Corporate Governance

The SEC and the Ban on Short Sales

By J. Robert Brown

Its Christmas and not a time when most people are paying attention to their blog posts.  We use the opportunity to go back in time and reexamine the Commission's behavior during the onset of the financial crisis. 

One of the more inexplicable steps taken by the SEC during the financial meltdown in the Fall of 2008 was the sudden ban on short sales.  It seemed like a doubtful step, devoid of empirical evidence and possibly done in violation of mandatory procedures.

An article in the New Yorker (Eight Days) cast an interesting light on the motivations for the step.  The article looks at eight days during September, just  before and just after the failure of Lehman.  The article mostly profiles Geithner, Paulson and Bernanke but with an occasional guest appearance from Chris Cox, then the Chair of the SEC.  On Sept. 18, with the markets teetering from the failure of Lehman and all of the collateral consequences, near panic had arisen over the potential failure of the two remaining large investment banking firms, Goldman and Morgan (Merrill had already agreed to merge with BofA).  Paulson apparently put pressure on the Commission to ban short selling to save these two firms.

As the article notes:

• Cox was probably the most free-market-oriented of the group [Paulson, Bernanke & Geithner], and a ban on short selling went deeply against the grain.  .  .  .  In fact, before that day, none of the five commissioner members supported such a ban.  During calls that day and the previous day, however, government officials came out in favor of a  ban.  And in one such call, when Cox said he was worried about unintended consequences, Paulson grew impatient.  "You can sort it out later!" he said.  "You have to save them now or they'll be gone while you're till thinking about it." 

What did the Commission do in response?

• At the meeting that night, the S.E.C. commissioners were informed that the Treasury and the Fed supported urgent action.  In light of this, and the fact that the U.K. had taken a similar step earlier that day, the commission voted unanimously to temporarily ban short selling in seven hundred- and ninety-nine financial stocks.

In short, the SEC was apparently pressured into it by the Fed and Treasury.

It would be easy in hindsight to suggest something untoward about all of this.  The SEC, after all, is an independent agency and ostensibly less susceptible to political pressure.  Nonetheless, the circumstances were largely unprecedented.  The markets, as the article reveals, were in meltdown mode.  Regulators needed to respond quickly, vigorously and without a script (like when Treasury decided to issue a "temporary" guarantee of money market funds).  Whatever the lack of empirical evidence for the impact of short selling, the immediate concern with two other mammoth financial institutions suffering the same fate as Lehman likely warranted the action.

Full post as published by The Race to the Bottom on December 25, 2009 (boomark / email).