You'd think that if we've learned anything from the past few waves of financial crisis, we'd have learned that shorts sellers play an important role in financial markets.

Shorts can check otherwise unbridled financial enthusiasm, improve price discovery and have often pointed out accounting chicanery at powerful public companies. Shareholders and management are incentivized to overlook or cover-up problems. They want stocks to go up. Regulators often lack institutional incentives to investigate wrong-doing.

But shorts, like John Paulson of Paulson & Company or Jim Chanos of Kynikos Associates, can make fortunes by uncovering hidden problems. In short (sorry), they are providing the market with a valuable service--let's call them positive externalities--all while pursuing profit.

Nonetheless, we haven't learned this lesson at all. Today the Financial Times reported that the UK securities regulator, the FSA, is going to impose new disclosure rules on short sellers who take positions on the shares of companies undertaking new share issuances.

How bad must things be up in Armonk?

It’s usually a sure sign of deep trouble when a company blames short-sellers or runs crying to lawmakers for protection. MBIA has announced plans to do both. It’s asking lawmakers to investigate or curtail “the unscrupulous and dangerous market manipulation activities of short sellers," according to a written copy of testimony it plans to give to the U.S. House Committee on Financial Services that Reuters obtained.

What really has MBIA’s knickers in a twist is that scheduled appearance of Bill Ackman before the committee.

"MBIA notes that Mr. William Ackman is appearing on the hearing on February 14th as an 'industry expert.' Mr. Ackman is in fact not involved in the industry in any capacity except as that of a short-seller, and, accordingly, MBIA questions the characterization of Mr. Ackman's expertise," the testimony says.

Scandalous. Everyone knows that short sellers cannot be experts. Only corporate management count as experts. Just ask Enron. That damned Jim Chanos guy got up in their face, and he wasn’t even in the energy trading business. They really showed him.

MBIA to urge curtailing short sellers [Reuters]

Jim Chanos, the legendary hedge fund manager who shorted Enron when the company was flying high, is predicting a "huge spike in defaults" of leveraged loans, according to Reuters.

"I don't know what crack pipes these guys were smoking, but some of the valuations were absolute madness," said Chanos, speaking to hundreds of investors, referring to private equity firms and their portfolio companies.

Short-seller Chanos sees raft of new opportunities [Reuters]

Business Week’s Matthew Goldstein reports that federal investigators are nearing the end of their 18-month probe into the “murky world of stock lending,” and it looks like it’ll be employees from Wall Streets stock-loan desks who’ll be going down.

The folks who’ve undergone the most scrutiny work for Bear Stearns, Janney Montgomery Scott, and Morgan Stanley. On June 18, Morgan Stanley vice-president Peter Sherlock, who’d been with the bank for 13 years, resigned after his name came up in the case. His lawyer, John Wallenstein, declined to say why his client had taken an early retirement, but did confess to “know[ing] there is an investigation by the Eastern District of New York” and “know[ing] the SEC is looking at it too."

Earlier: Trouble In Stock-Loan Scheme Town

Criminal Probe Snares Morgan Stanley VP [BusinessWeek]

This month, the number of shorted shares on the NYSE reached 3.1% of the total number of shares traded on the exchange. This is the highest percentage since 1931 (just to give you a sense of how long ago that is - in May of 1931 the Empire State Building had just finished construction). The bulls may carry the day though, as shares of the S&P 500 are trading at only 17.8x earnings on average, which is a far cry from the 32.8x earnings S&P 500 shares were trading at on average at the end of the last bull market. As short sellers continue to hold firm, they may continue to eat it, according to Bloomberg:

Hedge funds that focus on shorting lost 35 percent from September 2002 through the end of April, according to the Credit Suisse Tremont Hedge Fund Dedicated Short Bias Index. That compared with an 82 percent gain for the S&P 500 in the same period. The funds are the worst performers this year among 10 hedge fund strategies tracked by the Credit Suisse/Tremont Hedge Fund Index, dropping 1.1 percent.

Short Sales Break Record on NYSE; Market Bulls Get More Bullish [Bloomberg]

Everyone knows that you’re nobody until somebody loves you stalks you slips a rohypnol in your drink accuses you and your kind of being criminals (it’s true). A “number” of people in Wall Street’s securities lending business may earn that kind of recognition in the very near future: Business Week’s Matthew Goldstein reports that federal prosecutors in Brooklyn are close to charging current and former Street employees with “taking part in a complex kickback scheme that may have collectively cost the financial houses and short sellers million of dollars in higher and unnecessary fees.”

Three Sal Bonpensieros are already cooperating with prosecutors. Past and present stock loan desk employees from Bear Stearns and Morgan Stanley are being the most thoroughly investigated. Prosecutors also have their eye on Goldman (and former Goldman) employees, as well as Janney Montgomery Scott, Merrill Lynch and Nomura Securities.

No doubt this has left many short-sellers on the train back from Greenwich this afternoon with mixed feelings. On the one hand, finally someone is uncovered for criminality in the short-selling business and it turns out they weren't working for a hedge fund. Take that anti-naked short-selling conspiracy theorists! On the other hand, it means that all those brainiac business school grads at the hedge funds were being taken to the cleaners by a bunch of guys at the stock lending desks of Bear Stearns and Morgan Stanley! Talk about humiliating.

The Crackdown on Stock-Loan Schemes [Business Week]

FINalternatives said it best: “Just because you’re in the process of shutting down after losing $6.5 billion doesn’t mean the Feds will cut you a break when it comes to naked short-selling.”

Amaranth Advisors has agreed to pay $716,819 to the SEC to settle charges that it shorted five stocks before their secondary offerings, and then covered the sales with the securities bought in those offerings. Amaranth didn’t admit or deny the charges, an in a letter to its investors, noted that the naked shorts had nothing to do with the meltdown last September, which result from bad natural gas trades and a lack of bad weather.

Wrote founder Nick Maounis, “The trades that are the subject of the settlement represent a variety of trading errors or misunderstandings of the application of the rule.”

Amaranth settles short-selling case with US SEC [Reuters]
Amaranth Hit For Naked Shorts [FINalternatives]

You remember AntiSocialMedia.Net, right? No? Yeah, we were doing out best trying to forget it also. It’s the website hosting what the New York Post describes as "bitter attacks … on the message board critics, accusing them of participating to various degrees in a conspiracy to malign the anti-naked short selling movement that Overstock.com supports."

Well, it turns out that there was very good reason that AntiSocialMedia.Net was supporting the same causes as Overstock.com. It was being anonymously run by Overstock.com’s director of social media Judd Bagley.

Gary Weiss, who has been all over this story, wants to know:

Only one question arises in my mind: What laws were broken? Not "were laws broken?" but "what were the laws that were broken?" The new federal cyberstalking law comes to mind, obviously, but what others? Regulation FD is another good possibility, given the ASM Lie Machine was created after Bagley became a corporate officer. (And speaking of corporate disclosure, shouldn't Overstock file an 8-K disclosing its involvement in ASM?)

Bagley is trying hard to distance himself from his employer, Patrick Byrne, which brought him on as "director of social media" in August with all the fanfare that you and I would use in buying a can of Raid cockroach spray. Nice try, but too late. Byrne himself promoted the site and contributed to it, and has indicated that he has advance knowledge of its disclosures. Once again, Byrne's big mouth has landed him in deep doo-doo.

Judd Bagley Fesses Up [Gary-Weiss.com]

Gary Weiss, author of Wall Street Versus Americapoints out that today is the close of the comment period for the Securities and Exchange Commission rule proposal on "fails to deliver" securities—basically, the anti-naked short regulation.

As he notes, the National Coalition Against Naked Short Selling—described by Weiss as an “”astroturf’(phony grassroots) group pushing the agenda of penny stock promoters and CEOs of foundering companies”—has submitted a 23 page comment letter. We were just about to pull it up to see exactly what NCANS were going to say, but fortunately Weiss saves us the trouble.

...I was looking forward to seeing that evidence when the anonymous NCANS said on its various anonymous websites it has got 1,100 actual people to send in their signatures to the SEC. I said to myself, "Surely these people are going to scribble in a note about what happened to them!"

But when I saw what the NCANS was sending in, all I saw were signatures below a statement saying that "The undersigned have been negatively affected by delivery failures of equity securities in the U.S. markets, and by the crediting of security entitlements in quantities far in excess of the issued securities they claim to represent."

Just name and address. No space for "what happened" or "what stock I owned that got counterfeited or naked shorted or stuff."

So they still haven't provided a single example of a company being hurt by "stock counterfeiting" or "naked short selling."

Annals of Baloney (continued) [Gary-Weiss.com]

Yesterday officials at the group which polices the New York Stock Exchange said they were investigating what may be improper short-selling prior to public stock offerings.

Specifically, the NYSE Regulation officials pointed to the practice of selling short a stock prior to the offering and then covering with stock purchased in the offering. This practice is banned by Rule 105 of Regulation M, according to the regulators who also noted that they did not yet have proof that it had occurred.

This announcement came one week prior to a scheduled Senate judiciary committee on the short selling activities of some analysts and hedge funds.

NYSE concerned about stock offer short-selling [Reuters]

From Gary Weiss we learn that the Senate Judiciary committee has pushed back its hearings on short-selling for a week. Maybe they took our advice to study up on the subject a bit more before launching headlong into what could have been a nightmare of gullible lawmakers getting duped by fast-talking (and possibly campaign fund contributing) corporate executives. The list of witnesses hasn't been published yet but there have already been questions about exactly where the push to hold these hearings is coming from. As Weiss points out, the history of these kind of hearings is not a happy one.

Increasingly, corporate managers who can't run their companies competently have been shifting the blame to short-sellers, who bet on stocks declining. This is actually an old phenomenon, and certainly not the first time that Congress has obediently served as a PR conduit for such scapegoating.

In Wall Street Versus America, I describe how a House hearing on the same subject in 1989 left one congressman -- future SEC chairman Christopher Cox -- wondering something aloud. He asked if the committee hadn't been "snowed" by excuse-mongering CEOs. It had been. The whining CEOs who appeared before the committee came from three companies, two of which were later prosecuted for fraud.