Government Ban on Naked Short Selling in 19 Financials Created the Greatest Short Squeeze of All Time

Remember this list of 35 stocks (mostly financial) that as of Thursday morning had returned (at least) 35% in 1 week? [Jul 24: 35 Stocks Financial Sector Mutual Funds are Mocking Us With] Some bursting nearly 100% upwards? Some with market caps $30B, $50B, $70B, even $100B? Our financial system trading as if they are penny stocks? Well it was the greatest short squeeze we're ever going to see... the numbers in this Reuters story border on the absurd

• Short positions have dropped further in shares of the 19 financial firms targeted by U.S. regulators' emergency short-selling rule this week, a market data company said on Friday. S3 said it compared short sale data from July 14, prior to the U.S. Securities and Exchange Commission emergency rule, to the close of trade on Thursday.
• Short sales, or bets a stock will fall, are now down 98 percent in shares of mortgage finance companies Fannie Mae (FNM) and Freddie Mac (FRE) and have fallen 85 percent for all 19 financial companies, S3 Matching Technologies said, citing data from its clients.
• S3's clients are primarily individual investors. Data on short sales by hedge funds, which have been active in this type of trading, is closely guarded by the firms.
• The rule is designed to prevent illegal "naked" short selling, which occurs when an investor sells a stock that they have not yet been borrowed. "You used to be all closed out before you had to show where the shares are. Now they have to show that they have the shares up front before you can even place the order," Standerfer said.

• While the SEC said last week that its rule was not intended to stop legitimate short selling, which can prevent stocks from becoming overvalued, S3's data showed that its clients are dramatically changing their strategies.

• "Retail traders were shorting Fannie and Freddie a lot and now it has become virtually impossible as there are no shares available to borrow against the shorts," Standerfer said. "Retail brokers are very concerned about complying with the SEC rule. As an intraday retail trader you used to be able to short during the day and cover near the end of the day with abandonment."

My take from the article is the retail investor is not so "dumb" after all, and knows the games the foxes play. Knowing the restriction on illegal naked short selling will drive these stocks up, they got out of the way quickly even with their legal short selling. And so you have the short squeeze of a lifetime. Or perhaps we can use the pundits' explanation instead: "better than expected earnings" (ahem)

I haven't spent much time on this subject since words escape me on how dirty it really all is, but again I want to emphasize we are just tiny mice running in between the legs of huge elephants. On short selling, especially of the naked kind, I could write a 10,000 word essay but I'll spare you. Shorting is good, legal, fine, and needed. Naked shorting is not. In summary we have now protected those who have been profiting from this game for years on end (the investment banks especially) because the gun was finally turned towards them. Instead of defenseless small caps. That's the short hand version, but for those who want the dirty details I encourage you to head over to Mish's blog and start at this post for the info CNBC will conveniently forget to mention while they clap like seals for the upteempth time as the "financials clearly have bottomed".

Open questions

1. Why is this rule only being enforced now? (we know that answer)
2. Why only for these 19 "holy" companies and not the entire market? (ah that would take away profit opportunities from these banks and their customers aka hedge funds so we can't have that)
3. What does it say that after the huge short squeeze up, many of these financials, especially of the government sponsored equity sort, began another leg down? (we know that answer)

Again, free markets?? Pfllpt....

So as all the King's Horses and all the King's Men once again reassure us the financial system is sound, sturdy, and quite frankly a wonderful place to be, 2 more banks went "away" in the still of the night and will re-emerge Monday with the word "Federal" at the front of their name. These are just babies compared to IndyMac. I assume this is now going to happen every other Friday? That appears to be the pattern - quiet knock on the doors late Friday, re-emerge Monday clean and sober. So let's count on Washington Mutual (WM) two Fridays from now or perhaps 4. Oh wait, maybe another shotgun marriage aka Countrywide (CFC) and Bank of America (BAC) will be arranged by the powers that be.... err, I mean perhaps the free markets will rule and another bank will scoop up WM. ;)

And as opposed to all the King's Horses and Men, it appears one of the best financial focused fund managers is not drinking the Kool Aid, per the Wall Street Journal. I'm not either.

• David Ellison, one of the most respected financial-stock managers in the mutual-fund industry, has had it. While he is pleased with the run-up in financials in recent days, he still sees signs of Armageddon in the sector.

• He recently pumped up the cash level in his two funds to as much as half his assets. His FBR Large Cap Financial fund stood at 50% cash at the end of June, up from 2% at the start of 2007, and his FBR Small Cap Financial is at 38% from 0%, according to Morningstar Inc. "I don't want to lose any more money," said Mr. Ellison, an intense fellow who speaks about the stocks with barely concealed anger.

• Having so much cash is a boldly bearish and unusual move. Investors pay money managers to pick stocks, and portfolios often limit cash to less than 5%. The cash levels are by far the biggest Mr. Ellison has ever had. His usual objective is to invest at least 80% in firms such as commercial banks, savings and loans, brokerages, insurers and real-estate companies.

• What also is unusual about Mr. Ellison is that he is one sector fund manager willing to be down on his own sector. Since these managers are locked into their sectors, be they tech, energy or banks, they are always optimistic. When times are good, sector managers say even better times are ahead. When times are bad, they say it is a great time to buy as the market overpenalizes the gems they can spot. (and this folks is why the "financial asset management system is broken. And yet another reason to not be locked into 1 sector)

• Mr. Ellison, 50 years old, has earned the right to be listened to. Ranked one of the highest in its field by fund tracker Morningstar, the $123 million FBR Small Cap Financial has returned 6.7% annually over the past 10 years, 3.8 percentage points better than the Standard & Poor's 500-stock index's total return and five points better than the finance sector.

• Spend an hour with him nowadays, and one will come away convinced the financial-service industry's glass isn't just half empty -- it is being shattered. He can cite dozens of facts about record foreclosures, nonperforming assets, uninsured liabilities and loan losses (I assume he has been reading the blog of late? Or maybe Peter Schiff's) (grin)

• The timing of a sector turnaround is impossible to predict, said Mr. Ellison. His downbeat themes: No one has any idea how much worse things will get amid poisonous debt lurking inside financial outfits, and this is just the beginning of a complete regulatory overhaul needed to eventually fix the problems.

• He likes that Wachovia Corp. has cut its dividend, but thinks too many financial executives remain in denial. (Bingo - as we enter the 5th "kitchen sink quarter" and we remain in the "8th inning of this dislocation". This has been the never ending 8th inning) Perhaps one of the worst offenses: the dearth of share repurchases by managers who "are so positive they have all this capital. Their words are saying one thing, but their actions are saying it isn't true." (so true. where is all the insider buying at these BARGAIN prices? laughable)

I continue to say this is nowhere near close to being over and aside from these occassional huge spikes (government aided or not) off of oversold conditions you need to try to avoid, the other 90% of the time these remain, by and large, excellent shorts. And will remain so. Much like Japan in the 90s, these institutions (financials) and their government handlers are leaking out bad news piece by piece (for well over a year now), instead of admitting to the mistakes and magnitude up front - or in some cases not even having a handle on the magnitude. (which in many cases is impossible until all these homes go into default one by one across America) I don't know which scenario is more frightening or dismaying - ignorance or denial? I just know we will have a lot more knocks on the bank door on a Friday night "Hi, we're from the government and we're here to help you."

Long Ultrashort Financial in fund and personal account