Risk Of Emergency SEC Emergency Rule Backfiring

There will be a temporary moratorium on naked short sale of select financial stocks, starting Monday, July 22. SEC enacted this moratorium to prevent flagrant speculations that, in the view of the SEC, were causing the financial stocks to be abnormally low.

Perhaps the SEC’s assumption is correct. However, the very action of forbearing natural capitalistic actions by employing such artificial stopgap measures will only cause a larger ripple in the market. The removal of the uptick rule for short selling perhaps was the undoing for the stock market. However, by implementing a desperate block on free and open trading, the SEC and the financial industry are inviting future litigations and reputational harm.

The basis of the stock market is the free and open trading of shares and options, based on a set of rules agreed upon by the stock exchange and the governing laws of the states. To change a major trading rule by carving out a list of no naked shorting when there is nothing in the market to indicate that there is a “run” or a panic, is openly admitting that there is something fundamentally wrong with the current pricing of the financial industry stocks to which the general public is not privy.

The Market will speculate on what the banks are hiding from public disclosure. These speculations will build and, when the naked short sale ban is lifted, look for new record lows for the financial stocks. The recent rise in financial stock prices is, in my view, a “fat” cat bounce, which is analogous to the dead cat variety. However, in this case, the bounce will allow those investors to cash out of their underwater position, before the total value of their portfolio is wiped out with subsequent valuation erosion.

The banks are not out of the credit mess. The picture is pretty bleak when one factors in the credit card landscape. More Americans are carrying higher balances on their credit cards as other sources of borrowing dries up for them. Having the credit cards still plying borrowers with zero interest until 2009 isn’t helping the matter.

Banks are still busily giving out credit cards. It will be only a matter of time, and soon at that, when they will start showing major losses and write-offs on ABS secured with credit card receivables. This will be on top of the write-offs of losses on vehicle leases. I am guessing that the 3Q 2008 will be just as bleak as the first half for the financial stocks.

So much for the temporary stop on naked short sales and SEC's vain attempt of manipulating the market. This action will only lead to more aggressive actions my those investors whose trading strategy have been hampered momentarily by the SEC.

Regards,
Ed Kim
Practical Risk Manager

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