After the collapse of Enron Corp. in 2001, Wall Street "short sellers" were hailed as heroes for helping to expose the company's massive accounting fraud.
Seven years later, the "shorts" -- traders who borrow stock and sell it, expecting to profit from falling prices -- are the reviled black hats of global markets. They have been damned by regulators and politicians who say they're largely responsible for the meltdown in bank and brokerage stocks that brought the financial system to its knees this week.
On Friday, the Securities and Exchange Commission took the unprecedented step of ringing a fence around 799 financial stocks -- from tiny Beverly Hills Bancorp to giant Bank of America Corp. -- and forbidding traders from shorting them for at least 30 days.
The SEC said it had become concerned that short selling of financial shares "may be causing sudden and excessive fluctuations of the prices of such securities in such a manner so as to threaten fair and orderly markets."
Note the "may be causing." The SEC is conceding that it doesn't know for sure what effect short selling has had on financial stocks. But with the Dow Jones industrial average at nearly a three-year low Wednesday and fear of a credit-market collapse rampant, the SEC faced overwhelming pressure to do something.
So now the agency, led by Chairman Christopher Cox, is blatantly trying to stop financial-stock prices from going down.
On Friday, the order had the desired effect, and then some: The average financial stock in the Standard & Poor's 500 index soared 11.1%, on top of the 11.7% surge Thursday, when rumors first began to circulate that the U.S. was planning bold steps to deal with the financial crisis.
Investors who have shorted financial stocks this year didn't try to disguise their anger.
"The irony is that the SEC is doing exactly what it claims to be against -- manipulating the markets," said Eric Newman, who manages the West Chester, Pa.-based TFS Market Neutral mutual fund, which shorts some stocks while going "long" (buying and holding) others.
Many academics were no less critical of the SEC. Jonathan Macey, a securities law professor at Yale University, said the ban on short selling was "an abomination."
The SEC wasn't operating in a vacuum. Securities regulators in London made the first move against short sellers Thursday, when they banned shorting of British financial stocks through year-end.
Also on Thursday, New York Atty. Gen. Andrew Cuomo said he had launched an investigation to look for evidence that shorts were spreading lies about the financial condition of banks and brokerages to drive the stocks down.
The SEC says it, too, is ramping up its probe of short sellers, and will require them to discuss their trading activities under oath.
There are plenty of shorts out there to interview.
The best-known ones are firms that have mostly made a living looking for companies that are outright frauds, or for legitimate companies whose shares have become grossly overvalued for whatever reason. These shorts include Kynikos Associates in New York, headed by Jim Chanos, and the Prudent Bear fund founded by David Tice.
Beyond that core of short sellers are thousands of hedge funds and other investors who can go long or short in a stock depending on which way they expect the price to trend. In many cases these investors go short to hedge their portfolios -- in other words, to offset long positions.
Finally, there are countless small-time short sellers who are merely momentum players looking to ride market trends.
In a typical short sale, a trader borrows stock from a brokerage's inventory and sells it. If the market price falls, the trader can buy new shares later to replace the loaned shares and pocket the difference between the sale price and the repurchase price.
If the stock rises instead of falls, the bet is a loser.
There's no question that shorting has been a growth industry over the last year. The number of shorted shares of New York Stock Exchange-listed companies totaled 17.69 billion at the end of August, up 42% in one year.
The latest total accounted for 4.6% of all NYSE shares outstanding, a relatively small share of the market. But the shorts have been much more aggressive in financial stocks.
For example, a record 382 million shares of struggling thrift Washington Mutual Inc. were shorted as of Aug. 29, or 26% of the total outstanding.
Unrepentant short sellers say they're being blamed for simply telling the truth about the extent of the disastrous lending and investing decisions that banks and brokerages made in recent years -- just as they helped to expose Enron, WorldCom Inc. and other frauds this decade.
"Investors are best served when they can hear both the reasons to buy and the reasons to sell any given security," said Kynikos' Chanos.
But some market pros say they believe that short sellers have, in fact, been in a predatory frenzy over financial stocks in recent months. Christopher Ailman, chief investment officer of the California State Teachers' Retirement System pension fund, asserts that some shorts were directly trying to foment a "crisis of confidence" in financial companies, including those that weren't at risk of failure because of bad investments.
There's only one way to find out, now that the SEC has stopped short sellers cold: The SEC, and Cuomo, should make good on their pledges to dig into short sales and tell us exactly what they find.
The SEC has made a dangerous move by halting a legitimate investment strategy that's as old as tulip bulbs. We need to know that it had a very good reason for interfering in what is supposed to be a free market.