SEC Halts Short Selling of Financial Stocks

We all experienced the US financial turmoil last week. Finally the US government has made the rescue plan to recover investor confidence. Prohibition of short selling is probably a consideration for bailing out those financial entities suffering from subprime mortgages.

On 19 Sep 2008, US SEC, acting in concert with the UK FSA, took temporary emergency action to prohibit short selling in financial companies. SEC's action applies to the securities of 799 financial companies. As explained by SEC's chairman, the temporary emergency order is expected to restore equilibrium to markets and would not be necessary in a well-functioning market.

Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.

The emergency order will terminate on 2 Oct 2008 but SEC may extend it beyond 10 days if it deems an extension necessary in the public interest and for the protection of investors, but will not extend the order for more than 30 calendar days in total duration.

SEC has also taken the following steps to address the recent market conditions:

• Temporarily requiring that institutional money managers report their new short sales of certain publicly traded securities. These money managers are already required to report their long positions in these securities.
• Temporarily easing restrictions on the ability of securities issuers to re-purchase their securities. This change will give issuers more flexibility to buy back their securities, and help restore liquidity during this period of unusual and extraordinary market volatility.

Of course SEC intervenes the markets (by prohibiting short selling of financial companies and taking up their bad debts) only in a very special circumstance, I am concerned about the abuse of such measures which could create more moral hazard. In 1998 Milton Friedman heavily criticized the HK government's intervention of stock markets. Ten years from 1998 the US government is doing the same. What would Milton Friedman think if he was still alive?