How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis

Shah Gilani

By Shah Gilani
Contributing Editor
Money Morning

[This is the eighth installment of an ongoing series in which Shah Gilani breaks down the credit crisis for readers.]

In the mid-80s, I ran a private partnership – call it a hedge fund – from the floor of the Chicago Board of Options Exchange Inc. (CBOE). I was an independent market maker, meaning I could walk into any trading pit on the floor and trade any options and any stocks.

I knew the stocks I traded very well. I knew my capital and leverage. I gauged the psychology of the crowd.

My plan was to cause the stock to drop, triggering the locals and others to panic out of their positions. They would sell their calls and if the price of calls fell too quickly, they would start buying puts to hedge themselves. As the stock fell and the price of puts rose higher and higher, guess who would be selling the locals puts?

Since I had bought a lot of puts and their price was rising, I would leave the crowd and have a broker in the pit sell my now-profitable put position to the eager crowd.

I am a trader. That’s my job. I trade to make money. That’s my job. That’s what everyone else does. But I succeeded much more often than most of the traders I competed against – because I followed these four basic rules of trading:

• I knew the instruments I was trading.
• I knew my capital and leverage limitations.
• I was able to gauge the psychology of the market.
• And I had a plan that I always followed.

Unfortunately, the story is much different for the U.S. Treasury Department, under the command of Treasury Secretary Henry M. “Hank” Paulson Jr., and the U.S. Federal Reserve, under the command of Chairman Ben S. Bernanke. Although these two top Bush Administration officials are the key architects of the bailout plan that’s being deployed even as you read this, they have violated all four of those basic trading rules. In short, neither of these two key officials:

• Has proven his grasp of the complexity of the instruments causing the credit crisis.
• Understands the extent of leverage used by the players who are central to this financial mess.
• Grasps the psychology of the markets.
• Or has a workable plan to fix the problem at hand.

The Genesis of a Global Financial Crisis

The Treasury and the Fed have several problems. First, they don’t understand the instruments that are at the root of this crisis. The complexity of collateralized mortgage-backed securities (CMBS) is beyond any simple explanation, though I offered one a few weeks ago. Second, and exponentially worse is that there is a “multiplier catalyst” in this devastating deleveraging and worldwide slaughter that isn’t understood, and isn’t regulated – by anyone.

I’m talking, of course, about credit default swaps.

Yes, collateralized mortgage-backed securities are at the bottom of the crisis. But, the frightening truth is that we can’t even get to them because they are covered so completely by what I’m calling the multiplier catalyst – credit default swaps. I also have offered a simple primer on credit default swaps.

These two instruments collided when traders wanted to either hedge their CMBS positions, or when they sought exposure to mortgage-backed securities, either by mimicking being long them or, in effect, shorting them. A credit default swap is a bilateral contract between, for example, you and me, under which we agree to a deal to insure a position you have because you own these dreaded CMBS. You agree to pay me a premium, up front and yearly, for the next five years. And I agree that if the CMBS you own defaults, I will pay you its full value. This is a good deal for you, right?

In fact it’s such a good deal that you ask me if I’ll insure you for the value of several different companies’ bonds and debts, in case they default. I agree. Pay me my premiums, please.

Your friend, who doesn’t own any CMBS, hears about the deal and asks me to insure them if the same CMBS securities default, even though they don’t own any themselves. I agree.

Pay me my premiums, please.

It didn’t matter to you that I’m not an insurance company. It didn’t matter to you that I never set aside any capital to pay you in the event that the instruments I was insuring you against actually did default. It’s a game – a trading game. Get it?

Unfortunately for the worldwide financial markets, I’m not the only one to play this game. Real insurance companies, investment banks, hedge funds, banks and lots of others have played this game. And, there’s a caveat. A big one.

All the bilateral contracts have a provision for margin to be posted; that is, collateral must be posted by me, or by American International Group Inc. (AIG), if they wrote these virtual-insurance-contracts and they start to go against us … which means that those instruments we insured actually might go into default.

AIG was bailed out to the tune of $80 billion, because it had margin calls on CDS contracts it wrote. Do you know why they now need an additional $38 billion in help? Because they are experiencing more margin calls on their credit default swaps. The Treasury and Fed never understood these instruments, let them run wild and now we are all paying the price.

That’s the story, but – as always – there’s also the story behind the story.

The leverage that was employed when CMBS and CDS contracts were bought and sold is not even known. How much did banks, investment banks, insurance companies, hedge funds and traders borrow to initiate their trades?  There are no accurate figures and not even any accurate estimates.

Now we come to the psychology of the market. No one – save my new idol, hedge-fund-manager extraordinaire and mega-billionaire John A. Paulson (who deserves every penny he made) – understood what “the crowd” was thinking. What they were thinking was that housing prices aren’t going to fall, companies aren’t going to default, and everything is under control because we’ve all calculated our Value at Risk and go merrily skipping along.

We’re not going to be okay because the plans that Treasury and the Fed have put forth weren’t plans to begin with. They are reacting, moment-by-moment to the markets.

With all due respect to Interim Assistant Secretary for Financial Stability, Neel Kashkari, he’s a “rocket scientist” and not a trader. And it was the rocket scientists who devised these securities for traders in the first place and neither group ever understood the instability and combustibility of the solid rocket fuel they were mixing. How is it possible for the talented Kashkari to gauge the markets and traders worldwide, when he’s never traded anything?

The global contagion is the direct result of margin calls that seeminglycrosses every security type (especially credit-default-swap positions), in very market, and seemingly in every country.

And the worst of it? As companies’ stock prices fall, as the value of their bonds fall and their debts mount, as they get closer and closer to actual default, the sellers of credit default swaps are getting bigger and bigger margin calls. Everyone is selling whatever they have to meet margin calls. It’s a worldwide de-leveraging – to an extent that we’ve never before conceived.

The Only Real ‘Exit Strategy’

Enough bad news. There is a way out: Shut down the CDS market. Net out all existing positions. Cancel contracts. Let CMBS holders keep their positions. And here’s why: There’s not enough money in the Treasury plan to buy them all up. Adjust the cost accounting basis on the books of holders so that they don’t have to mark those securities down. Give the Fed and Treasury unlimited transparency into every financial firm’s books on a strictly private basis and let them manage, merge and close down the insolvent “basket cases,” while guaranteeing every depositor in every bank and money-market fund.

And there’s more. Provide incentives for depositors and investors to stay with salvageable institutions by eliminating any capital gains on net new investments into these government-backstopped institutions.

Who are we kidding? Fannie Mae (FNM) and Freddie Mac (FRE) insure most of the troubled mortgages already. And that means the government. So allow all mortgages – after a certain date – to be refinanced by healthy banks whose cost of funds to make new loans should come directly from the Treasury at the Federal Funds rate. This will allow banks that write new loans to make them cheap and still have good profit margins. Make those homeowners pay back the favor by sharing the appreciation on those homes with the taxpayers who bailed them out, when they sell them.

Also absolutely necessary: Make key cuts. Cut taxes. And cut all wasteful government spending on all earmarked and pork barrel projects.

And last, but not least, put all the lobbyists in jail – especially the former legislators and their staffs who sold the American people short just to feed their own disgusting greed and avarice.

[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis – and to propose an alternate plan of action. It's a perspective on the near-financial meltdown that more than 140,000 readers have read in Money Morning alone – to say nothing of the hundreds of other Internet outlets worldwide that have picked up and published Gilani’s unique insights.

If you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani’s plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry M. “Hank” Paulson Jr. It actually contains contact information for readers who still wish to protest the government’s action with the bailout bill by passing their disenchantment along to their elected representatives in each state’s governor’s mansion, and in both the House and the Senate. Check out Gilani’s plan of action.

With the U.S. financial markets in such disarray, Money Morning is looking for profit opportunities beyond U.S. borders: For instance, just check out this new report on a Wisconsin-based company we've discovered that's posting quarter after quarter of earnings surprises – while the rest of Wall Street tanks. Not only does this company have a lock on China – the fastest-growing market on the planet – this corporate gem is also riding the profit wave of the most-powerful global trend that we're following right now. If you act on this opportunity now – as an added bonus – you'll also receive a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse."]

News and Related Story Links:

• Money Morning Special Investigation of the Credit Crisis (Part I):
  The Real Reason for the Global Financial Crisis…the Story No One’s Talking About.

• Money Morning Special Investigation of the Credit Crisis (Part II):
  The Credit Crisis and the Real Story Behind the Collapse of AIG.

• Money Morning Special Investigation of the U.S. Credit Crisis (Part III):
  How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System.

• Money Morning Special Report: How to Fix the Credit Crisis (Part IV):
  Dear Hank: Here’s How to End the Credit Crisis at No Cost to Taxpayers.

• Money Morning Special Investigation of the U.S. Credit Crisis (Part V):
  Heads They Win, Tails You Lose: Why the Bailout Plan Will Fail U.S. Taxpayers.

• Money Morning Special Investigation of the U.S. Credit Crisis (Part VI):
  Credit Crisis Update: An Inside Look at the Commercial Paper Debacle.

• Money Morning Special Investigation of the U.S. Credit Crisis (Part VII):
  Inside the Credit Crisis: How the Fed’s Efforts to Lower the Fed Funds Rate May Leave it Powerless to Stop the Financial Meltdown.

• Wikipedia:
  Federal Funds Rate.

• Money Morning Market Analysis:
  By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?

• AllExperts.com:
  Using Banks and Bank Accounts; Cost of Funds.

• Wikipedia:
  Mortgage-Backed Securities.

• Wikipedia:
  Commercial Paper.

• Reuters Financial Terms Glossary:
  Matched Book.

• Wikipedia:
  Discount Window.

• Wikipedia:
  Term Auction Facility.

• Wikipedia:
  Federal Deposit Insurance Corp.

• Money Morning News:
  Federal Reserve to Buy Commercial Paper to Free Up Frozen Market.

• Wikipedia:
  Federal Open Market Committee.

• McClatchy Newspapers:
  Fed’s half-point rate cut proves no match for Wall Street’s fear.

  About.com/Investing for Beginners:
  What is a Market Maker and How do Market Makers Make Money?

• Wikipedia:
  Mortgage-Backed Securities.

• Wikipedia:
  Credit Default Swaps.

• Wikipedia:
  Bilateral Contracts.

• Wikipedia:
  John A. Paulson.

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Shah Gilani

About the Author

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Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains.Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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