U.S. SEC to consider about 4 short sale proposals

U.S. SEC is reconsidering about rules for short-selling, after many blamed short-selling as the cause for accelerating severe downturn of the US financial stocks.

What exactly is short selling?

Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered.

The removal of "Up-tick" rule and the ignorance from the regulators towards "Naked Short Sales" in the last couple years have made short selling quite vicious. As soon as the vultures (specialized institutional investors) spot weakness in troubled companies, these companies could go completely bust in a matter of days. Even if some companies have a good chance of surviving, investors were too panicked to buy shares at discounted price. Meanwhile, vultures could technically take advantage of the market condition and sell the stock down to the ground, since they can continue to short the stock without promise to ever physically own the stock.

Short-selling is an important mechanism in the capital market. If we are only allowed to purchase stocks, the market may be inflated with expensive stocks and creates even greater bubble bursts. We definitely need such mechanism in place, but the current system seems to be broken. A few people getting all the pie just by being reckless and with no benefit to society.

An article from Bloomgberg illustrated how Lehman Brothers gone bust in a matter of days might have something to do more with the vultures, instead of its broken business model.

Here are some key points I find interesting:

As Lehman Brothers Holdings Inc. struggled to survive last year, as many as 32.8 million shares in the company were sold and not delivered to buyers on time as of Sept. 11, according to data compiled by the Securities and Exchange Commission and Bloomberg. That was a more than 57-fold increase over the prior year’s peak of 567,518 failed trades on July 30. The SEC has linked such so-called fails-to-deliver to naked short selling, a strategy that can be used to manipulate markets. A fail-to-deliver is a trade that doesn’t settle within three days.

“Suffice it to say that in a readily available stock that is traded frequently, there has to be an explanation to the appropriate regulator as to the circumstances surrounding the fail-to-deliver,” said Baker, who served in the U.S. House of Representatives as a Republican from Louisiana from 1986 to February 2008.

Lehman Brothers had 687.5 million shares in its float, the amount available for public trading. In float size, the investment bank ranked 131 out of 6,873 public companies -- or in the top 1.9 percent, according to data compiled by Bloomberg.

And

Short sellers arrange to borrow shares, then dispose of them in anticipation that they will fall. They later buy shares to replace those they borrowed, profiting if the price has dropped. Naked short sellers don’t borrow before trading -- a practice that becomes evident once the stock isn’t delivered. Such trades can generate unlimited sell orders, overwhelming buyers and driving down prices, said Susanne Trimbath, a trade- settlement expert and president of STP Advisory Services, an Omaha, Nebraska-based consulting firm.

On at least two occasions in 2008, fails-to-deliver for Lehman Brothers shares spiked just before speculation about the bank began circulating among traders, according to SEC data that Bloomberg analyzed.