SEC bans short selling of financial stocks

— -- The Securities and Exchange Commission issued a temporary ban Friday on short sales of 799 financial stocks, a dramatic move against traders who have sought profits from the most severe market crisis in decades.

Short selling is a legal form of stock trading in which a trader bets a stock's price will drop. The trader borrows the stock and sells it, with the understanding the loan must be repaid with similar shares bought in the market. If the stock does drop, the trader profits on the price difference.

It is illegal, however, for short sellers to spread false information or negative rumors in an effort to drive down a stock's price.

The SEC said the action "calls a time-out to aggressive short selling in financial institution stocks, because of the essential link between their stock price and confidence in the institution."

In its early-morning announcement, the SEC said ban the ban would remain in effect until midnight Oct. 2. But it could be extended for 10 additional business days if the agency "deems an extension necessary in the public interest," the SEC said.

Speaking at the White House hours after the ban took effect, President Bush said the SEC action "is intended to prevent investors from intentionally driving down particular stocks for their own personal gain."

SEC Chairman Christopher Cox, criticized by both Republicans and Democrats for not responding more quickly to this week's financial market crisis, said the agency is considering additional measures against short-selling in other stocks.

"The commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets," Cox said.

The SEC ban mirrored action taken Thursday by Britain's Financial Services Authority.

It also came one day after the SEC adopted rules aimed at forcing traders and brokers to actually borrow shares used in short selling. Additionally the SEC on Thursday enacted a rule that bans sellers from deceiving brokers about delivering borrowed shares to buyers.

Short sellers say their trading in financial stocks represented legal bets based on analyses that showed the companies had broad exposure to the shaky mortgage-related securities that helped trigger the national fiscal crisis.

Richard Baker, CEO of Managed Funds Association, which speaks for hedge fund professionals who may use short-selling strategies, said the SEC action "could inflict long-term damage on the markets by reducing liquidity and may well further market instability."

"Short selling is a legitimate investment strategy that responds to market fundamentals and contributes to the proper setting of stock prices," Baker said. "It is also a vital component of good risk management for many investors that allows them to provide much needed liquidity to our capital markets."

But officials of Morgan Stanley and other financial firms this week blamed short sellers for battering their companies' stock prices and called for action to halt any illegal trading.

The latest SEC action represented just the latest shot in an escalating war against suspected illegal trades by short sellers.

Likening such traders to "looters after a hurricane," New York Attorney General Andrew Cuomo Thursday said his office is investigating "a significant number" of complaints about improper short selling in shares of Lehman Bros., AIG, Morgan Stanley, Goldman Sachs and other financial stocks.

Cuomo said his investigation would use the New York state Martin Act, which subjects violators to criminal as well as civil penalties, to combat the illegal practices.

"The markets need to be stabilized," Cuomo said. "And one way to bring about such stability is to root out and deter short-selling that is based on the spread of false information."

Separately, the California Public Employees' Retirement System, the New York State Common Retirement Fund and the California State Teachers' Retirement System said Thursday they would stop lending Morgan Stanley and Goldman Sachs shares to short sellers.

"This speculative selling has put downward pressure on the entire stock market and threatens to drive our national economy deeper into decline," said New York Comptroller Thomas DiNapoli, the sole trustee of his state's pension system.