Short-Sale Ban Led To Billions Of Price Inflation -Report

   DOW JONES NEWSWIRES 
 

A ban on short-selling financial stocks imposed by the Securities and Exchange Commission in September led to substantial price inflation in the banned shares, according to a report published by three business professors who estimate at least $4.9 billion of overpayment.

The SEC began to implement a series of short-sale restrictions last summer, and the three professors focused on the effects of the absolute ban imposed by the SEC in September on some 1,000 stocks. The move was intended to protect them from the ravages of the market and cast a wide net, with the rules coming under fire from investors because of the many changes and alterations the agency put forth after the concept was announced.

Short-selling is the sale of borrowed shares by an investor hoping to profit by buying an equal number of shares later at a lower price to replace the borrowed stock.

The professors' report noted the SEC's actions were based on concerns that short sellers were manipulating, or could manipulate, the stock prices of financial companies that were facing strong downward price pressure due to the global financial crisis. By preventing short sellers from trading, the authors argued the SEC created a bias toward higher prices, unintentionally leading to investors buying shares at prices above fundamental value.

If so, the authors reason that the buyers would face significant losses when prices ultimately adjust downward to the shares' true intrinsic value.

For example, before the ban on short-selling, Freddie Mac (FRE) and Fannie Mae (FNM) common shares were trading near 30 cents and 50 cents, respectively. During the ban, the shares rose to nearly $2, but after the ban ended, the stocks soon dropped back to about 60 cents. If the ban inflated their share prices by withholding short-selling supply from the market, the authors reasoned the buyers whose purchases drove the rise in stock prices during the ban executed those trades at artificially higher prices.

Inflation may have transferred $570 million from buyers to sellers in shares of those two companies, the authors said, who added that, for the long-position sellers, the ban on short-selling provided an unexpected windfall.

The abstract report was written by Lawrence E. Harris, of Marshall School of Business at the University of Southern California, Ethan Namvar of the Paul Merage School of Business at the University of California-Irvine and Blake Phillips of the School of Business at the University of Alberta.

The SEC is expected to unveil several short-selling restriction proposals on Wednesday, including one to reinstate the "uptick rule," a Depression-era rule abolished by the SEC in 2007 that prevented traders from short-selling unless the price of the stock from the most recent trade was higher than the previous price.

The recent financial crisis has raised short-selling concerns and prompted calls from politicians and some industry players to reinstate the version of the old rule.

-By John Kell, Dow Jones Newswires; 201-938-5285; [e-mail]