Ofuoma Odje stock market comments

Ofuoma Odje on the recent market crash
The uptick rule established after the 1929 crash, may have contributed to the recent market declines.

Not acting quickly to restore this rule may still be costly to the markets.

It is clear that massive shorting of stocks of major financial institutions by big hedge funds and other big investors were a catalyst to the current financial crisis.

Even worse was the illegal naked shorting these stocks. Usually when shorting a stock the trader or investor borrows the stock on margin and sells in the market with the expectation that the stock price will go down in the future in which case he would buy and return the stocks but keep the difference as profit.

Naked shorting however is a practice of selling the stock without borrowing or owning them to ensure that the transaction can be completed within the required timeframe. This is pure speculation and can be used to manipulate the market.

Naked shorting sometimes leads to a result known as a "fail to deliver, which means the seller does not obtain the shares within the required time frame. However the damage to a stock price would have been complete at that stage.

One way to realize how damaging this practice can be to the financials is highlighted in this scenario.

Take a blue-chip company like Coca Cola or say Johnson and Johnson.

If the stocks of these 2 companies are shorted and go down to extremely low levels, people will still continue to buy and drink coke and use baby care products, Listerine mouthwash etc because these are essentials, therefore the companies will still continue to conduct business as usual even at low stock prices.

However, when stocks of banks are shorted and go to very low levels, people get concerned and begin a run on the banks because they are concerned about the safety of their deposits.

This in turn diminishes the banks’ financial posture in addition to market cap lost by the price drop in stock. It even goes on to hurt their credit rating with the rating agencies who could downgrade the bank's bonds(debt) to junk status and increases cost of credit to the bank who are often asked to put up more assets as collateral against its debt since a loss in market cap would hurt any debt secured by its stock.

Also small investors see their trading accounts and 401ks take a big hit. In extreme cases the bank gets seized by the FDIC and the deposits are sold to a healthier bank and the common equity holders are left holding the bag. The demise of Washington Mutual was one example of this. It was ultimately seized by the FDIC who sold its deposits and assets to JP Morgan Chase.

The uptick rule established after the 1929 crash was clearly intended to at least mitigate the kind of crash that recently occurred in the markets.

Before being eliminated by the SEC on July 6th, 2007 the uptick rule prevented sellers from adding to the downward pressure on the market by barring sellers from shorting stocks on a downtick. It mandated that after shorting a stock, the next order must be entered at a higher bid. This offered protection for honest investors as well as small and retail investors.

Eliminating the rule was at best unhelpful for the markets as it resulted in the rushed destruction of some of the most outstanding financial institutions which in turn destroyed confidence in the Global Financial System

The SEC has recently hinted that it will consider an even more stringent uptick rule that would not only prevent shorting stocks on a downtick, but would force the shorts to enter their orders at a price higher than the highest bid.

While betting against the market is a legitimate means of making money, unregulated shorting can destroy or decimate healthy institutions, destroy bullishness, and ultimately make the markets a place where growth can seldom be expected.

The SEC and/or Congress should at least ban short selling financial institutions until a new uptick rule is in place.

If a ban is not enacted pending a new uptick rule, we would at best see sideways movements in the financials or even worse, we could see another serious decline in the stock prices of major financial institutions catalyzed by these short sellers.

We also risk scaring away an entire generation of small and retail investors.

Ofuoma Odje