SEC extends ban on short selling, but does it work?

— -- Criticism over the effectiveness of the Securities and Exchange Commission ban on short sales of more than 900 financial firms' stocks intensified Thursday after the agency extended the emergency restriction.

The SEC extended the ban until at least three business days after final approval of the $700 billion financial industry bailout that's scheduled to be considered today by the House.

The restriction could be extended up to 11:59 p.m. on Oct. 17, the SEC said.

The extension of the ban, issued Sept. 19, was needed to "allow time for completion of work" on the effort to rescue the U.S. financial system, the SEC said.

The ban halts a legal practice in which traders borrow shares and sell them in the hope of profiting by replacing the borrowed shares with equivalents bought later at a lower market price.

It is illegal, however, to spread misinformation in an effort to drive down a company's share price while short selling its stock.

While conceding that short selling plays an important market role, the SEC said it imposed a ban because the tactic could also be used where "a manipulator sells the shares of a company short and then spreads lies about a company's negative prospects."

But critics Thursday questioned the ban's effectiveness.

The 799 financial stocks initially included in the ban posted an average drop of 5.5% during the last two weeks, an analysis by TFS Capital found. That was little better than the 7.7% average drop on the Standard & Poor's 500-stock index in the same period, the analysis found.

"If short-selling pressure is what was pushing these stocks down, then when you remove that pressure, they should come back a lot more," says Chao Chen, a TFS Capital portfolio manager.

The ban also robbed a volatile stock market of liquidity during two weeks when it was needed most, says Richard Baker, president of the Managed Funds Association, a 600-member group representing hedge funds and managed futures funds.

Hedge fund loans to publicly traded firms constituted an $80 billion business in the last 12 months, says Baker. But the funds have interrupted those loans because they cannot guard against losing money by short selling the stock the firms pledge as repayment collateral.

"At a time when financial markets are under their most significant stress … the effect of the SEC rule has been to take that ($80 billion) out of the marketplace," Baker says.

Nonetheless, the extension was necessary to block "Saturday-night massacres" by short sellers driving down shares of companies they believe the federal government will rescue on grounds the firms are "too big to fail," says Donald Luskin, chief investment officer of Trend Macrolytics, an investment strategy consultant.