The SEC's Desperate Move

With mortgage giants Freddie Mac (FRE - commentary - Cramer's Take) and Fannie Mae (FNM - commentary - Cramer's Take) on the verge of crumbling, the government is again aiming to lend a hand to the struggling financial sector. Last week, the Securities and Exchange Commission decided to immediately put a stop to "improper" short-selling by investors in Freddie, Fannie, and a basket of 17 other financial firms, including the usual suspects Lehman (LEH - commentary - Cramer's Take), Merrill (MER - commentary - Cramer's Take) and Morgan Stanley (MS - commentary - Cramer's Take).

With Freddie and Fannie holding $5 trillion of the nation's $13 trillion in mortgages, the implosion of these government-sponsored entities would make the Bear Stearns episode seem like a dress rehearsal. The widespread effect on the mortgage industry, not to mention the broader consequences on the U.S. markets due to a failure of a government-endorsed entity, would be disastrous at best, catastrophic at worst. However, using the government hand to prevent short-selling in specific entities, two of which are GSEs, sends the wrong signal to all investors during these turbulent times.

A Misguided Attempt

Specifically, the SEC will curb short-selling beginning today for an initial 30-day term. A typical short sale involves first borrowing the shares and then selling them with the commitment to buy them later and returning them back. You make money by first selling high and hoping to later buy low. The SEC's rule aims to prevent investors from going short without first having actually borrowed the shares, sometimes referred to as "naked" shorting. Many short-sellers today will go short and borrow the shares later if need be.

It's not the SEC's aim of curbing naked short sales that concerns me. As an investor myself, I don't engage in short sales. The economics of a short sale don't add up for me and many other investors. When you go short, you are making a bet where your upside is capped at 100% (stock price goes to zero) and your downside is unlimited (in theory, a stock price can go up and up).

I won't deny that the ability to short shares without formally borrowing them has probably exacerbated the fall in financial companies. What is concerning, however, is that the SEC is doing nothing more than giving the financials a quick shot of adrenaline, which could end up doing more harm than good to investors who might now decide to invest without understanding the balance sheet.

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At the time of publication, Gad had no positions in the stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of the Gad Partners Fund, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.

Gad also runs a value investing blog inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at [e-mail].