The ability of American investors to delude themselves and further inflame the evolving financial disaster has reached new depths. Or rather, it has reached new heights of stupidity in allowing short sellers to return to Wall Street, as the Securities and Exchange Commission did. The ban had prevented short selling on nearly 1,000 companies, including financial firms and industrial groups such as GM. The ban was lifted by the SEC on Wednesday night.

Since the ban was introduced on September 19, the US banking sector has lost a quarter of its market value. More institutions have disappeared off the map and if anything, the severity of the meltdown has increased, so some, especially in some UK and US financial media, argue that the ban is irrelevant.

But that also ignores the knock on effect from the decision to allow Lehman Brothers to collapse, and then the bailout out of Washington Mutual (which wiped out all bond holders). Both contributed as much to the subsequent steep plunge in the prices of banks and other US financial stocks. It’s a view that has been peddled in UK and US business media. Both also ignore the terribly destructive effect of the US House of Reps defeat of the Paulson bailout bill.

That crunched investor sentiment and belief in the strength of the S&P 500 index, which is the key global measure for investors and regulators.

The reasons why it was that decision which helped send prices lower, and not so much the absence of shorters was well explained last night by Macquarie Bank interest rate strategist, Rory Robertson:

The stunning 9% one-day drop in the S&P 500 two weeks ago caused massive damage to sentiment, and sparked massive further selling pressure. That the S&P 500 – a proxy for global “risk assets” – broke down from around 1200 to 1100 two Mondays ago has been a disaster for global investors, the global financial system and the global economy. That savage drop in wealth bred intense fear of further major drops (heightened “risk aversion”) and has driven – in part via increased redemptions – this week’s further sizeable losses in global markets.

It was that silly “dummy spit” two Mondays ago by just a dozen uncomprehending members of the US House of Representatives – rejecting, by 228-205, the proposed $700b emergency intervention in the market for mortgage-related assets – that sparked the latest disastrous leg down in asset prices.

It has been downhill ever since. And now the shorts have been allowed to return to the game. So what is the US SEC really interested in: an orderly market, or the wealth of the hedge fund and associated industries? Just banning stock lending all together would be a start. The absurdity of pension and other long term funds actively destroying value for their clients and members by lending shares to shorters and other investors for a few cents in the dollar return is staggeringly stupid and self defeating.

Shares in GM fell 31%, Ford, 22% and Morgan Stanley 26%. No wonder the Dow was off more than 7% and the S&P 500 more than 7.6% (to a level not seen since May 2003). It was a year ago that the world’s key market index hit its all time high of a touch over 1562. At the close this morning in new York, it was down 42%.

Morgan Stanley had reportedly been expected to be attacked yesterday by shorters ahead of completion of the bank’s deal to sell a 21% stake to Japan’s Mitsubishi bank group for $US9 billion. There was speculation that the shorts were trying to frustrate the deal to drive the price to a level where Mitsubishi would back off and the deal would collapse: If that happened, the entire US financial sector would suffer a terrible drop in the present climate. Mitsubishi says the deal will complete next Tuesday.

Also helping to drive down the banks in particular was the suggestion that the US Government would follow Britain and look to invest directly in banks: that could dilute existing shareholders, who sold on that basis. but as many have big losses, they preferred to crystallise those rather than stay and see if the Government’s move will help restore value. If there is any sign of the move happening, watch the nervy seller of today become an over enthusiastic buyer in the future.