Concerned by the SEC's Latest Moves

I like homework and today I’m preparing to fill in for Neil’s show on Fox News called Your World at 4pm. So I’m sitting here reading more about the announcements that Christopher Cox, chairman of the SEC, made during the hearings yesterday... and I’m getting confused. If you need a brief description of what he is proposing, you should read this article titled “SEC Limits Short Selling of Financial Firms.” It’s on our home page at FOXBusiness.com.

So why am I confused, frustrated, losing my marbles? Because I’m not sure that I like what the SEC did on July 6, 2007. What happened on that date? The SEC repealed what is known as the “Uptick Rule” or Rule 17 CFR 240.10a-1. Some call it the “short sale tick test.” The initial rule was put in place in 1938 to prevent situations like the stock market crash in 1929. It required traders to wait for a stock’s price to make an upward move before it could be sold short. Repealing that rule last summer allowed investors, predominantly hedge funds, who can short stocks, to sell on a downtick or minus ticks. The SEC before repealing the rule studied the effects and ran a pilot program for what they say amounted to several years before they put the new rules in effect. ETF’s and certain securities were shortable before the SEC repealed the “Uptick Rule” on all stocks.

So what’s my point? It’s simple. Since we removed the limitations on how hedge funds and investors can short stocks, we have seen volatility and short interest in the NYSE stocks balloon. Take these statistics as an example. The short interest last summer on the NYSE totaled some where north of 12.5 billion positions at June quarter end that short interest now stands at just north of 18 billion positions. In the summer of 2006 before the new rule went into effect, the short interest in the NYSE was closer to 9 billion. My good friend at Miller Tabak, Peter Boockvar, told me that short interest was up 10.4% in June versus May and that was the second biggest increase in at least 5 years. Now you can play devils advocate and say it would have happened any way and that the subprime debacle would have brought us to these levels but you cannot argue with the fact that the repeal of this rule has lead to increased volatility and a money making windfall for hedge funds who have been the biggest beneficiary of this change. Some will tell me that stocks traded in pennies make this a moot point and perhaps they’re right.

When I read the details of the chairman’s plan, I became frustrated. Is he doing what he should be doing? Absolutely! Do I applaud him for going after the rumor mongers? Yes. Will they find smoking guns in emails or instant messages? Yes. Is he trying to put an end to some of the pain seen in the financial names? Yes. But, how can you say that we are going to temporarily make a change to the rules for 19 financial firms, including Fannie Mae and Freddie Mac? The temporary rules would require those who plan to short to prove that they have borrowed the stock ahead of time and receive it upon settlement date instead of what’s known as “naked” shorting where the intended shorter has not located or borrowed stock from someone who owns it before they make a downside bet. Call me crazy but there are a couple of things that don’t work for me here.

One, when I worked on Wall Street -- and note it was five years ago -- we had to locate stocks or call our prime brokerage area (stock loan department) and get a locate on a stock. In other words, our stock loan group would tell me if they could find an owner whom the short seller could borrow the stock from. I know now that most of that locating process has become electronic and more efficient but if we couldn’t show that we could deliver that stock when the trade was settled, we got in BIG trouble. Has that changed and if so, how did that happen? Was the SEC monitoring the settlement process while they were testing selling on downticks? Or did we allow a feeding frenzy on the downside by hedge funds who knew that they would cover or buy back their positions before the trade settled and therefore neither the buy or sell side trader or company would experience the ramifications? Also how can the Chairman put a rule in effect albeit temporarily for 30 days and possibly a little longer? Is that enough time to alleviate the downside risks to the banks or financial institutions that have seen a run on their banks or assets? And how can this temporary change be suited for only the names on this list? If you were the executive of any number of other institutions where your industry experienced extreme volatility or heavy speculative risk, wouldn’t you say, hey wait a minute, what about me? Is it fair or is the SEC tailoring a set of rules that only work for a few because they didn’t think this through or are we doing it at a time when the risks are exacerbated because it’s earnings? Sounds a little fishy to me. Does it sound that way to you?

I would love for the chairman to come on one of my shows and explain these questions to me. I am by no means an expert. I am just one of the many people who want some answers, some explanations on how this is going to help or why it happened in the first place. I am not saying that this rule is the only reason for why the market is where it is but I do think some of the burden of a free market rests with the SEC and how well they are regulating the hedge funds who do this for a living.

One other note, if the short interest is as high as I mentioned, when those shorts get squeezed, the market could make a move. Short interest is not the best or only good indicator but it is one. We may need to see the VIX get to 35 but look at a name like Wells Fargo today. Yes, they reported a good number, but they’re also reflecting a short base that has had to cover. Who is next?