Let’s observe a moment of silence to mourn the slow demise of capitalism in the US, says Dan Amoss. “Our government is now overtly manipulating the stock market. We have crossed the Rubicon. We can no longer pretend to be a free market capitalist country while also maintaining confidence in the US dollar as reserve currency.” The SEC’s temporary ban on short selling is a case in point.

Allow me to state the obvious: Short sellers did not bring down the investment banks. Once the investment bank executives made the decision to operate their balance sheets like Long-Term Capital Management on steroids, the writing was on the wall. They relied far too much on quant models, rather than good old-fashioned common sense.

Rather than target the individuals who had been warning about this situation for years, why doesn’t the SEC investigate the proprietary trades of the banks’ trading desks? I’d expect it would find evidence that the investment banks were short selling each other’s stocks at the same time that they were cutting each other’s lines of credit. In the autopsy of Lehman Brothers’ balance sheet, we have discovered that Lehman management wildly overvalued its toxic assets. Why wasn’t this taken as evidence that the lack of transparency at investment banks is at the root of last week’s crisis?

The SEC’s decision to ban short sales of financial stocks is throwing sand into the markets’ gears. Like most government action, it pays lip service to consequences. Convertible bond traders use short selling to hedge equity risk. After this ban, the price of convertible bonds will probably fall.

Hedge fund managers use short sales to offset the risk in holding long positions. After this ban, fund managers will have to use other means to cut risk, which include selling off huge chunks of their long positions.

Finally, at market bottoms, short sellers provide demand for stocks when they buy to close out short positions. Without this buying pressure, the market could possibly go “no bid” at crucial periods when long investors want to get out at any price.

The SEC would really benefit the market if it cleaned up the system of trade clearing. Naked short-selling occurs when brokers take orders for short sales and don’t locate the shares to borrow. If a broker cannot locate them, then it shouldn’t tell the short seller that it is able to execute the order. Since the broker doesn’t want to lose the short seller’s business, it probably executes short sales of “hard to borrow” stocks anyway and hopes it can locate the shares in time for settlement. “Quant funds” - the ones that use computers to trade millions of shares every minute — are lucrative brokerage clients. These funds are most likely to be the ones unknowingly requesting “naked” short sales. The orders come in so fast that it’s hard for the broker to say no, we cannot locate those shares to borrow.

In my view, the SEC can solve the problem of naked short-selling with better enforcement of existing rules. Brokers should not be allowed to execute orders to short shares that they have little chance of borrowing. It’s vital that we restore liquidity to our stock market, rather than implement poorly thought-out decisions made overnight.

Source: The SEC’s “Shortfall”