UPDATE 1-Short sells drop in firms after SEC rule--S3 data

(Recasts, adds S3 executive quote, background, byline)

By Emily Chasan

NEW YORK, July 22 (Reuters) - Short sells dropped dramatically in shares of the 19 financial firms targeted by U.S. regulators' emergency short-selling rule this week, a market data company said on Tuesday.

Short sells dropped 90 percent in shares of mortgage finance companies Fannie Mae (FNM.N) and Freddie Mac (FRE.N), and declined 70 percent in shares of the other 17 financial firms affected by the rule, S3 Matching Technologies said, citing a review of data from its clients.

The firm said it compared short sale data from July 14, prior to the U.S. Securities and Exchange Commission emergency rule, with data for Monday, July 21 -- the first day the rule took effect.

The SEC's rule is part of an effort to clamp down on market manipulation that some blame for the sharp declines in financial stocks and the demise of investment bank Bear Stearns in March.

The rule is designed to prevent illegal "naked" short selling, which occurs when an investor sells stock that has not yet been borrowed.

It affects Fannie and Freddie and major financial firms including Citigroup Inc (C.N), Lehman Brothers Holdings Inc LEH.N, Goldman Sachs (GS.N), Merrill Lynch MER.N, Morgan Stanley (MS.N) and JPMorgan Chase & Co (JPM.N).

While the SEC said last week that its rule was not intended to stop legitimate short selling, S3's data showed that its clients had dramatically altered their strategies.