Why is short selling getting such a bad rap?

McClatchy Newspapers (MCT) - Short selling, in which an investor borrows shares, sells them and hopes to profit if the price falls so they can be repurchased more cheaply, came into focus last week as a culprit in the recent Wall Street mess. The Securities and Exchange Commission has forbidden investors from short selling 799 financial stocks for 10 business days in hopes of stopping the skid of major financial institutions.

Ireland and Australia followed suit, while France said its rule that short sellers must hand over shares in three days trumps any need for a ban, Bloomberg News reported. The U.S. ban can be extended, but for no more than 30 calendar days, the SEC said.

Short sellers have been accused of greasing the downward skids of stocks like Bear Stearns, Lehman Bro s. and AIG in recent weeks. But it's hardly a new activity.

Short selling goes back hundreds of years, if not a millennium, with hedging on the delivery of grain by barge, says Pete Locke, a finance professor at Texas Christian University's Neeley School of Business.

Today, it's generally a reality check on companies that might be painting too blue a sky for their outlook, said Christopher Snow, director of investment advisory services at Signal Securities in Fort Worth. "They're right more often than they're wrong," he said of short sellers. "They are not dummies."

Friday's stock market surge was a result of many short sellers scrambling frantically to buy shares to cover their bets before losses mounted, Snow said. "It's called a short-covering rally. If you are a short seller, this is not a good time."

Naked short selling, which can be illegal, is putting up for sale stock that isn't even borrowed. Most naked short sellers are large financial entities and clearing houses, not individual investors, Snow said. In some cases, far more stock than exists is sold in a company targeted by short sellers, he said.

On Friday, the SEC closed a loophole for naked short selling and established a rule requiring short sellers and their brokers to deliver shares within three days after the date of the short sale or face penalties. Although the measures took effect on an interim basis Thursday, the SEC will accept public comment for 30 days.

An emergency order this summer stopped naked short selling of shares in mortgage lenders Fannie Mae and Freddie Mac before the federal government bailed them out.

But there are questions over the role that each type of short selling played in bringing down hard-hit financial stocks. "The SEC has made plain that we have zero tolerance for naked short selling," Christopher Cox, the commission's chairman, said Thursday.

Under normal market conditions, "short selling contributes to price efficiency and adds liquidity to the markets," the SEC said. "At present, it appears that unbridled short selling is contributing to the recent sudden declines in the securities of financial institutions unrelated to true price valuation."

Locke criticized the SEC's 10-day ban on short selling stock of the companies, saying it would hobble an important market function. Moreover, it might reflect the regulatory agency's inability to effectively monitor the strategy, Locke said. "I think they lost the ability to track the difference between short selling and naked short selling."

Snow said the temporary measure is a "Band-Aid" that allows people to catch their breath. "It's good for my clients and for me," he said, but he questioned whether in the long run, bailing out astute investors is good for a free market.

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© 2008, Fort Worth Star-Telegram.