Oh yeah, let's ban short selling - great idea!

Those financial stocks love a bit of press. Mid month, Lehman Brothers filed for bankruptcy protection and large insurer AIG shortly followed with similar financial woes. While the US government have a good history of handling economic conditions, it looks like they’ve not done so well this time.

The banning of short selling by the SEC during the month was just plain nonsense.

It may be true that some large traders can use short selling to deliberately push the market lower, but the banning of this practice is a bandaid fix at best. The simple fact is the entire options and futures market allows and investor to short sell far easier than short selling in stocks. One can hardly claim that removing the ability to short sell stocks can support a market or reverse a crisis.

What you can say however it that it makes a good scapegoat. Remember the whole ‘weapons of mass destruction’ thing in Iraq? Serious claims with little or no evidence. There are parallels here. During this crisis several of the failing banks have spoken out about how “improper short selling” was the cause of the weakness in their share prices. So it was the short sellers to blame, not mismanagement, excessive leverage and outright incompetence? Well it was a lie the SEC believed.

As for that ‘$700million bailout’, the details seem to be changing on a daily basis, so it’s hard to comment until it all comes out in the wash. However, one has to wonder why anyone would bailout the companies and management that created the problem in the first place. Bailing out investors is one thing. Bailing out mismanaged companies is another.

Also one has to wonder what the real crisis is. Is it a bunch of bad mortgages? Perhaps that is enough to rock several banks, a bunch of broking companies and the entire economic system. Another thing however that can rock an entire system or make a problem worse is confidence.

The ‘doom and gloom’ view point is one that is self fulfilling. If enough people think the world is over, then their actions will cause it to happen. The Fed and the SEC seem to have acted in a way that has triggered a complete lack of confidence on the financial system.

If everyone thinks a bank is about to fail, everyone will take their money out and stop dealing with the bank. That in itself will cause the bank to fail. Back in 1946, James Stewart’s character in the movie ‘It’s a Wonderful Life’ knew this. Here in 2008, the Federal Reserve and the SEC do not.

You see this lack of confidence has put some serious brakes on the financial system. Credit markets have almost frozen as financial institutions have stopped lending to each other as each fear counterparty risk (risk that another bank will fail).

So what is the solution? It is clear that the US government has to step in somehow. In fact it seems highly unlikely that there will not be some sort of bail out. The ideal bailout however will be one that does two things:

• Restores immediate confidence.
• Limits the risk that this kind of thing can happen again.

The second point is a detailed one – and will probably take months before it can be addressed. But without a concerted approach to stop banks doing silly things, then what’s to stop this happening again in a few years?

Here is a bold prediction – it will happen again. The next time, the guns of Wall Street will have some new whiz-bang product and everyone will get carried away with it all - again. Hey, in the 80’s it was LBOs. In the 90’s, securitization became popular as did complex derivatives.

In the 00’s it was more securitization and complex derivatives, but with different names like CDOs. Slack credit policies and clever packaging does not a good investment make.