The federal government has imposed a two-week ban on short-selling of stocks in nearly 800 financial institutions, including several in Maryland, to improve investor confidence amid continued turmoil in the stock market.
The Securities and Exchange Commission said yesterday that the temporary crackdown on short-selling - in which investors make money by betting that the price of a stock will fall - has contributed to drastic declines in the market value of financial institutions and that it wanted to prevent further erosion.
Some money managers have blamed short-sellers for precipitating the collapses of financial behemoths Lehman Brothers and American International Group.
In normal market conditions, short-selling is a legal trading practice that can add efficiency and liquidity, the SEC and finance experts said.
First Mariner, T. Rowe Price, Provident Bank and insurer Aegon are among the Baltimore-area companies whose stocks cannot be shorted. Legg Mason said it was inadvertently left off the list and submitted a filing with the SEC yesterday to be included.
"The commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets," SEC Chairman Christopher Cox said in a statement. "The emergency order temporarily banning short-selling will restore equilibrium to the market."
Area financial institutions reacted with relief to the SEC announcement.
A Provident Bank spokeswoman said the bank's share value had declined because of shorting.
"We think that the SEC move to ban short-selling will help stabilize the market and let investors know that financial stocks are worthy investments," Vicki Cox, the spokeswoman, said yesterday afternoon. "We've seen a difference already. Our stock price is up significantly."
Provident shares rose 17.81 percent, or $1.89, to close at $12.50 on the Nasdaq yesterday.
Andrew Brooks, the head of U.S. equities trading at T. Rowe Price, said the SEC didn't go far enough in helping companies. The ban should have included more companies and should have been put in place for longer than two weeks, he said.
Brooks also called for a return of the uptick rule, which allowed short-selling only when the most recent movement in the stock price was positive. He also said the SEC should look at setting a minimum trading increment of 5 cents.
"At the end of the day, we have to have a market that is viewed as transparent and fair and offers investment protection," Brooks said.
T. Rowe shares jumped 9.7 percent, or $5.75, to close at $65.01 on the Nasdaq yesterday.
The SEC said in a statement that the temporary ban is part of the comprehensive set of steps being taken by the Federal Reserve, Treasury and Congress.
The Treasury said it would a use $50 billion fund created during the Depression to guarantee assets in money market mutual funds. The Federal Reserve said it would allow commercial banks to finance purchases of asset-backed paper from money market funds. It also plans to purchase federal agency discount notes from primary dealers.
Congress, meanwhile, is working with Treasury on a plan to have the government take over billions of dollars in bad mortgages and other debt.
"I think what is happening in this crisis is institutions are acting to avoid even a worse situation," said Celso Brunetti, assistant professor of finance at the Johns Hopkins University. "What they're trying to avoid is that speculation can bring down the price on the banking sector. It's sending a very good signal to the market. At some point, you have to restore confidence."
What is 'short-selling'?
Investors "sell short" if they think the shares of a particular company are going to decline and they want to profit from the drop. To do this, an investor borrows shares of Company X, usually from a broker, and then immediately sells the shares at their market price, say $100 per share. If the share price falls, say to $80, the investor buys back the shares and returns them to the broker. The investor pockets the difference - in this case, $20 per share.
The practice can be risky: If the shares increase in value, the investor has to buy them back at the higher price and loses money.
Why did the SEC temporarily ban it?
The government and some money managers blame widespread short-selling by hedge funds for contributing to the collapse of several troubled companies by driving down their share prices.
Such sharp drops erode the market's confidence, which makes it harder for the companies to raise capital and could scare away clients, further weakening the companies.
What is 'naked shorting'?
"Naked shorting" involves selling shares without actually borrowing them, a practice that critics say is particularly prone to abuse because it potentially enables more shares to be sold into the market than exist.
The SEC temporarily banned naked shorting of 19 financial companies in July. On Wednesday, it restricted the practice but did not ban it outright. Some money managers have called for the SEC to prohibit naked shorting.
How much are short-sellers really to blame for the mess we're in?
That's a hotly disputed question. The SEC said that in normal times "shorts" can make markets more efficient and bring in more capital, but it decided a "time out" is needed.
Will the SEC's move work?
It helped reverse the slide in financial companies' shares yesterday. Goldman and Morgan Stanley each jumped about 20 percent.
The hope is that by the time the ban is lifted, the rest of the government's rescue plan, which includes acquiring some bad mortgage-related assets from large banks, will kick in and the market will stabilize on its own.