Unbelievable! I actually need to say that twice…. Unbelievable! They are actually thinking about expanding the ineffective ban on short sales. Have they completely lost their minds?

Thanks to Marc from Sante Fe, a TDI podcast listener who wrote me to tell me about a recent finding that there may be a new set of rules pending against short sales. In essence it is looking like there will be circuit breakers that will kick in if a stock moves down by 20%.

Here is the brilliant idea as reported by Bloomberg:

Oct. 10 (Bloomberg) — U.S. exchanges may seek to impose a temporary ban on short sales for individual stocks that plunge, as regulators seek to rein in a practice blamed for forcing down shares of financial companies such as Morgan Stanley.

The New York Stock Exchange and Nasdaq Stock Market may file their proposal with the Securities and Exchange Commission as soon as today, said three people who have seen a draft of the rule. Under the plan, a stock that ends trading with a loss of at least 20 percent would be protected from short sellers for the following three days, the people said.

NYSE Euronext Chief Executive Officer Duncan Niederauer and Nasdaq CEO Robert Greifeld have met with SEC officials to discuss the plan. A final rule may reflect other options being considered by regulators. The so-called circuit breaker against betting a stock will decline would add to SEC rules imposed to restrict speculators contributing to a plunge in stock prices.

“We’d rather let the markets do what they want to do except in extreme panic conditions, in which case it does make sense to put in breaks to create a breather,” said Joe Ratterman, chief executive officer of Bats Trading Inc., the third-largest U.S. exchange. “The general plan as proposed is workable, it will address the concerns, and I’m supportive.”

John Nester, a spokesman for the SEC; Bethany Sherman, a spokeswoman for Nasdaq; and Scott Peterson, a spokesman for NYSE Regulation, all declined to comment.

Mack Seeks Ban

The SEC imposed a temporary ban on short sales last month after Morgan Stanley Chief Executive Officer John Mack and New York Democratic Senator Charles Schumer blamed the practice for driving companies to the brink of collapse. Morgan Stanley tumbled 22 percent in New York Stock Exchange trading today, extending a decline that has erased 82 percent of its value this year. The Standard & Poor’s 500 Financials Index is down 50 percent this year.

Hedge funds said regulators were blaming traders for companies’ mismanagement and the banking industry’s over- concentration in mortgage-backed securities that lost value after credit markets froze last year.

“I am surprised after several iterations with little to no benefit that they continue to go back to the same dry well,” said Ron Geffner, a former SEC lawyer who now represents hedge funds at New York-based Sadis & Goldberg LLP. “It’s hard to play a game when the rules change week to week. This is just another reason for people to stay on the sidelines.”

SEC Prohibition

The exchanges sought to craft rules as the SEC ban on short sales expired Oct. 8. The 969 finance-related stocks on the SEC list fell 9 percent while the trading restrictions were in place, compared with a 15 percent drop for the Standard & Poor’s 500 Index.

The ban hampered trading, fueling volatility in prices, according to Nasdaq data. The difference between bids and offers, a measure of trading costs for investors, more than doubled, and was almost 60 percent higher than the average for stocks exempt from the restriction, Nasdaq data showed.

The NYSE and Nasdaq initially disagreed on their proposals. Niederauer favored reviving a version of the uptick rule, which allowed short sales only if a preceding trading was at a higher price. Greifeld proposed instead to establish thresholds after which a stock would be protected from short sales.

“The SEC staff and most of the Commissioners do not appear to support a return to an uptick rule, nor do the other U.S. exchanges or a majority of the leading market participants,” Niederauer said in an Oct. 8 letter to issuers. “It is clear to me that we are in the minority.”

Daily List

Under the proposal that may be filed with regulators, the exchanges would publish a daily list of protected stocks and short sales would be barred across all markets, the people said. Market makers and some option traders would be exempt from the targeted ban. The circuit breaker could apply to all stocks, instead of only finance-related companies like the emergency ban, and expire after Dec. 31.

“This makes a lot more sense,” said James Angel, a finance professor at Georgetown University in Washington who studies short-selling. “By doing something on a stock-by-stock basis that only kicks in during times of market turmoil, you allow short selling to do what it does under normal circumstances, but you prevent it from exhausting liquidity.”