SEC Bans Naked Shorts of Fannie, Freddie

The regulator will require short sellers of the two government-sponsored entities and broker-dealers to borrow shares before selling them.
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Securities and Exchange Commission

Christopher Cox on Tuesday said the regulator planned to crack down on naked short-selling of

Fannie Mae

and

Freddie Mac

, helping to lift financial stocks in afternoon trading.

Cox said in testimony to the Senate Banking Committee on Tuesday that the agency will require short-sellers to borrow shares of the two government-sponsored mortgage giants and broker dealers including

Lehman Brothers

(LEH)

,

Goldman Sachs

(GS) - Get Report

,

Merrill Lynch

(MER)

and

Morgan Stanley

(MS) - Get Report

before selling them. The new restrictions are called for under a temporary emergency order that expires in 30 days.

Short sellers borrow shares and sell them in the hopes the stock's price will fall, allowing them to pay back the lower price. "Naked" short sellers do not borrow the shares first, allowing them to drive down the stock's price without regard for natural supply and demand.

Cox's comments come as the financial markets slipped and then recovered on Tuesday amid sobering comments on the economy from

Federal Reserve

Chairman Ben Bernanke. Treasury Secretary Henry Paulson also provided testimony and further clarification on the proposed

federal bailout

of the two mortgage giants.

The

NYSE

Financial Sector Index, which fell more than 4% on Tuesday, more recently was up fractionally to 5,720.16. Fannie and Freddie were both down around 18%, but Goldman, Lehman and Morgan Stanley were rising. Merrill was down fractionally.

"

As events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress, in part because the outlook for the economy and thus for credit quality, remains uncertain," Bernanke said during prepared remarks for the Fed chairman's semiannual monetary policy report to Congress.

The economy, while continuing to expand, did so at a "subdued pace"; the housing sector "continues to weaken", while overall consumption spending "seems likely to be restrained over coming quarters," he said.

Bernanke was particularly concerned regarding inflation along with how "financial speculation has added markedly to upward pressures on oil prices." The potential for rising energy prices, tighter credit conditions and a contracting housing market posed downside risks for growth, while upside risks to inflation have grown.

"Given the high degree of uncertainty, monetary policy makers will need to carefully assess incoming information bearing on the outlook for both inflation and growth," he said.

Paulson defended measures proposed earlier this week to help strengthen the two government-sponsored mortgage companies. "Our proposal was not prompted by any sudden deterioration in conditions at Fannie Mae or Freddie Mac," he said in prepared comments.

On Sunday, the U.S. Treasury temporarily increased the department's lines of credit for the two companies. The plan will also give the Treasury temporary authority to purchase equity in the two companies to increase their capital. Fannie and Freddie also now have access to the Fed's emergency lending window.

Fannie and Freddie either own or guarantee about $5 trillion of residential mortgages, roughly half the amount outstanding in the U.S. If either government-sponsored entity were to fail, the ramifications for mortgage lending would be severe and housing prices would plummet further.

"Let me stress that there are no immediate plans to access either the proposed liquidity or the proposed capital backstop," Paulson said. "If either of these authorities is used, it would be done so only at Treasury's discretion, under terms and conditions that protect the U.S. taxpayer and are agreed to by both Treasury and the GSE."

Bernanke also noted Tuesday that the Fed approved final rules regarding new regulations to prohibit unfair or deceptive practices in the mortgage market the day before.

Under the new rules, mortgage lenders are prohibited from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and required to verify the income and assets of customers. In addition, for "higher priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance will be included in consumers' regular monthly payments," among other rules.

During a lengthy question-and-answer session, Bernanke was asked by one senator about the failure of

IndyMac

. Bernanke responded that the Pasadena, Calif.-based mortgage lender, which was

seized by regulators

over the weekend, was "weighted down with low-quality mortgages."

"Those losses created a capital hole that it was unable to fill," he said. "Its failure, barring an acquisition by another firm, was inevitable."

Still, "

our banking system is well capitalized," he said. "We are watching the situation very carefully. My concerns have turned less on the solvency

of the banks and more on the ability to extend the credit that our economy needs to keep growing."