The move by market regulators to ban the practice of short-selling financial services stocks temporarily has angered many hedge fund managers and other short-sellers, who feel unfairly punished by the restrictions.

The ban on shorting financial services stocks was scheduled to lift in early October in the U.S. and Canada, but bans will remain in place in other jurisdictions, including Britain and parts of Asia.

“I never thought the regulators would impose such restrictions — it was completely outside my view of reality,” says Phil Schmitt, hedge fund manager and chairman of the Canadian division of the Alternative Investment Management Association in Toronto. “The continuing volatility in the markets, even with the restrictions on short-selling, suggests that short-sellers are not the cause of the problem. There are a lot of false perceptions and emotional reactions around short-selling.”

Rampant short-selling of global financial services stocks in the wake of the subprime mortgage meltdown has been blamed for dramatically driving down the prices of financial services companies’ shares, making it difficult for those companies to raise equity and restore their balance sheets. A free fall in equities’ prices can also translate into uncertainty in the minds of those who do business or place deposits with those institutions, resulting in runs on banks and other destabilizing events. Governments have been trying desperately to stave off a collapse in the global financial system.

In the U.S., the short-selling restrictions originally applied to 799 financial services stocks, but were subsequently applied to 950 when it was determined that a broader group of companies had exposure to the financial services business. In Canada, the ban extended to 13 financial stocks that were interlisted on U.S. and British markets.

Many fund managers are concerned about the unexpected changing of the rules by regulators without industry consultation. There is a fear the ban on short-selling could be extended or lowered again, or that other rules could be arbitrarily put in place to influence markets.

“Desperate men are doing desperate things in a desperate attempt to patch things up,” says Eric Sprott, president of Sprott Inc. in Toronto. “We’re in the middle of a systemic financial meltdown. The powers that be are doing everything in their power to keep it from playing out, including banning the short-selling of financial services stocks.”

Sprott has maintained most of his existing short positions in U.S. financial services companies, but has been unable to add new ones because of the ban.

“There are some huge gains to be made by shorting financial services stocks, but the ban has prevented us from doing things we would normally do under current market conditions to make money for our clients,” he says. “For the most part, the shorts have been right about what’s going on in the financial system. It’s risky to go short, and you have to be massively convinced that there’s a serious problem. But we’re finding out, after some of these financial services companies go bankrupt, that they’re worse off than anyone thought. Short-sellers are being used as scapegoats.”

Corporate trouble will eventually come to light and be reflected in stock prices, whether or not short-sellers are able to employ their strategies, Sprott says. He points to the continuing decline in stock prices for a variety of global financial services companies and the need for further rescue operations for those companies since the ban was imposed in mid-September. Shares in major U.S. banking conglomerate Wachovia Corp. lost more than 90% of their value in a single day recently, before the firm spurned Citigroup Inc. ’s offer for its banking business and agreed to merge with Wells Fargo & Co. of San Francisco in a stock-for-stock transaction.

Surveys in the U.S. show as much as 25% of market volume may be attributed to short-selling. Short-sellers actually grease the wheels of market liquidity through both their selling and buying activities, and covering shorts may have launched many market rallies by starting an early buying wave.

Banning short-selling disrupts natural market-making forces, Schmitt says, not only for financial services stocks but for markets overall. Many long strategies are hedged by counteracting short positions. Regulators should stick to maintaining the market’s ability to settle trades, he says, and stay away from trying to influence direction.

@page_break@“Short-selling is a critical component of the smooth operation of capital markets,” says Ken McCord, president of Webb Asset Management Inc. in Toronto. “Short-sellers can help in the maintenance of efficient markets by improving liquidity. The decision to ban shorting was akin to killing a fly with a sledgehammer.”

What has contributed to the unpopularity of short-sellers in some quarters is a practice of naked short-selling, whereby short-sellers dump a stock without borrowing it first. The practice has allowed manipulators to conduct bear raids on companies and hammer their shares into the ground to make a fast buck.

Although naked short-selling is illegal, regulators have found it difficult to catch perpetrators and enforce the rules. It is only since the bear raids have targeted giant U.S. financial services institutions that the regulators have gotten serious about cracking down on the practice.

“More regulation is on its way,” says Jim McGovern, managing director and CEO of Arrow Hedge Partners Inc. of Toronto, speaking at a recent conference of hedge fund managers in Toronto. “For those coming into power, it will be an opportunity to get back at the fat cats of Wall Street and get their pound of flesh. But it’s likely the regulators will overshoot and go far beyond what’s required. To cast hedge funds as evildoers is not only naive but wrong.”

Many managers believe it would be more effective to replace the ban on short-selling with more prudent rules to stop abuses and enable effective enforcement. Sprott, for example, believes it would be helpful for the U.S. to reinstate the “uptick rule,” which was removed this past July after being in place since 1929. That rule stipulated that short-selling could be done only after a rise in the stock price, which prevented an avalanche of short-sellers from suffocating a stock to death.

“Traders shouldn’t be able to short with impunity,” Sprott says. “Fear can too easily be fomented, and some guys run things way down and scare the heck out of people. An uptick shows that there’s also a positive view out there.”

Even with the ban, there have been opportunities for money managers to profit in down markets by buying put options or selling calls. (See Richard Croft, page 34.)

“The options market is still liquid and managers can create synthetic shorts by buying puts and selling calls,” says David Guarasci, hedge fund manager and managing director of Sherpa Asset Management in Vancouver. “That gives them an edge to extract money out of a falling market.”

There is no ban on the trading of leveraged exchange-traded funds offered by BetaPro Management Inc. of Toronto. Horizon BetaPro ETFs allow investors to double the daily returns of a variety of indices, commodities or baskets of stocks, from broad market averages to narrow niches such as gold, financials and grains. But that’s not all. The funds come in bear versions, which rise by double the amount of the daily loss in the underlying investment, allowing investors to profit in a down market.

BetaPro president Howard Atkinson says the volume in Horizon BetaPro’s bull and bear financial ETFs tripled following the ban on short-selling, and institutions, including hedge funds, were big contributors to the trading.

Even if the ban on short-selling continues, McGovern sees opportunities for hedge fund managers in the use of other strategies based on anticipating strategic mergers and acquisitions, or buying up distressed debt and equity securities.

“Hedge funds have been referred to in the U.S. as ‘cockroaches of financial markets’,” he says. “Cockroaches have lived a long, long time, and we will survive.” IE