Selling Fannie and Freddie Short

Rarely do such obscure businesses as Fannie Mae and Freddie Mac make the front page, but then these are rare times. As many know by now, Fannie and Freddie are "Government Sponsored Enterprises," and are responsible for repackaging and reselling almost half of the mortgages in this country.

As Fannie and Freddie nearly folded their tents last week, U.S financial markets came close to what could have led to a Depression-style collapse in our economy. But the interesting sideline to the story is buried in the details.

Along with Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke, SEC Chairman Christopher Cox decided to come out of hiding. Chairman Cox was appointed by President Bush a few years ago when "business interests" expressed dissatisfaction with his predecessor, William Donaldson. Although "business interests" have been pleased with his willingness to look the other way, Cox has been the subject of public controversy since his appointment, and gathered headlines last year when he took steps to protect corporate interests in the Tenet Healthcare fraud.

Last week, Cox announced restrictions that will be put in place on "short sales" of the stock in 19 of the largest financial services companies. Without getting into the details, a short sale allows the sale of a stock one doesn't own, and a profit if the price of the stock falls. As it turns out, this can result in a very big profit for short sellers.

Up to this point, the SEC has done little to enforce existing regulations (Regulation SHO), and last year eliminated the little-known "uptick rule," included in the Securities Exchange Act of 1934. The "uptick rule" was put in place a few years after the Crash of 1929, and was intended to prevent fear from creating a stampede of selling and another stock market crash.

The rule was eliminated by the SEC, effective July 6, 2007, which raises an interesting question: why would the SEC eliminate a rule that was put in place more than 70 years ago to prevent another market crash? The "uptick rule" doesn't restrict the sale of a stock an investor owns. It only restricts the sale of a stock one borrows ("short sales") or fabricates ("naked short sales"). So why would the SEC eliminate this restriction?

Maybe it was the average "Mom and Pop" investor who put pressure on the SEC, but I doubt it. Or perhaps it was the typical 401K account holder who demanded a change in the rule, but 401K plans almost never include funds that sell stocks short. Folks with IRA's insisting that the rule be eliminated? Nope. You can't short stocks in an IRA.

The answer says a lot about how the Bush administration views the role of government, and special interests. The largely unregulated hedge funds that specialize in short selling wanted the "uptick rule" eliminated, and so it was. Hedge funds have traditionally been limited to wealthy investors ($1 million or more in net worth), so the average American doesn't qualify.

So the SEC made the decision to give wealthy hedge fund investors a little extra bonus last year. And billions were made driving down the price of financial stocks, making it difficult for the banks to bring in new capital to deal with the housing crisis, and ultimately putting the economy as a whole at risk.

This may seem like a minor detail and it didn't "cause" the mess we're in, but it says a lot about the current administration's attitude toward regulation, and whose interests they really care about (hint: not yours). You may not think it's especially important, but you'll feel the impact when you see your next IRA or 401K statement.

And you'll also get to help pay for the taxpayer bailout of Fannie and Freddie, if Hank Paulson gets his way.