Shorts blamed for Morgan Stanley plunge

Bank stocks sank across the board Thursday and some market watchers blamed the drop on expiration of the short selling ban on financial stocks.

Wells Fargo (WFC, Fortune 500), Wachovia (WB, Fortune 500) and Morgan Stanley (MS, Fortune 500) were particularly hard hit, with each posting double-digit percentage declines.

Morgan tumbled over 15% as of midday as the investment bank continued to be plagued by rumors that Japan's Mitsubishi UFJ (MTU) agreement to buy a 20% stake in Morgan was in jeopardy.

A Morgan spokesman dismissed such rumors, saying the deal will close this coming Tuesday under the same terms announced earlier this week.

Mitsubishi also said in a statement Wednesday morning that the rumors are not true and that it expects the deal to close next Tuesday.

A source familiar with the Morgan-Mitsubishi deal blamed the slide in Morgan Stanley's stock Thursday on the expiration of the short selling ban.

Jack Ablin, chief investment officer at Harris Private Bank in Chicago, also blamed the drop in Morgan's shares on short selling.

The Securities and Exchange Commission barred stock traders from shorting most financial stocks on Sept. 19 as the credit crisis unfolded. The SEC extended the ban last week and said that if a bank bailout bill was signed into law, the ban would end three business days after that.

Short sellers borrow stock at one price and sell it with the hopes of buying the stock later at a lower price so they can pocket the difference. Some have blamed short sellers for spreading false rumors about banks in order to send the stocks drastically lower.

But the ban was controversial, with some arguing that short sellers do a service to the market by identifying overvalued stocks and that prohibiting short selling was nothing more than an artificial manipulation of the market.

Still, even with the short selling ban in place, bank stocks took a beating. The S&P Banking Index plunged 30% since the ban took effect.

Short selling may not be the only thing weighing on bank shares Thursday. The U.S. government is also thinking about buying bank stocks, the White House said.

The move would be an attempt to directly inject capital into banks - which have been starved of cash as homeowners default on mortgages and inter-bank lending dries up.

But banks would issue new shares for the government to purchase, diluting the value of existing shares for current stock holders. Also, analysts said the government would likely buy shares of the banks facing the most financial trouble, which isn't exactly a vote of confidence for the industry.