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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.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.
Mr. Gilani
I hope you're sending your ideas to Henry Paulson et al, minus the sarcasm. Lord knows they need some direction.
CMBS stands for Commercial Mortgage Backed Securities. MBS stands for Mortgage Backed Securities, and is inclusive of Residential and Commercial, thought often it is used exclusively to refer to Residential (as is RMBS). CMO is Collateralized Mortgage Obligation. I think you're mixing CMO with MBS, and frankly I stopped reading when you called all MBS, CMBS. A quick google search, surprisingly, reveals you're not the only one who made this mistake, but I've never heard any respectable source from this industry call an MBS a Collateralized Mortgage Backed Security and then denote it CMBS.
Hello Shah:
Of all the news letters I read, you are the only one who seems to truely understand this fiasco. I couldn't agree with you more on your take and solution. It's really too bad the public, politicians and economists don't read more of your articles. They might grow to undersatnd this crisis and solve it quickly and painfully instead of dragging out the whole ordeal that will hit us all the harder in the future by delaying the inevitable. I know based on the same overleveraging that Canada is not going to be spared either. Keep up the good work.
Mr. Gilani – Great explanation, hope you send your ideas to Paulson. My two questions:
1- Why would a bank or institution accept the counterparty default risk if the funds were not shown to be available to pay the potential claims (insurance companies must have reserves for claims)?
2 – What's an individual investor to do in this environment? Cash seems safe till they run the printing presses. Gold is getting hit with everything else right now.
Until the Fed is abolished we're going nowhere faster. Bankruptcy is the goal of international finance. No one even considers stopping our wars of aggression. Nothing short of a coup will change the future.
Add to last comment: And I pray it is a nonviolent coup.
Everyone has heard the adage: “It takes one, to know one”.
Mr. Gilani, by his writings today, has confessed his own practice of avarice and greed, as a so-called independent “market maker” out to make money on the backs of those “deceived” honest folks who do “real” work in service to society.
Tragically, however, his “sins” (or “crimes”) of both, “omission” and “commission” as a “whistle blower” are 'fessed up way “beyond” the “eleventh” hour.
The clock is about to strike 12 midnight!
Mr. Gilani, and far, far, too many others like him in “practice” around the globe, should have filed their exposé reports a long, long, time ago.
Such “market makers” should have sounded their warnings to “government leaders” of those who “gather the eggs” and those who “pick the fruit” and those who go to their jobs at grocery stores to “stock the shelves” in order to “service” a “culture” of worldwide “subterfuge thieves”.
Instead, the “money hungry” opportunists, by “slight of hand” chose to “hone” their “skills” upon "legalized" floors of “money exchange houses of ill repute”.
Now, the “workers” who have been “deprived of their wages” cry aloud in the streets.
Hi Shah,
Excellent 'insider' view into the deep abyss that potentially lies before us! The reason for the failure of AIG was never actually properly explained at the time, but I found out it was in fact due to margin calls on CDS, as you rightly say. The CDS market is a potentially even bigger nightmare than the Subprime problem by a factor of more than 10!.
None of the plans being put forward so far by any government actually identify the real cause of the problem but simply try to deal with the resultant symptoms. The pending further corrections will go a long way to addressing what went wrong; painful though it might be for all of us. I think we also need to address what we can now call an 'asset' on a balance sheet and to re-write the financial accountancy rules that allowed us to get in this mess in the first place. How can we be allowed to package up any kind of debt and call it an asset?
Mr. Shah Gilani,
I expect you're right about what it will take to normalize the markets at this time, but suspect that normalization isn't the policy goal being pursued.
As you pointed out, markets exist to be manipulated, and profiteers are positioned to take advantage of the market turmoil at present, even as you did back in the day.
It seems likely that, while Paulson and Bernanke may well not have the pulse of the market, there are others that did, when they precipitated, or stood ready for, this recent deleveraging crisis. The underlying problems, while defiant of precise quantitative representation, have been obvious, and obviously potentially devastating, for the decades they have been generating.
Recently we have seen predatory assaults by BofA, the House of Morgan, and Goldman Sachs. Additionally we have observed moves by Berkshire Hathaway, Sovereign Wealth Funds, and Russian oligarchs to capture income streams from financials, and global oil producers.
Should we assume that these players are the market makers that have prepared to profit from this turmoil, or do you think that the real players yet hold their cards close?
Are these moves we should be shadowing, or just more blindfold dart tossing, with really big darts?
Thanks!
VC
Hi Shah,
Many thanks for helping me understand this mess.
Your article raises the unanswered question as to why the government fails on the 4 point plan.
It is probably much to do with the nature of politics and the overriding principle-
'politics is the appearance of seeming to do something'.
Regards
From Oz
Thank you for your clear picture of the mess we're facing in the world economy. Thank you for sharing your insights and understandings and giving options and solutions to this crisis.
Thank you for your continued focus on these issues.
Its war on the economy and we need a soldier who knows battle tactics and the determination to weather the storm. We don't need a poser.
[…] How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis […]
May I respectively respond to Ray’s comment:
Debt IS an “asset” or “promise to pay” IF it is “straightforward” value-for-value that is fulfilled, without “tricks” or “slight of hand”.
Trouble is, we find ourselves to be the beneficiaries of an evolved “culture” of “tricks” that have been “upheld” by too many for too long, that has now “backfired”.
Yes, indeed, Mr. Gilani provides an excellent “insider” view into the deep abyss, as you say, but may I add that our “view” is also from “inside” an abyss, that only now can we “see” an unbelievable trap.
The world is now “reaping” from what the financial players have “sown”.
Some of those big financial players today are identified within the fourth paragraph of Valued Customer’s comment. In fact, such ones were identified symbolically by the ancients as “the ten kings, but without a kingdom”. By use of their huge capital clout, they are the ones who have “sucked” huge pools of cash out of so-called “normal” circulation. Unbelievable billions and trillions of this cash is “horded” and/or put to use “exclusively” in “self-interest” and not to the best interests of the population at large.
This is the reason there is “liquidity” or “currency” chaos today. Within this mess, there now exists “valuation” madness. Meaning, we cannot attach an accurate “price tag” to anything.
May I remind everyone who should read my words, that within my previous comment, I use the word “beneficiaries” with tongue-in-cheek.
Suggestions from third parties, such as Mr. Gilani, are meaningful to readers who want to understand the facts, rather than the politics. Unfortunately, politicians live in a different world where facts are not of prime importance. So, no matter who is elected president, we still have politicians interpreting things to suit their fancy. Facts are still subordinated to perceptions.
Fact is, politicians are not going to change, no matter what. Suggestions from the outside are usually ignored by them.
We are probably headed to a 1929 Style Market Crash and still don't really know it quite yet. Nobody does. In addition, we are in a multi-year drought in the Western United States and parts of the Great Plains. If we have anything like a "Great Depression", it will probably wipe out the middle class, as we know it. It does not really matter who gets elected, the die is now cast. Let the chips fall where they may.
Yes, I agree with you, that Mr. Gilani understands and can explain the facts.
This time around, however, more than just the middle class are, and will, be affected as the chips continue to fall where they may.
NONE of this could have ever even gotten started without the
removal of the Glass Steagall Act by President Clinton in 1999.
This opened the door for the banks to sell off risky mortgage bundles to investment firms who then sold them off in thousands of bits all over the world – all betting on a housing market that had no top. Brilliant financial experts created this mess. Add to that pushing people to sign up to buy houses so far out of their league, this was the perfect storm waiting to happen.
Well Mr. Gilani,
your own words to describe your activity in the trading pits depict yourself as a market manipulator, that as far as I understand is a criminal activity. As a consequence, why should people really care of what you believe is right or wrong when it comes to Paulson's or the Fed's decision?
Much more interesting instead would be to know from you, based on your personal experience, what should be done to get rid of all the market manipulators. That should prove quite interesting to the many that are robbed of their savings and also to the public companies that would be released from this often lethal trap
[…] But history tells us that the massive sell-off in stocks is similar in magnitude to the average sell-off since 1890. And value indicators already have been screaming, “Buy” for months. The market is terribly oversold and offers tons of value as banks, hedge funds and other leveraged investors have been forced to sell – not because of fundamentals – but because of losses they’ve taken (and, in some cases, continue to take) in unrelated investments that force margin calls. […]
[…] experience suggests that one or more hedge funds have imploded. Whether by margin call or redemption proceedings is a moot point. We won’t know for sure until much later next week […]
[…] Money Morning Special Investigation of the U.S. Credit Crisis (Part VIII): How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis. […]
[…] and hedge funds were forced to liquidate assets across the board. This so-called “de-leveraging” is taking place for a number of reasons, but one is due simply to asset allocation […]
[…] as “credit default swaps” has exacerbated the fallout from the global financial crisis, and touched off the aforementioned de-leveraging process. As asset markets have melted down, hedge funds, financial institutions worldwide, and even […]
[…] experience suggests that one or more hedge funds have imploded. Whether by margin call or redemption proceedings is a moot point. We won’t know for sure until much later next week when […]
[…] Money Morning Credit Crisis Investigative Report: How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis. […]