Could the probable halt of dividend payments from Fannie Mae and Freddie Mac have led the SEC to adopt an emergency rule curtailing short-selling? There's no doubt that financial regulators all over Washington DC are highly focussed on saving the mortgage giants from impending doom, so it wouldn't be too surprising if awareness of the need for a dividend cut at the companies would have fed fears of rampant short-selling and triggered a move to prevent this.
To understand how a dividend cut can make short-selling easier, it's important to understand the mechanics of short-selling. Many stocks that short-sellers borrow are held by brokerage customers in margin accounts. When companies don't pay dividends, brokerage customers are encouraged to hold shares in those margin accounts.
The tax code creates this incentive system by treating dividend payments differently from substitute payments investors receive when their shares are lent to short sellers. When a customer's shares are lent out, the customer doesn't receive dividends. Instead, the customers receives a payment in-lieu of dividend, which lacks the tax advantages of actual dividends. Brokerage customers respond to this by holding high dividend paying stocks outside of margin accounts, making it more difficult for short-sellers to locate shares to borrow. The other side of the coin is that they move non-dividend paying stocks to margin accounts.
This calculation is somewhat muddied by the fact that brokerages often reimburse customers for the additional taxes incurred. But halting dividend payments should have the effect of encouraging investors to hold shares of Fannie and Freddie in margin accounts, making the stocks of the companies easier to short and increasing the outermost bounds of short interest in the stock.
A tax expert we spoke with this morning thinks this fear of a rise in the ability to short Fannie and Freddie could well have led to the new rule.
"The rule makes shorting more difficult, which looks like an attempt to balance the pro-shorting effect of the dividend cut," the expert said. He asked that we not name him because he'd totally lose his high-paying job at a white shoe law firm if he was quoted on this.
Posted by guest, Jul 16, 2008 12:01PM
Just look for the gender-shifting tax attorney.