Short-selling, big concerns

NAKED shorts, Fannies and Freddies - all of a sudden the world of high finance seems very low-rent.

NAKED shorts, Fannies and Freddies - all of a sudden the world of high finance seems very low-rent.

Welcome to the world of the short-seller, under close scrutiny from the regulators around the globe who are struggling to contain the real-world fallout from sliding share prices and financial markets.

"Shorting" - selling a company's shares when you don't own them because you expect to be able to buy them back more cheaply in the near future and turn a profit on the difference between the two deals - is seen as largely the province of hedge fund managers.

Short-sellers borrow the stock from big investors such as superannuation funds, which are long-term holders.

The funds charge a fee to "rent" the stock, increasing the return on it for their members rather than just keeping the shares in a vault. The risk is that the short-selling might destabilise the price so much, the shares are worth far less when the lending agreement expires.

The US Securities and Exchange Commission, which regulates markets and traders, yesterday tightened the rules on betting against a fall in the share prices of 19 banks and other financial companies, among them the multitrillion-dollar mortgage giants Fannie Mae and Freddie Mac.

Look at the trading figures published by the New YorkStock Exchange over the past year, and you can see why they are nervous.

In May last year, before the SEC wiped a rule that had been in place since the first great market crash in the 1930s, the number of shares subject to short-selling was about 11 billion at any one time.

While that's only 3.4% of the total number of shares available for trading, since then the number has soared to close to 5%, with the last figures from the NYSE running at 18 billion shares by mid-June in more than 3700 securities (the Australian market has only 2100 listed companies, and short-selling is largely confined to the top 200).

Part of that can be explained by the sudden turnaround in market fortunes. When a market is rising, it is a lot harder to pick the right stock for a short-selling profit. Short-sellers come into their own in a falling market.

As one local trader said yesterday : "Hedge funds don't pick the fight, but they sure finish it."

Drill down into the individual US stocks and the effects are clear. In IndyMac Bancorp, where people are queuing to recover their deposits, the daily average number of shares declared as short sales has been 35 million over the year - but the volume of shares traded "normally" has averaged less than 5 million. In that time the bank's share price crashlanded from $US45 to less than $US1 a share.

That doesn't mean the shares of IndyMac didn't deserve to fall, but it does show that opportunist traders knew a vulnerable stock when they saw it.

In investment bank Lehman Brothers, the number of shares subject to short-selling jumped from 40 million a day to 80 million between January and May.

From that peak period of shortselling in May, Lehman's share price plummeted from around $US45 to current levels of $US13. Great profits for the short-sellers, bad news for longterm investors and the bank.

Bank analysts have reportedly accused short-sellers in Lehman of also spreading rumours about it. The SEC's enforcement unit yesterday served subpoenas on leading Wall Street brokerages, including Deutsche Bank, Goldman Sachs and Merrill Lynch, seeking trading records and emails amid allegations that the share price has been manipulated.

News of the investigation broke only hours after SEC chairman Christopher Cox had made his case for the emergency rule to crack down on "naked" short-selling, forcing traders to borrow the securities they want to sell first, so they will be able to settle the transaction on time.

The SEC's new rule aims to stop parties who don't own any shares continuing to "sell" and drive a share price down, deferring settling on the deals within normal market rules, and then buying the stock much later and much more cheaply.


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