Reinstate the Uptick Rule Immediately

What needs to be done to remedy the ongoing financial crisis?

Everyone has heard of the Glass-Steagall Act, enacted in 1933, which was intended to prevent banks from engaging in speculation by prohibiting bank holding companies from owning other financial companies. Glass-Steagall was repealed in 1999 by the Gramm–Leach–Bliley Act, and ever since the most recent financial crisis, there have been calls for its reenactment. In mid-2009, senators John McCain and Maria Cantwell proposed re-imposing the separation of commercial and investment banking, and in January 2010 President Obama belatedly proposed regulations to limit the banks' trading and investment capabilities. Yes, it is indeed time to force the banks to go back to the "boring" business of lending money to worthy borrowers, thereby preserving the integrity of the U.S. financial system, but that's only part of the problem.

Although everyone knows about Glass-Steagall, how many people are familiar with the Uptick Rule, whose repeal contributed directly and immeasurably to the severity of the most recent economic crisis and thwarts future economic growth?

The Uptick Rule went into effect in 1938, also in response to market abuses that threatened the health of the U.S. economy, and prohibited the short selling of securities except on an "uptick". As summarized by the SEC:

"Rule 10a-1(a)(1) provided that, subject to certain exceptions, a listed security may be sold short (A) at a price above the price at which the immediately preceding sale was effected (plus tick), or (B) at the last sale price if it is higher than the last different price (zero-plus tick). Short sales were not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions."

The Uptick Rule was cancelled in 2007, thereby enabling hedge funds to short shares, i.e. sell shares they did not own, in almost unlimited, immediate quantities, and permitting them to benefit from the resultant investor panic in almost any given traded company.

Example: Micro-cap Company "X" has patented a better widget, manufactures cutting-edge wozzles, and is developing a new kind of werble. Recently, the achievements of "X" have made their way into the news, and its shares have risen. Farmer Joe, who attends night school and reads the financial news, decides to buy 1,000 shares of "X". However, unbeknownst to Farmer Joe, Slick Eddy at Hedge Fund "Z", who couldn't care less about the merits of Company "X"'s widgets, has also noticed the rise in the share price of "X". With almost unlimited resources behind him, Eddy borrows "X" shares from various financial institutions and begins to sell vast quantities into the market, causing a precipitous decline in the market price of "X". Eddy then blocks any rally in the share price and immediately sells shares at the bid after any significant purchase. Worried by the huge downswing in the price of "X" accompanied by unusually high volume, and also concerned that at the end of each trading day "X" always goes down (Eddy always sells into the market in the last seconds of trading), Farmer Joe dumps his shares at an enormous loss ("Someone must know that something's wrong at 'X'"). Having succeeded in panicking Farmer Joe and other small investors in "X", Eddy buys back the shares at a significantly lower average price than that at which he sold them, resulting in enormous profits for Hedge Fund "Z". Eddy's bosses note his "fine" work and reward him with bonuses as the shares of "X" tumble.

Of course, there are those who will say that ultimately the stock market is "efficient", and the price of "X" will recover to an appropriate level. However, in the process we have witnessed the flow of wealth from Farmer Joe and other small investors to Hedge Fund "Z".

Also, consider the damage to Company "X", which, owing to doubt raised by the run on its shares, is suddenly unable to raise additional funds to finance production of a new line of widgets.

According to Muriel Siebert, former state banking superintendent of New York:

“The S.E.C. took away the short-sale rule and when the markets were falling, institutional investors just pounded stocks because they didn’t need an uptick. We have to look at that and say, ‘Did that influence and add to the volatility?’”

http://select.nytimes.com/2007/08/26/business/yourmoney/26gret.html?_r=1

John McCain was far more blunt than Ms. Siebert:

"Sen. John McCain called for the dismissal of Christopher Cox, chairman of the Securities and Exchange Commission, blaming him for much of the financial crisis that is now ripping the nation.

'The chairman of the SEC serves at the appointment of the president and has betrayed the public's trust,' he told a rally. 'If I were President today, I would fire him.'

Working to seize momentum in the unraveling financial crisis that has knocked his campaign off stride, Sen. McCain put much of the blame on the SEC. The agency, he said, allowed abusive short-selling, or bearish bets on a company's stock, to turn 'our markets into a casino.'"

http://online.wsj.com/article/SB122175692668652881.html

Interestingly, in January 2009, Chairman Cox, on the day he left the SEC, wrote a letter supporting reinstatement of an Uptick Rule:

“I have been interested in proposing an updated uptick rule. However, as you know, the SEC is a commission of five members. Throughout 2008 there was not a majority interested in reconsidering the 2007 decision to repeal the uptick rule, or in proposing some modernized variant of it. I sincerely hope that the commission, in the year ahead, continues to reassess this issue in light of the extraordinary market events of the last several months, with a view to implementing a modernized version of the uptick rule.”

http://www.house.gov/list/press/ny05_ackerman/PR_012709.html

Why has the Uptick Rule not been reinstated? Obviously, there are powerful lobbyists opposed to its reenactment, yet this requires immediate action.

Looking back at Glass-Steagall and the Uptick Rule, it turns out that our forefathers gained much wisdom in their attempts to pull the U.S. out of the Great Depression and to prevent a recurrence of this tragedy. Today certain American politicians would ignore their wisdom.