significant increase in short selling. That underscores the idea that the real reason for falling prices is a general loss of investor confidence.

A share-price decline does not hurt a company directly, but senior administration officials worry that it can function as a warning light, leading depositors and business partners to withdraw. Officials said a share price that stagnates below $1 could force the government to intervene. Low share prices already have prompted the government to intervene in some cases, as with the latest round of aid for Citigroup last month.

A short sale is a bet that a share price will decline. The bettor borrows a share of stock for a fixed period of time and sells it at the current price. At the end of the period, he buys a new share and returns it to the lender. For example, a bettor might borrow a $1 share, sell it, watch the price fall 20 cents, then buy a new share at 80 cents to repay the initial loan -- realizing a profit of 20 cents. By contrast, if the price of the share rises to $1.20, the bettor would lose 20 cents.

The practice is controversial because it can create its own momentum. Other investors, seeing a large number of short sales, may conclude that the bettors have learned something troubling, and therefore begin to sell their own shares. And short sellers can encourage this process by spreading rumors.

Over the past year, since the failure of Bear Stearns produced a windfall for short sellers who had bet against the company, financial executives have complained repeatedly that they are being victimized.

"What's happening out there? It's very clear to me," Morgan Stanley chief executive John J. Mack wrote to employees last fall. "We're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down."

The government's first response, a ban on short selling of financial stocks in September, was backed by Christopher Cox, then chairman of the SEC; Henry M. Paulson Jr., then Treasury secretary; and his successor, Timothy F. Geithner, who headed the Federal Reserve Bank of New York.

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