Damaging The Market By Curbing Short-Selling (FNM)(FRE)(MER)(LEH)(MS)(GS)

Newly-minted legend says that short-selling put Bear Stearns out of business and has swamped the stock prices of Lehman (LEH), Fannie Mae (FNM), and Freddie Mac (FRE). To keep evil from further invading the stock markets, short selling should be put to sleep.

According to The Wall Street Journal, “In a dramatic emergency order, the SEC said it would immediately move to curb improper short selling in the stocks of struggling mortgage giants Fannie Mae and Freddie Mac, as well as those of 17 financial firms, including Goldman Sachs Group Inc (GS)., Lehman Brothers Holdings Inc., Morgan Stanley (MS) and Merrill Lynch & Co. (MER).”

Breaking that down for a moment, “improper short selling” has always been against the law. Banning it twice is not likely to change the complexion of that prohibition.

Short selling is one of the great services that a portion of investors do for the markets. Public company managements cannot help but feel good about their own prospects. It is the nature of the beast. Executives work for good results and the upbeat nature of their forecasts is part of the psychology that keeps them slaving for their shareholders. Short selling plays the “emperor has no clothes” role

Banning short selling assumes that those long shares in a company have no power to influence the media, stockholders, and securities analysts. The theory claims that all of the weapons are in the possession of one side in the fight, which means that the other side will surrender.

Since the problems at companies like Fannie Mae and Merrill Lynch are real and not imagined, it is hard to make the argument that short sellers made them worse. The shorts bet against companies that they knew had made mistakes and they made profits doing it. Forcing them to act otherwise gives investors who want a stock to go up a substantial advantage, even if they do not deserve it.

Putting shorts out of business does not do the market any favors. It just pushes the day of reckoning for companies that failed their stockholders out a little further into the future.

Douglas A. McIntyre