Unprecedented Financial Turmoil: How Did It Happen?

First of all, let me apologize for this long post. However, I wanted to summarize the reasons behind the unprecedented financial turmoil the U.S. is facing, resulting in a loss of faith in many financial institutions and a mad dash to safer investments by consumers.

Something extraordinary happened this past Friday - extraordinary even by the standards of last week, with the markets fumbling and the doomsday scenario probability going up from "about as likely to find a live dinosaur" to something far more feasible.

Even among all this turmoil, the governmental intervention to suspend short-selling on nearly 800 financial stocks (including commercial banks and investment banks) stood out rather dramatically. This intervention has raised very fundamental questions about the limits on trust placed in free markets under extreme conditions. I cannot recall such uncertainty in the financial markets in my lifetime.

Why did this happen?

Imagine for a moment that IBM's stock went down 90%, GE were to lose 95% of its value, and Wal-Mart, GM and Ford were about to go into bankruptcy. I don't think that even in this circumstance we would see the current level of government intervention to rescue those companies. The irony is that IBM, GE, Wal-Mart, GM, and Ford are much larger and employ far more people than the companies who did get the government bailout - the top three or four investment banking firms in the country.

My hypothetical loss of GE, IBM, Wal-Mart, GM, and Ford would have relatively benign consequences compared to the top investment banking firms going under. The key difference is that the investment banks have underwritten trillions of dollars of an exotic derivative known as Credit Default Swap (CDS) and none of them has the corresponding requisite capital reserves, nor are they required to have them according to regulations. This has been an incredibly lucrative business for years for the firms and their executives due to a minuscule default rate – until a year ago.

Then the Sub-prime mortgage crisis changed everything; rapidly rising mortgage defaults abruptly crashed the wild party. Investment banking firms are now on the hook to pay hundreds of billions of dollars against the Credit Default Swap related to mortgage-backed securities, and they have no money at hand. Their downfall does not have much to do with short-sellers; simple math shows that these firms have no option - none - but to default on their commitments to pay, providing an unprecedented opportunity for short-sellers to benefit.

On the other hand, the Fed knows that not only would these banks would go under for their inability to pay the CDS buyers for doomed mortgage-backed securities; the collateral damage would be catastrophic. Its not only the mortgage-related CDSs, but others ones, as well, which would have become worthless, resulting in massive losses at an unimagined scale to the investors, insurance companies, and so on. This certainly would have caused a complete financial meltdown in the country and very likely in the rest of the world.

So, when faced with this epic battle between the heart and the mind – a strong belief in the free market philosophy challenged by its inherent contradictions at the extreme end - the Fed sacrificed the philosophy and suspended the short-selling. It also announced formation of a government owned debt holding company; Resolution Trust Corporation (RTC). These two actions, I believe, are integrally tied, the defaulting assets forcing the CDS payments will be moved to the RTC – thus shifting the entire liability from banks to the taxpayers. I think the plan must be to accomplish this in 30 days, then with the dead weight around their neck removed, these investment banks would get a second life (It’s almost surreal that the second life is more real than a first death!) with no current liability requiring immediate payment. Then the short-sellers will have no reason to short these stocks - hence the suspension for 30 days.

So my question is what would you do if you were Hank Paulson or Ben Bernanke? I realize there is an incredible amount of outrage we share, the ideologues among us insist that the banks and their incredibly well-paid executives are responsible for their own actions and if, in the process, they go under, then so be it. That is what the free market is all about.

When faced with a monumental choice - a certain death of the free market and the consequences (closed factories and businesses at a scale never seen before, lost lifelong savings, a wiping out of 401K and resulting unemployment that would dwarf every single depression seen so far) or alternatively accept a deep yet likely curable wound, that will enable the economy to live for another day? It’s not fair to have to make these choices, yet one has to decide, so the multi-trillion dollar-question is:

Which one do you choose?