Meltdown 101: Investors get back to shorting

Will stocks benefit now that the government is letting investors bet on financial stocks going down? It's a strategy known on Wall Street as short selling. And, for three weeks, the government banned the practice to protect financial companies whose shares had come under siege.

Short sellers were blamed for the massive declines in companies like Lehman Brothers and Bear Stearns that were already crippled by the credit crunch. Still, debate continues if the ban did more harm than good.

With the ban having expired Wednesday night, here are some questions and answers about short selling's return to Wall Street.

Q: How does short selling work? How can you put money on a stock going down?

A: In short selling, investors borrow shares and sell them with the hope they'll go down in value, so they can pay for the shares later at a lower price and turn a profit.

It's an investment strategy that turns the "buy low, sell high" idea on its head — instead, you sell high first, then wait for a good time to buy low.

Q: Why was the practice temporarily banned for financial stocks?

A: Securities and Exchange Commission Chairman Christopher Cox hoped the ban would stop unlawful manipulation of stock prices. The concern was that short-sellers deliberately targeted financial companies, pushing their share prices down and leading to their collapse.

Q: Did the ban help stabilize these companies?

A: Not really. Even without short sales, shares of Lehman Brothers — a 158-year-old investment bank — were crippled and the company was forced into bankruptcy. And financial stocks plunged 23 percent while the ban was in effect.

Q: More broadly speaking, how did the ban affect the stock market?

A: The jury is still out about what difference the ban made on trading, with many experts saying that the measures might have increased volatility in financial markets instead of stabilizing them.

Between the ban's introduction on Sept. 19 and Wednesday, Wall Street had its worst six-day rout since Black Monday in 1987. The Dow Jones industrial average sank nearly 19 percent, suffering two days when the blue chip index at times fell nearly 800 points.

The ban "did more to destroy investor confidence than anything," said William Ackman, who runs hedge fund Pershing Square Capital Management.

Q: Why might the absence of short sellers be bad for the stock market?

A: Some people on Wall Street believe that short selling was wrongly blamed for problems in the financial sector, and that removing them eliminated an entire class of investors.

The problem is that short sellers act as a cushion during declining markets, snapping up falling shares to cover their positions. In other words, when they complete a short sale by buying a stock that's fallen, they're often buying shares that other investors don't want — and that helps push prices upward.

Richard Baker, president and CEO of the Managed Funds Association, said short sellers will help stocks recover from its latest losses by injecting more money into the markets. "This, in turn, should assist businesses in raising capital, restore investor confidence and help to set a course for economic recovery," he said.

Q: What happened on the first trading day after short sellers were allowed back?

A: The market had another rough day Thursday, but experts believe that's because of the general malaise about the economy and concerns about the credit crisis. It could take some time before technical analysts can look at volume levels and determine whether short sellers even rushed back into the market.

Brian Gendreau, investment strategist for ING Investment management, said some of Thursday's drop can be attributed to short sellers. For instance, General Motors and Morgan Stanley, two companies that were favorites of short sellers, both tumbled on Thursday. But he and others point out that these companies weren't doing so well during the ban either.

"As an emergency measure, the ban might have helped a bit," he said. "But, these are highly unusual times, and there's really no way to measure how much a stock is being impacted by shorts."

Q: Could regulators bring back a ban, or place any other restrictions on short selling?

A: There doesn't appear to be any motivation by regulators to keep the ban around, even on a temporary basis. The SEC could have kept the ban in place until Oct. 17, but opted not to. Instead, their economists are focused on studying the impact of the ban.

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