Government restriction on short sales may have unintended consequences

A lot of my investments are in S&P 500 index funds, which, until the recent dive by financial institutions, included financial stocks as its largest sector of investment (finance is now third after energy and IT). Over the past couple years, I've held shares in the Prudent Bear Fund (BEARX), a mutual fund that uses a strategy of shorting various stocks, purchasing put options, and investing in gold, as well as making some short-term trades of the exchange-traded funds ProShares UltraShort S&P 500 (SDS), which goes up when the S&P 500 goes down, and ProShares UltraShort Financial (SKF), which goes up when the Dow Jones U.S. Financials Index (DJUSFI) goes down.

I had been holding some shares of SKF for a couple weeks with a 30-day limit order to sell at $142, which would give me a nice profit. When it shot up Thursday, I upped my limit, and ended up selling some of my shares at over $150, and closing out my position. The market then reversed, and SKF dropped as low as $110, so I picked up a few more shares at around $117. Friday morning, SKF dropped to $87 and started to climb back up, when all of a sudden it stuck at $93 and no more trades went through. Trading was halted.

The SEC announced a "temporary emergency action" to ban short selling in 799 stocks of financial companies for the next ten business days (until the end of the day on October 2), which may be extended for up to another twenty business days (until the end of the day on October 31, bringing us right up to the election). The UK instituted a similar ban. Because of this ban, trading in SKF was temporarily halted. The SEC seems to be under the illusion that short sellers are responsible for the stocks of financial companies falling, rather than the fact that these companies have been engaging in risky behavior and are now loaded down with bad debt.

But a short time later today, trading in SKF resumed, after ProShares announced that they cannot accept orders to create new shares in the fund, since that would require taking new short positions in financial stocks, but those who hold existing positions are still permitted to trade them.

This effectively turns SKF into a closed-end fund, making SKF shares more scarce than they otherwise would be. When I saw that SKF was again trading, I bought more shares at $90, reasoning that the financial problems are far from fixed, the proposed government action is likely to be full of holes, and with normal routes to short selling closed, more of those who wish to hedge their bets against further drops in the financial sector will turn to other alternatives such as put options (though options markets are likely to be hurt by this ban as well, since the U.S., unlike the UK, didn't make an exception for options market makers) or shares in funds like SKF, the latter of which they will only be able to purchase from existing holders of the fund.

It's a serious mistake to think that short selling is something solely done by vultures trying to destroy companies at risk--it's a defensive measure against catastrophe for those who are mostly holding long-term investment positions.

An Associated Press story on the ban shows that the SEC is starting to recognize that it may cause some unintended problems:

But on Wall Street, professional short-sellers said they were being unfairly targeted by the SEC's prohibition. And some analysts warned of possible negative consequences, maintaining that banning short-selling could actually distort -- not stabilize -- edgy markets.

Indeed, hours after the new ban was announced, some of its details appeared to be a work in progress. The SEC said its staff was recommending exemptions from the ban for trades market professionals make to hedge their investments in stock options or futures.

"I don't think it's going to accomplish what they're after," said Jeff Tjornehoj, senior analyst at fund research firm Lipper Inc. Without short sellers, he said, investors will have a harder time gauging the true value of a stock.

"Most people want to be in a stock for the long run and want to see prices go up. Short sellers are useful for throwing water in their face and saying, `Oh yeah? Think about this,'" Tjornehoj said. As a result, restricting the practice could inflate the value of some stocks, opening the door for a big downward correction later.

"Without offering a flip-side to the price-discovery mechanism, I think there's a pressure built up in stock prices that only gets relieved in a great cataclysm," he said.

Disclosure: I presently hold no shares of BEARX or SDS, but do have a position in SKF. This post does not constitute investment advice.

UPDATE (September 20, 2008): Paul Krugman critiques leaked details of the bailout deal. If accurate, I agree with him that it's a bad deal and I expect to see SKF climb on Monday.