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SEC muscle, finally

The agency's emergency rule on short selling reflects its power, which it should exert more often.

July 17, 2008

The subprime mortgage meltdown has taken a toll on the financial sector, triggering the collapse of one of Wall Street's oldest firms, wild gyrations in the market and a loss of faith by investors in some institutional cornerstones. Yet the most vigorous responses have come from the Federal Reserve and the Treasury Department, not the cop on the beat -- the Securities and Exchange Commission.

This month, the SEC appeared to rouse itself from its torpor. Motivated in part by the precipitous demise of Bear Stearns Cos., the commission is investigating whether traders are spreading false rumors to manipulate the price of certain stocks. As part of that probe, it has subpoenaed data from more than 50 large hedge funds. It has also called a temporary halt to a questionable trading tactic -- "naked short selling" -- on the shares issued by 19 companies in the finance industry, including Fannie Mae and Freddie Mac, whose stocks have plummeted. Some longtime critics of such sales, in which the sellers don't actually hold the shares they're unloading, say the commission should go even further and ban them on all stocks.

It's hard to defend naked shorting, which enables speculators to drive down a company's stock by offering an overwhelming number of shares for sale. And the emergency moratorium decreed Tuesday wasn't the first time the SEC sought to deter it. The commission adopted a rule four years ago to help track and restrict these sales, then tweaked it in March to more clearly criminalize abusive incidents. But traders move much faster than the SEC, meaning that the damage has already been inflicted by the time the enforcers show up.

Complicating matters is the fact that conventional short sellers don't own the shares they're selling either. The difference is that they at least make arrangements to borrow the stock (typically from brokers lending clients' shares). And although this kind of speculation doesn't exactly make the country more productive, it can help investors hedge their bets and rein in stocks whose prices rise irrationally.

That's why the emergency rule itself isn't as important as the fact that the SEC is actually responding with some alacrity to the allegations of manipulation. This is, after all, a commission that has been excruciatingly slow to identify and punish those in the securities industry whose deceptions and collusion helped fuel the subprime lending fiasco. And just last year, the commission actually made it easier for manipulators to drive down shares by eliminating a 70-year-old restriction against successive short sales. Adopting more rules won't deter bad actors if they're not convinced that the cop on the beat is paying attention.

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