Are short sellers contributing to financial woes?

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Government officials looking to blame someone for the recent financial meltdown have set their sights on a particular type of trader -- the short seller.Short sellers profit by betting that specific stocks will fall in value. They've been accused of playing a key role in the current crisis, helping to force Lehman Bros. into bankruptcy and pushing other companies to the brink of financial ruin by driving down their stock prices.The Securities and Exchange Commission on Friday slapped a 10-day ban on short selling shares of 799 banks and other financial institutions, hoping to prevent the wild swings in stock price that hit Goldman Sachs and Morgan Stanley earlier in the week. Here's a primer on the practice.-- What is short selling? Short sellers look for companies whose stock may be overvalued. They borrow shares of that stock, usually from a brokerage or a large institutional investor, then sell that stock at market price. Later, after the stock has dropped in value, they buy it back and return it to its original holder. Because the short sellers spend less buying back the stock than they made from selling it, they keep the difference as profit. There's an obvious danger here. If short sellers are wrong and the stock rises, they stand to lose a lot of money.-- What role does short selling play in the market? Much as shareholders despise it, short selling is legal. It's a regular part of how hedge funds and other large investors operate. And most economists say short sellers help the market by ferreting out overpriced companies."If not for short sellers, many securities would get overvalued," said Larry Harris, professor of finance and business economics at the University of Southern California's Marshall School of Business. "When securities are overvalued, anybody who buys them risks losing money when rationality returns to the marketplace, which it always does."-- What role have short sellers played in this week's meltdown? Short selling can turn into a self-fulfilling prophecy if a company's investors lose confidence after seeing the share price drop. Just how the SEC will enforce its short-selling ban remains unclear.In addition, New York Attorney General Andrew Cuomo said last week that he will investigate whether short sellers had spread rumors in the market in a deliberate attempt to drive down share prices. He will specifically examine short selling of American International Group, Goldman Sachs, Lehman Bros. and Morgan Stanley. But not everyone holds short sellers responsible for last week's market carnage. Some banks, for example, may deserve a lower stock price because they face more fallout from the credit crunch, said Stanford University economics Professor Monika Piazzesi. "It's nice to find someone to blame right now, but maybe we should look at the banks," she said.(E-mail David R. Baker at dbaker(at)sfchronicle.com)(Distributed by Scripps Howard News Service, www.scrippsnews.com.)