Abuse by speculators keeps investors on the sidelines

Investor’s confidence in the stock and bond markets has been shaken, not just by economic weakness but also by the feeling that professional speculators are using tools not available to ordinary investors to plunder the markets.

Individual investors, many of whom have put their cash in money market funds and certificates of deposit, won’t return to the markets en masse until they are convinced that the odds aren’t stacked against them. Investors must feel confident that the abuse of these tools, such as short selling and the purchase of credit default swaps, has been curbed.

The Securities and Exchange Commission last week said that it is seeking public comment for five uptick rule proposals. Although that is a step in the right direction, the regulator needs to look at the bigger issue of naked short selling.

For that reason, it is vital that regulators examine thoroughly the impact of these tools on the markets.

Naked shorting involves placing a sell order without actually first borrowing the stock. Regulators have declared that naked short selling is prohibited and isn’t widespread, but these declarations aren’t taken seriously by individual investors, or by professional investors, for that matter.

In fact, many industry observers think that naked shorting by speculators helped drive the collapse last year of The Bear Stearns Cos. Inc. and Lehman Brothers Holdings Inc., both of New York.

Credit default swaps, whereby an investor in fixed-income securities buys insurance from a third party against the issuer’s defaulting on interest or principal repayments, caused perhaps even more damage in the crisis than naked shorting, as it brought New York-based insurance giant American International Group Inc. and other institutions to the verge of collapse.

The purchase of credit default swaps by buyers of fixed-income securities may be justifiable when the economic outlook is uncertain or if the accuracy of the ratings assigned to the securities is not fully trusted.

This was the case with credit default swaps sold by institutions such as AIG to investors in mortgage-backed securities.

But the purchase of such swaps by those who don’t own securities is a speculative bet that the issuers will default. It is akin to naked shorting in the equity market or to allowing a speculator to buy insurance on his neighbor’s house.

Nothing good can come from it. In fact, it can only lead to a great deal of mischief, as shown in AIG’s case, requiring a massive government rescue.

There are reams of evidence about how much of the crisis can be blamed on naked short selling and the unrestricted sale of credit default swaps.

No doubt, over time, academics will wade through this evidence, but the financial markets can’t wait for them to set the pace.

The SEC should immediately sponsor such research from a group of financial academics. The markets need answers, and they need them soon.

In the meantime, the SEC should rigorously enforce the naked- shorting prohibitions.

What’s more, insurance industry regulators should examine whether credit default swaps do indeed meet the definition of “insurance” and whether they should be regulated at the federal or state levels.

The regulators should at least examine whether the purchases of credit default swaps by speculators who don’t own the underlying securities should be prohibited. This would reduce systemic risk by restricting the volume of swaps sold to a level unlikely to threaten the existence of institutions that are “too big to fail.”