In the wake of a nice bear rally, the SEC is once again discussing the reinstatement of the uptick rule, or some version of it (see Financial Times article). The rule was abolished in July 2007, but now various politicians are writing to SEC chairwoman, Mary Schapiro, asking that the rule be reinstated in order to produce an “unambiguous commitment to promulgate and enforce regulations that put an end to naked short selling”. Of course, naked short selling is already not allowed. While selling on a down-tick may have facilitated naked short selling, reinstating the uptick rule will not by itself rid the market of naked short-sellers. Enforcement of current rules might actually be the place to start. Until the SEC gets serious about investigating delivery failures, naked short selling will continue, regardless of changes in the uptick rule.

In addition politicians, the largest US exchanges have also recently written to the SEC asking that some version of the rule be put back into place, and further suggest that the new rule only allow short selling to be initiated by posting a quote for a short sale order that is priced more than the prevailing national bid. While such a change seems slightly different from the requirement of selling only on a new plus-tick or previous plus-tick (the current price being the same as the last, which was up), the change is significant. A value higher than the bid can still be below the ask. Not only are the prices lower than a plus tick (which is not that difficult to find for highly liquid stocks, even during a sell-off), selling between the bid and ask also makes the transaction less transparent. To make matters worse, the exchanges don't stop here, but also suggest that as an added precaution (guess for who), that a new type of circuit breaker be used that would initiate the rule only when the stock had a precipitous decline - defined as 10 percent. No more killing a stock in one or two days. Now it will take you at least 10 days. Not sure this is much of an improvement.

As for the motivation of the exchanges, you cannot really blame them for being proactive. While it is essential to keep the hedge funds and other drivers of order flow happy, helping to convince individual investors that it is safe to wade back in the waters will also be good for trading and revenue generation. I am sure that it is also hoped that any collaboration will make it more unlikely that the SEC will temporarily change the rules at a later date, selectively deciding what can and cannot be shorted. As for the SEC, they send the message that the days of the wild-west are over, and politicians get to take credit for putting pressure on the regulators and exchanges to look out for the little guy. Yet the changes will be ineffective at best - since naked short selling is not really directly addressed, and will most likely get worse given that shorting on a price higher than the bid is no improvement at all, but simply helps to mask the underlying transaction.

When I began to see the increased focus recently on finally bringing back the uptick rule, my initial thought was that if the rule was so vital, why has it taken this long to get back on the books? Looking at the latest collaborative effort, a little more delay might be in order.

It appears that short selling levels have receded at both the NYSE and Nasdaq in the first two weeks of October, falling 8.3 percent on the NYSE and 10.5 percent on the Nasdaq (see WSJ article). As quoted in the article:

"This decline in short interest, particularly the decline in brokerage stocks, is a continuation of a 12-week trend. Shorts have been large net buyers and therefore stabilizing these stocks, calling into question the rationale behind the SEC's ban on shorting."

You ban short selling and it results in less shorting and more short covering. Is this a surprise? As for refuting the rationale behind the SEC decision, I am not sure the trend is really calling the ban into question. If anything, the trend supports the decision (even if for other reasons it was short-sighted - no pun intended, see previous posts here and here). Of course, one could argue that the ban was lifted October 8th, therefore the second week of short interest declines shows that the ban was not necessary to reverse the trend. Yet given the SEC's recent proclivity to change the rules at the drop of a hat, not to mention the significant market decline (and recovery and decline) over the last few weeks, it appear likely that only a few brave traders would take such a position, even if it seems to make sense. I suspect that someday rationality will re-enter the picture, but it probably will not happen until the short selling cuffs are taken off the invisible hand of the free-markets and thrown away for good.

The SEC is reminding financial services firms that they don't have to use fire sale prices when evaluating hard to price assets (see Reuters article). In making the clarification, the SEC reaffirmed that management's internal assumptions can be used to measure fair value when relevant market evidence is not available, and that "distressed or forced liquidation sales are not orderly transactions." Now, instead of relying on fire sale prices, companies can go back to marking-to-model, even when the inputs to models that are based on observable factors are no longer being observed. The greater use of assumptions for valuation has caused a former SEC accountant to state that the SEC directive could be titled "pick a number, any number" in how it gives banks too much leeway in choosing numbers for valuation. Other opponents also feel such steps just reduced the transparency of the real risk facing institutions. While the move may in fact make the real risks less transparent, I am not sure the existing method as used, at least in the current environment where problem assets are nearly impossible to price, is helping the situation. I suspect that at least in the short-term investors are not going to be underestimating the risks that financial institutions are facing just because mark-to-market rules are a little less transparent. At least the new interpretation, and possible additional changes being considered in Congress and elsewhere, should help with liquidity problems while other steps are being taken to help open up and stabilize the credit markets.

Hedge fund executives are telling CNBC that Wall Street is beginning to market a new hedging product that would allow them to short stocks on the banned short sale list (see CNBC article). No doubt that this will be a new derivative-based product given that puts and other derivatives are still allowed to be sold, and that market markers are still allowed to short securities in order to hedge their own writing of derivatives. Many opponents of the new products feel they are nothing more than a loophole to the SEC order. Of course, those introducing the products stress that they will only be used for hedging purposes. Yet, it is still not clear to me how you verify this, or whether this will be just another "wink-wink" arrangement where it is assumed that everything is for hedging purposes. If the shorting product is abused and impossible to verify for hedging, then the ban on shorting financial stocks will prove to be useless, unnecessary, and itself a loophole for creating stable markets and handcuffing those who are thought to be causing the problem. In fact, does anyone else find it strange that the very firms that are protected by the short selling ban are developing products to find a way around the restrictions? Are hedge funds biting the hand that feeds them, and are financial companies just facilitating their own destruction? It all seems a little odd to me. Then again, I am still trying to understand the logic of mark-to-market accounting for illiquid assets, or why rating agencies can be so wrong and so late, yet still have the power to start the financial dominoes falling. Not a lot makes much sense right now.

The global federal-induced short-squeeze is now going global, as countries from Australia, Taiwan, and the Netherlands join the U.S. and U.K. in prohibiting some short selling (see WSJ article). Potential problems with the short-sell ban are already becoming evident as those needing to hedge positions, or those making a market in derivative products, are finding it difficult to comply. During the last order the SEC had already considered some restrictions on market makers who need to short stock when making a market in put options. Now, the SEC is also considering allowing short-selling to be used in some cases as a hedge - it is expected that they will allow such shorting.

Of course, where do you draw the line? What about hedge funds that actually hedge their positions? Will they be excluded? What about convertible bond and arbitrage positions? What about allowing investors to hedge their investments when companies raise money in a rights offerings? What if the sale is for risk management purposes? If risk management is considered a viable reason for shorting, couldn't everything be considered risk management to some degree? Isn't shorting an overvalued company a way to take the risk of the overvalued stock out of the marketplace? Yes, this argument is a little much, but the points is that once again it is difficult to know where to draw the line when making exceptions, which only becomes more difficult as the unintended consequences start becoming worst than what the order was hoping to accomplish in the first place.

While the order did seem to stem the selling tide last week, it ultimately makes the stock market more inefficient. If now less efficient, does this mean that the market is in fact now more risky, given that prices are more artificial than before, and that any snap-backs could be worse in the long-run (if the order is removed)? These are questions that will no doubt only be clear with 20-20 hindsight. Extraordinary times do often require extraordinary measures, but eventually we are going to come to regret interfering with a market structure and mechanism that was put in place to keep us all honest, and keep prices as efficient as possible. Finally, I do find it ironic that for the last year or so we have continued to complain about how the prices of all the various credit default swaps and CDOs were difficult to price, making it even more difficult to know their current value and a company's true level of exposure for holding such securities. One can argue that we are now starting to make transparency mistakes with our equities.

The latest SEC rule change that restricts the short selling of financial stocks is causing many hedge funds to reconsider some of the models they use (see WSJ article). As an added pressure, some pension funds that invest in hedge funds are asking fund managers if they have strategies that rely on shorting, causing some less diversified pension funds to consider withdrawing hedge fund investments. Many smaller hedge funds with less sophisticated back office operations are also now finding it more difficult to comply with the new SEC regulations and still respond to the market, continuing the recent trend of challenging times for small funds (see previous post). The new rules, if successful in reducing the selling pressure on stocks, may also affect hedge funds that have been profiting recently from volatility (see previous post), although the last short-squeeze and trend reversal was short-lived (yet the rule affected less than 20 companies). Are funds eager to get back to shorting? Of interest is the following:

"Now the market is popping big time, and it's going to frustrate people. Are the short sellers wishing today that they could be shorting at these levels? Yes, they are."

No doubt that some will take this quote as a further indication that the shorts simply want to drive the markets down at the expense of everyone else. Others will see this as further proof that the markets are still over-valued. Of course, such a quote could just be an admission that the new rules have in fact created an artificial SEC-induced short-squeeze. If the natural tendency is towards a reversion to market efficiency, the new rules certainly don't help us achieve this goal over the long-run, even if they do slam the brakes on what some believe might have been an over-reaction in the opposite direction.

A new proposed SEC plan will overhaul oil and gas reporting rules that have existed since the 1970. The new rules will boost the proven reserves reported by oil companies, and in the process boost their shares and potentially increase interest in takeovers (see Financial Week article). The plans will essentially allow companies to book reserves from “unconventional” oil and gas sources, including oil sands and coal-bed methane. Some deep-water projects that to date have not been allowed to be described as “proven” will also now be included. Furthermore, firms will be able to publish data on what are called “probable” and “possible” reserves, where recovery is not as certain. The new rules obviously don't change the amount of oil and gas that is available worldwide, but they will help investors better calculate future cash flows and thereby place a proper valuation on a company. Needless to say, the oil companies are in favor of the new rules.

The plan will affect both U.S. and international companies that report under SEC rules, which often includes most of the larger international firms. Those with the largest non-traditional sources of future production are most likely to benefit. Analysts expect that Royal Dutch Shell is likely to benefit the most among the oil majors given that they are investing capital to retrieve crude from bitumen-soaked soil in Canada, as well as extract natural gas in coal beds in Australia and China, both of which can now be included as reported proven reserves. ConocoPhillips (COP), Exxon (XOM), and BP (BP) have also invested in non-conventional sources of oil. The reporting of non-traditional proven reserves could also have an impact on acquisitions and takeovers. As mentioned by Neil McMahon, analyst from Bernstein:

“We believe that these rule changes could be the catalyst for a wave of acquisitions, with those companies with the largest unproved resource bases making juicy takeover targets for some of the larger cash-rich majors.”

McMahon feels that Marathon Oil (MRO), with investments in oil sands and shale, and British gas producer BG, with its stakes in the deep-water Brazilian fields and a new 25% stake in Chesapeake Energy (CHK) and the Fayetteville shale, are potential targets. In fact, given that the changes will make the SEC rules more in line with European rules, the impact on UK-listed firms, among others, is expected to be positive.

The rule changes are likely to apply to 2009, and not 2008 year-end reporting since the SEC is still in a consultation period and has not committed to a time line for implementation. Given that the market is forward looking, share prices may nonetheless begin to see the impact of the proposed changes which are expected to be approved and put into place quickly.

As reported in a Reuters article and elsewhere, the SEC is expected to propose a new short selling rule in the next few weeks that will be broader than the original temporary order that protected 19 financial stocks (17 major Wall Street firms, along with Freddie Mac and Fannie Mae). SEC Chairman Cox is quoted as saying the proposed rule "will focus on market-wide solutions," implying not only larger breadth, but possible other restrictions or changes affecting the markets that reach beyond just widening the number of stocks and sectors affected. One possible change is to require investors to publicly disclose large short positions, similar to the current requirements for disclosing large long positions. Whether a more encompassing rule will prop-up the markets longer-term and give some non-financial stocks a boost is difficult to predict. Even with crude oil continuing to sell-off, the Financial Select Sector SPDR (XLF) has given back some of its gains and is near short-term, yet technically-weak support. With the S&P 500 having trouble getting above 1,300, and the DJIA having difficulty around the 11,750 level, another SEC-induced short covering rally that is now more inclusive may be just what the market needs short-term to break resistance, even if not the original goal of the SEC. While potentially beneficial short-term, one can only hope that any new regulation will not have any harmful or unintended consequences for the market long-term. Then again, sometimes hope is all you have to work with.

Former SEC Chairman, Harvey Pitt, has teamed up with two others to create a web site that provides a real-time electronic stock lending and location service to help sellers and brokerage firms comply with SEC rules on naked short selling. The SEC recently limited the practice for 19 of the larger financial institutions, and there is an expectation the order will increase to more stocks. The web site, called RegSHO.com, matches traders with stock available for borrowing for short sales and provides data on the short-sell market. The creators of the web site believe it will help sellers reduce their costs because transactions are done electronically, and not over the phone as is still often the case. The site also helps to alert subscribers to any possible compliance problems they may be encountering, as well as offering advice and solutions. Access is also given to LocateStock.com, providing a real-time lending and borrow marketplace specializing in hard-to-borrow stocks, and Buyins.net, which helps to identify the demand for borrowed stocks. As mentioned in the Washington Post article, other companies that offer similar services include ShortSqueeze.com and Stock-Borrow.com. What's the kicker? Clients to the RegSHO.com site pay a monthly fee of $995 for standard access, along with an additional per-share fee for locating stock. New regulation? No worry. We can solve your problem ...... for a fee of course. You have to love capitalism.

As reported at the Financial Times, US banks are being asked by the Federal Reserve to run a comprehensive series of stress tests to ensure they have enough liquidity to withstand various types of financial shock. The Fed regulators are asking for scenario analysis and testing to get an idea of how the banks would perform if there was a sudden and sharp downturn in the markets, or if an individual bank had to endure a major liquidity shortage, such as the one that brought down Bear Stearns. The tests are simulating mild to catastrophic disruptions, and appear to be focusing on the balances held for the various prime brokerage businesses that lend money to hedge funds. A few hedge funds have blown-up as a result of the recent credit meltdown. It is unclear if these failures were simply a warning sign of something bigger that is worrying the Fed, or just one of many areas in need of scrutiny.

While it is unknown if and how the Fed will use the specific data, the results could provide the information they need to implement new regulatory requirements if as proposed by policymakers they eventually take over some of the responsibility currently given to the SEC and other regulators. New requirements for regulatory capital are always met with mixed emotions. On the one hand, diligent and conservative risk management can provide confidence to both the markets and investors that a company can remain solvent, even in tough times. On the other hand, stricter regulation is usually followed by higher levels of regulatory capital that must be set aside, thereby reducing the banks ability to deploy its capital in the most profitable manner. The Fed and SEC recently identified the monitoring of liquidity as something they want to cooperate on with the investment banks. This current move appears to be one of the initial steps.

As somewhat expected, it is being reported at Reuters, the WSJ, and elsewhere that the SEC is planning to extend the temporary curbs on short-selling set to expire Tuesday. Plans are also being made to extend the curbs to cover additional equities, beyond the original 19 financial stocks. New curb limits could now include insurance, housing, and additional financial stocks. The SEC is also apparently considering making the rules permanent, but that would require later finalization, not to mention changes in the way shares are borrowed in order to speed up and automate the process beyond making phone calls for authorization.

Some on Wall Street, including executives and hedge fund participants, are lobbying the SEC in an attempt to get them to reconsider. I would suspect that if the curbs were extended, increased to cover more stocks, or made permanent (which I would assume would include all stocks), then we may get another SEC induced rally that now obviously includes more than just the financial stocks. Or will we? Some, even in the hedge fund industry, have mentioned that it is still easy to borrow anything you want. Others say that while borrowing is still possible, the cost of borrowing has increased, and is having an impact. Due to their size or frequency of trading, the real impact may be on smaller firms and those using programmed trading.

Markets certainly get nervous when regulators start getting more involved, but on the surface this seems more like a way to enforce what should have been done in the first place. Of course, that does not mean it will not impact a market that is used to borrowing now and worrying about that messy back office stuff later, or that it will not negatively affect those that need to provide liquidity to the market (the SEC is already considering market maker exemptions). A more automated system for borrowing will also need to be implement if the rules are extended and expanded. The worst thing would be for the SEC to continue to micro-manage the current sectors in trouble. Where does this end, and is it really the sign of a healthy market, rally or not?

The NY Times has an article regarding the preliminary results of a task force study headed by the Commodity Futures Trading Commission, along with staff from the departments of Agriculture and Energy, Treasury, the Federal Reserve, the FTC, and the SEC. While some will argue with the composition and motivations of the task force group, the study found that speculators were not responsible for driving crude oil prices higher. As an example of their findings, swap dealers who provide investors a future return tied to commodity market performance were nearly balanced between purchases and sales of energy futures contracts. In fact, from January to May of 2008, more of these swap positions were selling than buying, even while oil prices rose 28% during the same period. Furthermore, the task force found that speculators were more likely to change their positions after prices had moved, and not before, suggesting they were responding to new information as is typical in an efficient market. The compete report is due in September, but the initial findings are interesting nonetheless.

As mentioned in a Bloomberg article, research by BeSpoke Investment Group has found that more than $1.4 trillion of global equities are now on loan. This is a third higher than at the start of 2007. Short selling on the NYSE rose to 4.6% of total shares in June, the highest level since 1931. As the market has sold-off, both short positions and subsequent short profits have increased. In fact, short positions in Frannie Mae and Freddie Mac generated profits of $1.4 billion in July alone.

In addition to recent credit and housing issues, and the higher energy and commodity prices that are fueling inflation and reducing profits, short positions are also increasing in response to extra interest in 130/30 funds. These funds, which often have up to a 30% short position to provide for a higher long exposure, have been on the rise as retail investors look for ways to generate hedge fund-like returns. In fact, investments in such funds are expected to clime to $2 trillion by 2010, from a mere $140 billion last year. This is in addition to other hedge fund replication strategies that also utilize shorting of various securities and products to mimic hedge fund returns.

Of course, just as the SEC is placing restrictions on short selling, other countries are either initiating or increasing access to short selling in a effort to curb rampant long speculation and help contain markets before they reach bubble territory. After the current credit crisis is over, and money begins to flow once again into the financial companies and other securities, don't be surprise if we begin to hear calls from regulators and others looking for ways to pop the bubble and reduce speculation. Ironically, such calls were happening just a few weeks ago in the crude oil markets (and will no doubt begin again in earnest if prices return to over $140 a barrel). When all is said and done, we may end up with trading that restricts short selling in beaten down industries, while encouraging it in those industries with higher valuations. I am not quite sure that helps the markets reach efficient levels, but it is certainly good news to the next Enron.

As is now well known, this week the SEC announced that it plans to tightened short-selling rules on Monday for 19 financial companies, essentially limiting naked short selling by now requiring short-sellers to actually borrow the shares they plan to sell before shorting. The new restrictions were loosen a little on Friday when the SEC said market makers wouldn't have to pre-borrow the stock, but would still need to deliver them within three days. Market makers had complained that the new rules would prevent them from providing the necessary liquidity for making an efficient market.

Upon first hearing of the rule change (or enforcement), in particular the listing of the gang of 19, I wondered in a post whether some companies on the list would prefer to not be included, given the attached stigma of needing Government intervention to prop up their shares. After all, the rule is effectively an SEC induced short-squeeze. Of course, that was 3 days and +20% ago. Now other companies are wondering why they were not included. After all, they like +20% moves as well.

As mentioned in a recent WSJ article, the Financial Services Roundtable, who represents 100 of the largest U.S. financial companies, wants the SEC to extend the order to include companies they represent as well. Companies like Wachovia, reporting next week, are not currently included. Apparently they are either not big enough to fail, or are not yet in poor enough shape to fail. Given the recent investigation of Wachovia, and speculation about poor numbers next week, that may soon change.

If history is any indication, and it usually is - it is rarely different this time - then companies may want to be careful what they wish for. Research by Professor Charles Jones at Columbia Business School has found that similar moves by the SEC have some unhappy precedents. As mentioned in the WSJ article: "In 1932, the New York Stock Exchange announced that, effective April 1, brokers would need written authorization before lending an investor's shares. "This wreaked havoc on the securities lending market, but the effect was completely temporary," he [Jones] said, because the move only added extra hoops, and didn't prevent people from taking bearish positions if they wanted."

More regulation, and temporary results. Not necessarily what we need long-term, but what we will probably get regardless. Maybe with less next quarter, short-term, results-generated management, by both investors and the government, we would not need additional layers of regulation.

There was a nice, shall we say really nice rally in the financial stocks yesterday, with the XLF surging up 12%. Fannie and Freddie also had big days. Down volume in the XLF has also recently spiked to record levels (twice), potentially indicating capitulation (see a nice article by Bill Luby at greenfaucet.com). Yet, I have to wonder how much of Wednesday's movement is based on the recent SEC changes in the short selling of financial companies, and how much is due to capitulation and a potential market bottom. Have all the problems with Fannie, Freddie, banking, housing, and credit been cured since we can no longer short without (heaven forbid) actually borrowing the shares we want to sell?

A WSJ article discusses the changes in the short selling requirements. In short, the SEC has created a temporary protected list of 19 financial companies that prevents naked short selling of their shares. The extra protection of the 19 companies will continue until July 29, but can be extend for 30 days beyond the original July 15 date, and could be extended to more companies. Now, instead of allowing brokers to sell a stock short as long as they have a "reasonable" belief they can locate the needed shares and actually deliver them, they will now need to make formal arrangements to borrow the shares before shorting. The new rules will prevent multiple brokerage firms from looking at the same available stocks from the same custodial banks, assuming they would be able to deliver these shares if necessary. While the stock prices of the listed companies reacted positively to the added restrictions, it is unclear that the companies themselves will appreciate the added stigma of appearing to need government and SEC protection. The effects of the new shorting rules on hedge funds - who actively engage in short selling - is also unclear, but certainly not positive as each will now need to secure shares first before shorting. Hedge funds do have the ability to use puts and swaps, yet those on the other side of these derivative trades may need to find other ways to hedge their exposure.

But is this the real problem, and will the current SEC changes really fix the underlying issues in the market? It is mentioned that short interest has risen sharply for financial stocks and the NYSE and Nasdaq markets since the last market correction eight years ago. But is this really any surprise? Financials have been one of the largest, if not the largest sectors in the market. Given that they are now suspect due to the recent credit and housing issues, and have been for some time, would you not expect both the financials and the market to see increased levels of shorting?

The recently increase in down volume experienced late last week and early this week may be the capitulation that the market is looking for. Regardless of whether it is or not, I am still not convinced that an SEC induced short sale restricted rally is the making of a recovery. If it is, what does this really say about our markets?

The NY Times and Wall Street Journal are reporting that the Treasury Department will propose giving the Federal Reserve broad new authority to oversee the financial markets and insure their stability.

As one step, the plan would merge the SEC with the CFTC (Commodity Futures Trading Commission). This will no doubt raise some objections. As a carrot, these agencies would also be given greater flexibility to regulate themselves and streamline the approval of new products. I can just see all the new ETFs. EFTs of ETFs anyone ....... but I digress.

The Fed would also be granted greater power, allowing it to examine the practices and bookkeeping of brokerage firms, hedge funds, the commodity exchanges, or for that matter, any institution that might pose a risk to the system (Does this include Congress? Just a thought.). There is also interest in allowing the Fed to have additional access to information from those securities firms and investment banks that might borrow money from the central bank. Maybe this will make it easier in the future to tell whether Bear Stearns is worth $2 or $10 dollars ...... but I digress again.

The proposal also calls for a Mortgage Origination Commission to evaluate state governments in regulating mortgage brokers. It would also eliminate the distinction between banks and thrift institutions, close the Office of Thrift Supervision (which regulates federal thrifts), and merge it with the Office of the Comptroller of the Currency (which regulates national banks). Given that the lines between these two are close already, this change may offer less debate.

But we are not done yet. The proposal would also create a national regulator for insurance companies, something currently done at the state level. Like with mortgages, there is a trend in the proposal to move regulatory authority from the states to the federal level. Somewhat of an unusual move for the current administration, but given the current mess, probably not totally unexpected.

It is believed that the proposal will take years to implement, given the depth of change and debate that is likely to ensue, so who knows what will become of it. There is already an expectation that some in Congress will want investment banks to fall under some of the same oversight currently placed on commercial banks. I imagine this debate will begin/continue in earnest.

Finally, most of the proposals are pitched as being geared toward streamlining regulation, but as we know, just because you take two or three existing agencies and create one larger one, you don't always get more efficiency. Unlike companies, which hope to cut waste after mergers (not always successfully), government agencies rarely do. Since they cannot typically layoff the employees, where would they go anyway? You often just get bloated agencies with even more layers of approval. I hope I am wrong, but I am certainly not optimistic.