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Will short-selling ban help – or hurt – banks?

London and New York stopped a practice seen as pushing stocks down. But some say short-sellers are merely scapegoats.

By Mark Rice-OxleyCorrespondent of The Christian Science Monitor / September 23, 2008


Selling something you don't own might sound like a crime in any other walk of life. On financial markets, it's been standard practice for decades.

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Not any more. On Monday morning, stock traders returning to their desks in London and New York will have to adapt to new rules: short selling, as it is known, has been banned for financial stocks. For the US market, that's through Oct. 2. For the British traders, the ban lasts until January 2009.

Authorities on both sides of the Atlantic took the drastic step late last week in an effort to prevent frenzied trading from putting any more banks out of business. This, coupled with a US plan to vacuum up all the bad mortgage debt in the banking system, generated widespread euphoria on Friday, sending the London's FTSE 100 index skyrocketing more than 9 percent in one day – its biggest ever one-day gain. The Dow Jones industrial average in New York closed down just 0.3 percent for the week, after a similar two-day rebound.

But with the dust settling on one of the most tumultuous trading weeks in living memory, questions are being asked about short selling and the decision to ban it. Were the short sellers really the scoundrels last week? If so, why is the practice allowed at all? And if not, will the ban really help restore confidence to markets traumatized by this escalation in the credit crunch?

Short sellers only make money if a stock price falls. They sell a stock they do not own in the hope of buying it back at a lower price in the future and pocketing the profit. Normally they borrow the stock, but sometimes they don't even bother to do that, a cavalier practice known as "naked" short selling. They typically prey on weak stocks, and their actions can become self-fulfilling if enough of them dump the stock.

Many in Britain have seized upon short sellers as the villains of last week's extraordinary events. The press characterized them as "sharks" and "greedy speculators." Short dealers were blamed not only for pushing down the share prices of US titans like Morgan Stanley and Goldman Sachs, but for pummeling Britain's largest mortgage bank, HBOS, such that it sought a buy-out rescue by retail giant Lloyds TSB.

For the authorities, it was clear something had to be done. Prime Minister Gordon Brown said on Saturday that he felt "the interests of savers and homeowners and mortgage holders came before the interests of a few hedge funds."

"There is a danger in a trading system which allows financial institutions to be targeted and subject to extreme short-selling pressures," said Sir Callum McCarthy, chairman of Britain's Financial Services Authority, "because movements in equity prices can be translated into uncertainty in the minds of those who place deposits with those institutions with consequent financial stability issues." US Securities and Exchange Commission chairman Christopher Cox added that the commission was "committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets".