Critique the Focus

In an episode of Seinfeld, George Costanza built a small bed and napping area beneath his desk at Yankee Stadium where he worked. I have a sneaking suspicion that Seinfeld is a huge hit at the SEC. I pose a question to the SEC very similar to that posed by audiences to Costanza: Do you actually do anything constructive at work?

In all fairness, SEC regulators actually do something. They watch porn. How does that sound for a job? Get paid to watch people screw, and in the same act, screw the people.

The focus of SEC regulators is in entirely the wrong place. SEC employees aim to satisfy their boss, the U.S. government, under the false assumption that if the boss is happy, the customers – U.S. citizens – are happy as well. However, the SEC must aim to please in exactly the opposite fashion. Please the customers first, and your boss will be happy (eventually, if not at the time), allowing you to keep your job and pursue your interests. In other words, the SEC should focus on what is best for the people, and in so doing, will satisfy the U.S. government.

Unfortunately, this has not been the case over the past few years. Whistleblower Harry Markopolos – who, in the context of our story, we can call a customer – submitted a report to the SEC back in 2005, describing the financial impossibility of Bernard Madoff’s returns and ultimately concluding Madoff was running the largest Ponzi scheme in history. A college junior with knowledge of the basic fundamentals of finance and investment strategies could have arrived at such a conclusion, given Madoff’s SEC filings. It seems apparent the securities and regulation “experts” at the SEC must have forgotten these elementary principles, or at least, did not come across this material at thedailybabelog.com.

When, of course, it was revealed that Madoff was running a Ponzi scheme, customers were unsurprisingly upset, and many had lost their life savings. This could have been prevented had the SEC been focused on its customers rather than their boss, who was content at the time. SEC regulators pulled a Constanza and hit the snooze button when the customers needed them the most.

In that brief example, the customers were dissatisfied, while the boss seemed to be content. A similar negative outcome is experienced in the converse situation in which the boss is upset and forces change not in the best interest of the customers.

Facing an upset superior, the SEC recently enacted curbs on short selling in an attempt to appease the pressuring U.S. government. Whether the boss was pleased or not aside, the focus was not on the customers. The customers are mad that their houses are worth nothing, their investment portfolios have crumbled, and they have been laid off, not that investors are utilizing short selling as a legitimate investment strategy. Focus on the customer!

Sure, the customers are angry and want the SEC to do something. But why short selling? The merits of short selling and the uselessness of this SEC regulation was discussed in a previous post. The customers know they have little understanding of financial markets and the forces that move it. That is why they pay taxes to the U.S. government, who has hired the SEC to implement policy in the best interest of the people. Get out from under your desk, close the browser window for hiboobs.com, and open up a real financial textbook.

Over the past couple of years, suffice it to say there has been a fan with some poop involved. The SEC, had it more carefully regulated mortgage-backed securities and financial derivatives trading, could have prevented or at least ameliorated the magnitude of the economic crisis and Great Recession. However, that is all in the past, and what needs to be determined is how such severe mistakes can be avoided in the future. The focus on the content boss, causing neglect for the telling signs of a major economic fallout, is to be blamed. Focus on the customers, what is best for the customers, and do not sleep on the job, and next time we might be able to avoid a $700 billion bailout. Oh yeah, keep the web-browsing clean while you're at it.

SEC: What are you thinking?

The Securities and Exchange Commission approved in a 3-2 vote a measure to limit the ability of investors to short sell. The rule will not allow the short selling of a stock that has fallen 10% in one trading session, and shorting of the stock will not be allowed for two business days – the day of the decline and the following trading session. The argument is that short selling puts extra, unnecessary, speculative downward pressure on a stock price, and the SEC expects this new curb to put a halt on this downward pressure for stocks whose prices have fallen drastically. However, despite the expertise the SEC is supposed to possess, a lack of understanding of the fundamentals of short selling and failing to recognize the true underlying reasons for the stock price declines have led the SEC to enact a rule that will do no good.

Short selling, in simple form, is performed by an investor who borrows a share of a stock, then resells it to someone else, hoping to buy back that share of stock at a lower price and return it to the lender, making a profit on the difference. For example, an investor could borrow a share of GE at $10 a share from a broker, and sell it to someone else for that same price of $10 a share. The investor then owes the broker one share of GE. If the price of GE stock falls to $8 per share, the investor can buy back that share of GE in the market, then return the purchased share to the broker, fulfilling his or her debt obligation. The investor sold the share for $10 and bought it for $8, netting a $2 profit. In brief, a short seller profits from a decline in stock price.

The SEC has been under pressure to make changes in light of the recent financial crisis and downward pressure on financial stocks in particular. The bearish and speculative nature of short selling has caused critics to concentrate their energy, and thus the focus of the SEC, on implementing new regulations to curb its use. Despite popular belief and understanding, an actual short sale will not cause a stock price to fall. The share of stock is borrowed, sold to another person, and the investor has completed the short sale. The net result is that a share of stock has been purchased, no shares of stock sold…no actual selling took place! This not only does not cause downward pressure, it is actually bullish. A share of stock has been purchased, which will help lift the stock price.

The SEC takes issue with short selling, because it communicates a bearish sentiment on a stock. If a large number of investors are short a stock, the investment community reads this as a negative outlook on a stock. Investors seeing negative outlooks will tend to reevaluate their position, and more investors will hop on the bearish bandwagon. The problem with the SEC trying to fix this is that it is not the short selling that needs to be looked at, it is the actually company that is the problem. As Peter Boockvar writes, perhaps there were more reasons to explain the rapidly falling stock prices of the world’s largest financial institutions than the fact their stocks were shorted. Investors short a stock when they expect it to fall.Although it may make more investors believe the stock is a sell, there must have been something about the company to generate the initial increase in shorts on the stock. Maybe it was the subprime lending, exorbitant leverage, and investments in high-risk securities by the financial institutions that caused massive losses and crashing stock prices? SEC, take another look.