What's next, a ban on stock sales?

By Bill Fleckenstein

The Securities and Exchange Commission has a list, and it's checking it twice. It's a compendium of nearly 1,000 companies the so-called watchdog has now pronounced off-limits to short-selling.

If this do-not-short list weren't such a travesty, it would be hilarious. Among the companies the SEC wants to "protect" are the ones -- Moody's (MCO, news, msgs) and McGraw-Hill (MHP, news, msgs), to name just two -- that did such a horrendous job rating the mortgage paper that helped cause this debacle in the first place.

The Cox virus unleashed

In the end, SEC Chairman Chris Cox and friends will discover that this will turn out to be an epic example of the law of unintended consequences. They've probably just succeeded in blowing up a tremendous number of quantitative-oriented money managers and hedge funds. In essence, this targets anyone who runs a long-short fund or arbitrage fund of any kind, and anyone who manages any sort of stock basket.

To distill those gory details down to their essence, what the SEC has done is guarantee that less liquidity will be available for markets.

• To hear Bill Fleckenstein discuss the bailout on a new Disciplined Investor podcast, click here.

I suppose that if this doesn't work, the next step will be to just outlaw selling altogether. After all, that does seem to be the government's response to prices it doesn't like. There was a witch hunt for speculators in commodities on the long side when oil (and various food items) went higher over the summer. Obviously, we've seen that lower stock prices have also precipitated a government response.

So when the bond market eventually revolts -- because of the cumulative effect of the Federal Reserve’s monetizing any and all pieces of paper the Treasury buys -- is the government then going to ban the short-selling of government bonds? Will it eventually say you can't sell dollars? How is any rational person supposed to plan for where the government may draw the line as to what sort of "manipulation" it may condone?

Meanwhile, one item you'll likely never see on the SEC's to-do list: leading the charge on reforming financial statements. Scrutiny of IBM (IBM, news, msgs) would be a perfect start, as the company has shown itself to be a financial engineer of the first order. Nevertheless, IBM last Tuesday begged its way onto the do-not-short list.

This happened even as IBM has been borrowing money to buy back its own shares while it crows about what good shape it's in. The stock is off only about 15% from the highest price it's ever traded at. And it sports a short interest of 10 million shares -- not that much more than IBM trades on any given day and microscopic relative to the 1.354 billion shares it has outstanding.

Any real, untroubled company would be completely embarrassed to be on that list. Thus, in my opinion, IBM's actions are perfectly fitting with how it operates.

The on-closer-inspection rejection

Of course, anyone with any knowledge of history and an IQ above room temperature knows that many of the financial institutions now in trouble have themselves, not the short sellers, to thank for their plights. I'd like to offer the following example, via a recent Bloomberg story headlined "Ten days changed Wall Street as Bernanke saw 'massive failures'":

"The storm in the markets began with a long-deferred nod to reality by Lehman. The 158-year-old, New York-based firm had possible acquirers inspecting its books. They discovered that Lehman hadn't yet written down its portfolio of subprime mortgages . . . as aggressively as some other Wall Street firms."

So, in all likelihood, what the short sellers are being blamed for is the harsh reality that Lehman shareholders would just as soon not take "ownership" of. That is not to say there wasn't any short-selling, but rather that short interest in Lehman was never large. In fact, short-selling was rather modest. As of the last reading, it had dropped to just less than 28 million shares from almost 54 million in June. (For reference, the company had 689 million shares outstanding.)

Continued: 'Henry's Helpful Handouts'

Security says, 'Remove your shoes -- and your shorts'

Nonetheless, despite any and all facts to the contrary, the SEC and the government have resolved to pursue their idiotic "solution" in terms of banning short-selling of certain stocks for the time being. They also have demonstrated that rules don't mean anything, because they are willing to change them whenever it suits their purposes, no matter how disruptive or foolhardy those changes may be.

A friend summed up the situation by commenting that we're in an environment where "short sellers . . . are risking private money betting against badly run businesses and governments are risking public money betting in favor of badly run businesses. You don't need a Ph.D. in finance to know which group of folks believe in truth and free markets. . . . You can expect to see all foreign banks move their toxic waste to their U.S. subsidiaries for delivery to Henry's Helpful Handouts."

One wouldn't have to be too cynical to conclude that we now know the real reason Treasury chief Hank Paulson decided he needed a $700 billion bazooka. I don't mind him helping out old friends at Goldman Sachs (GS, news, msgs), and I would prefer that the financial system not implode. But I find this bailout bill completely outrageous. Though I won't hold my breath, I hope it doesn't get enacted as currently proposed.

The silver lining: Halting a money-fund run

If I were to try to find the piece of last week's actions that was least objectionable, I would say it was putting a halt to the run on the money market funds. I know that places at a disadvantage all the people who prudently owned government-only paper, like many of my readers. But just as, when push came to shove, American International Group (AIG, news, msgs) had to be bailed out, a run on the money market funds would have been devastating to too many innocent bystanders.

The bottom line is that the government has decided it doesn't like where the prices of houses are, where the prices of mortgage-related debt securities are, where the prices of commodities are and where certain stock prices are, so it has elected to change them all by fiat. It won't work, and one of these days, the bond market will be absolutely shattered.

If Congress manages to agree on a bailout bill, the financial crisis will probably be over (but I'll reserve judgment until I see the action in all markets in the wake of the legislation).To that extent, the government's actions will keep the economy from getting "extra-worse" on the back of a stock market crash and a run on the money funds.

Having said that, when folks discover just how weak the economy is, especially now that we've blown out all kinds of participants in the stock market, we may still get some sort of a crash or serious sleigh ride south, though it's really hard to draw conclusions at the moment.

We obviously have been close to a crash in the stock market and a seizing up of the financial system. But regardless of what the "experts" say (most of them, after all, saw none of these problems coming), my fear is that the worst is still in front of us.

At the time of publication, Bill Fleckenstein was short shares of IBM.