Lots of folks--including Randy Newman--have a problem with short people. And Wall Street and Capitol Hill apparently want to do something to rid us of the pain of dealing with them.

I write not of those lacking in height, but of short sellers.

It seems that short sellers are really the ones that should get the full blame for the market’s mess. And maybe they’re accountable for the near collapse of the mortgage market, the ensuing credit crunch and the lengthening list of troubled banks.

Listening to the politicos talk about short sellers, you’d wonder why anyone would ever choose to be one.

Well, short sellers explain what’s been happening in the markets. The amount of trades reported (and there’s important distinction here I’ll explain in a moment) has ballooned during the last three years.

According to published information about trades executed just in the US, the aggregate market value of short sales quadrupled from 2003 through the end of 2006. And I imagine it’s multiplied again over 2007 and so far in 2008.

Who’s doing all this shorting?

The group most responsible for this explosion is the so-called hedge funds, which accounted for $3 trillion of the $5 trillion of 2006 short sale volume booked in the US.

Public mutual funds, bit players compared to their private peers, have about $30 billion embedded in vehicles that work around Securities and Exchange Commission (SEC) rules from the 1930s and ’40s that prohibit them from shorting stocks, as well as limiting their ability to lever up with credit and margin.

And everyday folks like you and me also short a stock or an exchange traded fund (etf) now and again; in fact, I’ve been recommending in Inner Circle a short position in an ETF that tracks an index of financials. We’re looking to cash in on the meltdown in the making for US banks.

But if mutual funds are considered bit players, we’re barely going to register when it comes to what and how much we might short.

Shorting 101

Before exploring the current issues of short-seller evil being batted around the market, let’s take a look at how a short sale works.

The mechanism is pretty easy. First, you’ll need to open a margin account with your brokerage company. The margin account is necessary because when you sell a stock short, you’re effectively borrowing the shares from the brokerage, only to buy them back cheaper to return them to the brokerage.

Let’s use the Inner Circle short position I referenced above as an example.

If you wanted to short 100 shares of SPDR KBW Bank (nyse: KBE), your broker would borrow the shares from the market or other accountholders. The cash proceeds--at the time of our original recommendation, $40 dollars--would be credited to your margin account in the amount of $4,000. To perform the transaction, you’d need at minimum $2,000 equity in cash.

With banks falling, the KBW Bank Index, which the ETF tracks, has tanked, taking the price of the ETF from 40 to around 30. If you wanted to close out the short and book the gain, you’d instruct your broker to buy the shares to cover the short. The cost of buying the 100 shares would be $3,000, excluding commission. The broker would credit your account with the shares that would be used to replace those borrowed to do the short sale.

The profit to you is the difference between the short sale proceeds of $4,000 less the cost of buying them back at $3,000. This amounts to $1,000 excluding commission, or a return of 25 percent.

Now let’s look at what would happen if the ETF went up. As in the case of a stock bought on margin, you’ll get a margin call if the market price moves against you. When you short a stock, the maintenance level would be at 30 percent of the value of the investment.

If the ETF shot up to 54, your equity would have fallen to $600 from your original equity of $2,000; you’d need to put more cash in the account or buy the stock back to cover the sale and book the loss.

Neither a Borrower nor a Lender Be

The procedural guidelines for you and me are pretty straightforward. Market heavyweights, however, operate under their own set of rules--or in the absence thereof.

By now you’ve heard about naked shorting. And no, it’s not as fun as it sounds, but it can be lucrative. If done right, the payoff for those who are allowed to naked short can be huge amounts of cash.

What is naked shorting, and how does it differ from the example described above?

When you and I do a short sale, we have to borrow the shares before the trade gets booked. And the buying power in our account is reduced by the amount of the margin required to sustain the trade.

Hedge funds, on the other hand, don’t have to borrow shorted shares, nor are they docked capital to cover the trade. They actually get credits to their accounts that enable them to lever up even more with their existing capital. Hedge-fund traders are essentially paid to short stocks--the more, the better.

But isn’t this against the rules?

First, the old short-sale rule got tossed out a few years ago. It was pretty cut-and-dry: You had to borrow the shares whether you were big or small; you could only short stocks above a certain price; and you could only sell short shares on an uptick in the market.

That seems fair, but the big guys didn’t like those restrictions. They wanted to be able to short whatever they wanted, whenever they wanted, without being encumbered.

The rule was dropped. And there are about 11 billion reasons why.

Those 11 billion are the estimated dollars earned those often referred to as prime brokers because they only deal with prime institutional investors. That amount of cash is less than a year’s worth of trading revenue from shorts and doesn’t count the rest of the revenue that flows from the processing of short sales.

A second rule, SEC Regulation SHO, dictates that shares need to be delivered to settle short sale trades. If not, the stock is placed on a threshold list that tells the market there’s an issue delivering shares sold short. Within this rule is some stuff about actually delivering shares, but it’s rarely enforced--except when individual investors are involved.

So, there are two sets of rules when it comes to shorting. The first is enforced on us and keeps us locked out of most of the fun and profits. The second set is for the Wall Street guys, and it lets them operate like the market is the Wild West.

Here’s one more little ditty: You can’t withhold your shares from being shorted. If you hold any shares of stock in a margin account, your broker has the right to lend them. You can’t refuse. The only way to keep them out of the hands of stock lenders and borrowers is to explicitly restrict your brokerage from lending your shares or to endure the painful process of registering your shares and taking custody. And even then, there are still some workarounds for your broker and your custodian.

Sounds like the rule makers on Capitol Hill have things pretty stacked against us, right?

You don’t know the half of it.

The Dark Side

Yet another curious element characterizes the short-selling part of the market. Even if relevant authorities chose to enforce Regulation SHO, there are problems detecting naked shorts. Not all trades being done in the market are being reported and tracked by the exchanges.

Over the past several years, hedge funds, as well as other large-scale investors such as pension funds, insurance companies and mega mutual funds, have been moving more of their activity off the major exchanges. And they’re migrating not just over the counter but to trading networks set up by major Wall Street financials and brokerages and even some of the major listed stock exchanges, including the New York Stock Exchange (NYSE).

There are many terms to describe what’s happening, but “dark pool liquidity” is the most appropriate.

Dark pools are private stock exchanges that enable member investors or firms to buy and sell larger blocks of stock, long or short, without being noticed by the general market or most exchanges. This supposedly prevents trades by large institutions from being exploited by other traders who might see large blocks of buy volume and motivate them to buy or sell, along with the momentum. Dark pool liquidity also enables hedge funds and other large-scale traders to short more stock with less scrutiny from regulators.

In effect, traders short a stock--and keep shorting it until it eventually falls. And if the shares are never actually borrowed, a company can see its theoretical number of shares multiplied by short sellers who never borrow the shares. The real stock holders get diluted by the phantom shares brought to the market; no wonder so many stocks that come under such trading activity go down.

White Knight

That’s where the trouble lies in the market. There’s nothing wrong with shorting stocks, as long as you deliver shares to settle trades. It’s simple, and it should be easy to regulate. The existing Regulation SHO should be enforced; if a stock is shorted and the shares aren’t borrowed, the trade should be broken, and the broker executing the trade should be liable for any losses on the other side of the trade, plus interest.

That’s all it would take.

Although it makes sense, the brokers that process all these trades for and rake in fees from hedge funds would lose out. We don’t get enforcement, and their lobbyists make sure the SEC doesn’t get involved.

But that may have changed this week. Ironically, the same financials and brokers that have been facilitating all abuses are now demanding protection. It started out with the call to forbid naked shorting of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). It continued with the deal cut with the SEC that these two, along with 17 other financial stocks, including Merrill Lynch (NYSE: MER), Goldman Sachs (NYSE: GS) and other heavyweights, wouldn’t be subject to naked shorting for 30 days.

It’s open season on the rest of the market.

The shorts are being squeezed, so any perception of any bit of life in the leading financials has led to a quick upturn in share prices. And many of the gurus on television are talking about a turnaround in the markets.

Fat chance. There’s little to suggest these 19 special cases will be able to stop the rest of the banks and financials--which number in the thousands--from being shorted instead, many rightfully so. And the financial sector, as well as the broader stock market, is far from being sorted out.

You can put at least a chunk of the blame on those awful short people.

A Short Break

How about a short break with me and my colleagues Elliott Gue and Roger Conrad on the 2008 KCI Investing Cruise? We’ll depart from Miami, sail the Caribbean (including one of my favorite islands, Saint Barthelemy) and continue through one of the world’s engineering marvels, the Panama Canal, before reaching Costa Rica. 

And we’ll talk about how to cash in on what still can work amid the economic and market mess.

Click here for more information.

Dead Guys of the Week

Two fellows who were never short in stature or demeanor died over the past couple of weeks.

The first, Tony Snow, the sharp and well-read journalist for Fox News (NYSE: NWS), was a stand up guy willing to sacrifice his family’s net worth to serve his country as White House Press Secretary. He died at a youngish 53 years.

Then there was Rocky Aoki. Although he’s dead at 69, his legacy lives on for diners around the world. Who doesn’t like Japanese barbeque? One of my favorite Japanese barbeque joints isn’t in Japan but in Hong Kong. You may have your own favorite, but if you asked most folks, their favorite would be Benihana. 

Rocky, the founder of Benihana, turned a wrestling scholarship to a small, New York college into an ice cream truck empire.

He parlayed his earnings from all the nickels, dimes and quarters from local kids into his true culinary desire. Funded by ice cream, he opened the doors to the first of his famous restaurants, on West 56th Street in Manhattan, back in 1964.

Speaking Engagements

“The coldest winter I ever spent was a summer in San Francisco,” a saying that’s almost a San Francisco cliche, turns out to be an invention of unknown origin, the coolest thing Mark Twain never said.

The natural setting is, however, among the most exciting in the US. Venture west for the San Francisco Money Show Aug. 7-10, 2008, and conduct your own field study.

Roger Conrad, Elliott Gue and I will discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.

Click here or call 800-970-4355 and refer to priority code 011363 to attend as our guest.

I’ll also be appearing at the following events:

.    The Financial Advisors Investment Conference, October 2008
.    The Washington, DC, Money Show, November, 2008
.    The World Money Show, London, England, November 2008
.    The 2008 KCI investing Cruise, Dec. 1-12, 2008

If you’re interested in having me or one of my cohorts address any investment or professional groups, please e-mail me at paymeweekly@kci-com.com with ideas or suggestions.