SEC's rumor probe will lead nowhere

After weeks of slumbering on the sidelines, Christopher Cox and the Securities and Exchange Commission have become engaged in the financial crisis that has swept the markets.
JUL 21, 2008
By  MFXFeeder
After weeks of slumbering on the sidelines, Christopher Cox and the Securities and Exchange Commission have become engaged in the financial crisis that has swept the markets. Belatedly, the SEC has begun to investigate whether malicious rumors were deliberately used by short-sellers to drive down the stocks of The Bear Stearns Cos. Inc. and Lehman Brothers Holdings Inc., both of New York, and other financial companies. It has sent subpoenas to more than 50 hedge funds as part of its investigation. The SEC also has imposed restrictions on the short sales of the stocks of major financial institutions. While these restrictions are for 30 days, they may be extended, and they could be broadened to cover all or most stocks. The question is whether either of these actions will be effective, and whether they might have been more effective had they been taken earlier. The SEC sat on its hands as rumors about Bear Stearns' capital position and its holdings of mortgage-backed securities caused the firm's sources of capital to dry up, driving it to the verge of collapse. If the SEC had issued a warning about spreading rumors without evidence and begun an investigation immediately when they surfaced, those rumors might have dried up, or at least diminished enough to allow Bear Stearns to survive or arrange an orderly takeover. If it had begun aggressively to investigate the short selling going on in the market, not just the Bear Stearns situation, it might have de-terred some of the aggressive short selling that has roiled the market. In fact, the investigation and the action on short selling suggest that the SEC finally realizes that rumors are contributing to the financial crisis. But the damage has been done, and confidence in the financial markets, and even the banking industry, has been shaken. The investigation into the rumors will likely lead nowhere. Any short-sellers who profited from unfounded or malicious rumors have had ample time to cover their tracks. Likewise, the restrictions on short selling the financial stocks will have little effect. The restrictions merely require the short-sellers to have actual agreements in place to borrow shares before initiating short sales. Previously, short-sellers merely had to have located shares to borrow but didn't have to have an actual agreement in place to borrow those shares. As a result, several short-sellers could use the same pool of available stocks to back their short sales. The new rule might reduce the amount of short selling in thinly traded stocks, but the stocks covered by the rule are widely available because the rule covers only the large financial-industry companies, which are generally large-cap stocks. The SEC must be careful as it tackles short selling, because many large institutional investors, not just speculators and hedge funds, have adopted short selling as a valuable investment technique. In the course of their work, stock analysts form opinions not only about which stocks will rise in value, but also which ones will likely fall in value. Short selling allows investors to profit from the insights into the stocks that will perform poorly. Because of this, some academics argue that the possibility of short selling makes the capital markets more efficient in allocating capital. The SEC has damaged its credibility by being late to the crisis. As it endeavors to repair that credibility, it must walk a fine line between continuing to do too little too late and appearing irrelevant, and doing too much and damaging the capital markets in the long run.

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