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Short Selling Activity in Financial Stocks and the SEC July 15th Emergency Order

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes from Arturo Bris, a professor at IMD who is also affiliated with the Yale International Center for Finance)

I have recently completed a report Short Selling Activity in Financial Stocks and the SEC July 15th Emergency Order that analyzes the effect of the EO that was issued to “enhance investor protection against naked short selling in the securities of Fannie Mae, Freddie Mac, and primary dealers at commercial and investment banks”. The EO dealt primarily with the stocks of 19 financial institutions, which I denote as the G19. The study is conducted by comparing stock returns, firm fundamentals, measures of market quality, and pricing efficiency of the G19 to a matching sample of financial stocks from the U.S. and abroad, all listed on U.S. stock exchanges. The control sample of U.S. financial institutions includes 59 companies, and the control sample of non?U.S. financial institutions includes 73 companies.

My preliminary findings are as follows:

• The performance of the G19 stocks is significantly worse in the period January 2008 through July 2008 than for comparable stocks.
• The short selling activities in the G19 stocks have not been significantly higher than for comparable stocks between 2006 and 2008.
• While short selling has increased overall, short selling activities in the G19 stocks have not increased significantly more than in comparable US Financial Stocks.
• After controlling for firm and market characteristics, all measures of shorting activity are indeed lower for G19 stocks than for comparable US Financial Stocks, but higher than for comparable non?U.S. Financial Stocks.
• I find that the issuance of convertible bonds has been relatively more frequent for G19 stocks than for the sample of comparable firms, and that this activity fosters shorting activity.
• There is clear evidence that some firms outside the G19 group have been the subject of heavy shorting activity over the sample period.
• Although the performance of the G19 stocks has been significantly worse than for comparable firms, the negative returns of G19 stocks cannot be attributed to short selling activities.
• I find that the market quality of the G19 stocks is significantly worse on most measures of market quality than for comparable US financial stocks before July 15th 2008, and that this lower market quality is not caused by short?selling activities.
• After July 21st, the G19 stocks have suffered a significant reduction in intra?day return volatility and an increase in spreads, which suggests a deterioration of market quality.

The full report and a video of my interview on CNBC’s Squawk Box Europe about the report can be found here.

Full post as published by The Harvard Law School Corporate Governance Blog on August 15, 2008 (boomark / email).