During the week of September 15, 2008, the financial world was rocked with rare events that would precede a near 6-month market decline of historic proportions. One of the largest insurers in the world, American International Group (AIG), and the fourth largest investment bank in the U.S., Lehman Brothers, sold off to sharp lows on large volume, and for the first time in 14 years a money market fund (the Reserve Primary Fund) broke the $1 threshold from losses related to the Lehman collapse. Lehman would declare bankruptcy, while officials at the Treasury Department and Federal Reserve would scramble to rescue the sinking titanic AIG, shore up the money market with Fed liquidity to prevent a run on money funds by investors, and force a merger between the third largest investment bank, Merrill Lynch, and the second largest U.S. consumer bank, Bank of America. Shortly thereafter, Mr. Paulson at Treasury convened an emergency meeting on the Hill with Congressional leaders, insisting that a massive public infusion of capital into U.S. banks was urgently necessary to forestall the purported tsunami effects of systemic risk, culminating into a run on banks. Enter the dragon we’ve all come to idolize: the $700 Million Troubled Asset Relief Program (TARP) was born and summarily delivered to financial institutions in the form of both capital infusions and government preferred equity stakes [1,2].

The broad equity markets didn’t sell off sharply until more than a month later, and the market declines would last until March 9, 2009, when the S&P reached a -43% retreat to 677, the Nasdaq -42% to 1269 and the Dow -40% to 6547.

Meanwhile, our nation has searched for answers to why the financial collapses have occurred, and for reconciliations as well as retributions – and in the process showing the ugliest side of American politics, politicians and government officials that we may have seen in modern history.

But let’s get to the ambit of this article: were the events caused by some sort of economic terrorism, and if so, by whom and for what purpose? Or were the events a fateful result of excessive government intervention and control, akin to non-random chaos that can lead to wild distortions, and amplification of random events, as seen in highly chaotic systems?

The economic or financial terrorism theory has been posited by several in the financial and popular media [3, 4]. For some, the theory goes that traders in collusion commit bear-raid acts that include massive concerted short selling of weak stocks, market indexes, or complex derivatives such as credit default swaps (CDSs) that are underwritten on companies or institutions that have credit risk, all to realize significant profits. For others, the theory goes that individuals or organizations that were possibly hostile to the Bush administration or to the U.S. (or both) saw the opportunity to manipulate our financial markets for personal, political, ideological or imperial gain. The usual suspects have ranged from infamous bear-raiders such as billionaire George Soros and his team of hedge traders to state-sponsored efforts sourced to China, Russia or Saudi Arabia.

The conjecture for Mr. Soros’ involvement in mass-market manipulation is his ideological bent toward international socialism [5], his disdain toward American foreign policy and economic stature [6], and his strong support for Barack Obama [7]. Early September was a pivot point for the election, with John McCain leading in the polls by 5 points (49% vs. 44%) according to Gallup. After the Lehman, AIG and Reserve Fund failures, with the markets and our Treasury and Congressional leaders in a frenzied tizzy, that lead began to wither, as the public grew wary and annoyed with the state of disorder and disarray. No doubt Mr. McCain did himself in by throwing his support to TARP and whatever bailouts were necessary to dig out of the proverbial missile struck hole, while Mr. Obama sat back and implicitly voted his usual ‘Present.’ Voters who found themselves supporting Mr. McCain suddenly felt alienated in whatever fiscal conservative sensibilities they might have had. Add to that a message that seemed to resonate: Mr. Obama would cut taxes for 95% of Americans, but that we now know has slim to no truth (and that some of us knew at the time held little credibility). Nonetheless, a swift shift in the polls took hold with Obama gaining a 9-point lead by late September, followed by an electorate in November that either stayed at home or shifted their vote to that marketed veil of ‘Hope and Change.’ Back to Mr. Soros: how could he have influenced the outcome? Some might argue he led the massive short interest in names like Lehman and AIG, and a few others who faltered at the time. His bear-raid fame extends back to the destabilized pound sterling currency market of 1992, which gave way to the steepest losses on “Black Wednesday.” Mr. Soros not only made a killing (over $1 Billion) in shorting the pound, but also reaped whatever political gain he might have sought in British parliamentary changes that reflected his negative positions toward Britain and Margaret Thatcher. Mr. Soros has been convicted of insider trading and has combined the trading prowess of his hedge organizations with his particular intents to extend his philosophical views on social and economic engineering around the world [8].

Involvement of China in such acts is not completely illogical if one accepts the idea that a destabilization of our financial markets may help their huge portfolio in U.S. Treasuries, which are estimated to be around $1-1.5 Trillion – i.e., that an ebb in the equity and corporate/municipal/mortgage debt markets coincides with a ‘flight to quality’ into Treasuries, driving up prices and the value of Chinese holdings. The flaw in this argument is that a Treasury bubble is not sustainable, and unless the Chinese cash out on the peaks, they risk a sharp decrease in value of their holdings with a Treasury sell-off and a reflation trade back into equities and other assets. We do know that the Chinese decreased their exposure of Treasuries in early 2009 [9], and at around the same time, Premier Wen Jiabao issued strong statements [10] regarding Chinese ‘displeasure’ with U.S. policy toward monetary easing (i.e., a weak dollar) and the inevitable threat of inflation, risking the value of their Treasury holdings. China central bank governor Zhou Xiaochuan shortly thereafter suggested [11] an alternative reserve currency system based on ‘Special Drawing Rights (SDR),’ which is essentially a basket of currencies that the International Monetary Fund (IMF) currently uses to fund various causes and interests worldwide. The speculation of Chinese involvement in U.S. financial market destabilization appears to falter with the obvious observation of robust U.S. dependence on Chinese imports – the Chinese have more to gain from a strong U.S. economy, even if it means contending with dollar weakness and inflation. Therefore the deliberate destabilization argument must be bolstered with an accounting of how China might benefit without an economically strong U.S.

Russia’s self-interest is perhaps centered on the price of commodities including oil, with a benefit when prices remain high. The U.S. and then global market turmoils sent oil prices spiraling from a peak of $147 in July 2008 to below $34 in February 2009 (~77% decline). In late January, Vladimir Putin issued assertive statements at the 2009 World Economic Forum in Davos [12]. Included in his speech were clear warnings to the U.S. regarding the over-reach of government intervention in resolving financial institution and business failures, which some have interpreted as a not-so-subtle prod to avoid the Marxist/socialist cavern that had engulfed the Soviet Union for the better part of a century [13]. Mirroring China, Putin also warned [14] against too much reliance on the U.S. dollar as a reserve currency – with oil globally denominated in the dollar and considerable currency fluctuation from weak to strong in the last year. Given these facts, it is difficult to believe in a coordinated manipulation of our markets by the Russian government, unless we accept that they were willing to suffer a setback from the global plunge in commodities in order to damage U.S. potency in the global financial arena and tarnish the reserve status of the dollar.

Saudi state-sponsored involvement in market manipulation doesn’t appear to pass muster with breadth of Saudi holdings in U.S. equities and debt. Prince Alwaleed (“Kingdom Holdings”) rode the market down on many core fund investments.

So what are we left with? Let’s start with short sellers and/or our own government.

Short sellers became a target for most of last year, with a flash point occurring just after the rapid Fannie Mae/Freddie Mac stock declines in late June/early July [15]. As an initial strike against short sellers, the Securities and Exchange Commission (SEC) issued an order to ban “naked” short selling on Fannie/Freddie and 17 large banks and financial groups [16]. Naked short selling occurs when shares are sold short by traders without a broker-lender delivery confirmation that the trader has indeed legitimately borrowed the shares. The purported danger of such an act is that more shares can conceivably be sold short than are available for borrowing, adversely affecting share price. SEC motives in instituting the ban were clearly tied to discouraging short selling period, as naked short selling was already illegal and that even the SEC could not substantiate the incidence of naked short selling vs. normal (legal) short selling. But instead of investigating and quantitatively verifying the naked short selling incidences, the SEC issued its ban from July 21 to August 12. As has been pointed out in an excellent analysis [17], the naked short ban did little to stabilize Fannie/Freddie; after an initial short squeeze, the instability and volatility in the markets continued during the ban period and thereafter. What did the SEC learn from this exercise? Not much. With Fannie/Freddie and all 17 institutions listed in the naked short ban guilty of extreme over-leverage and saddled with housing-related assets declining in value daily, even savvy ordinary investors were dumping their shares to reduce risk. By September 5, Fannie/Freddie had reached the same stock price as at the trough of their sharp July declines before the ban.

And then something happened that could be classified as a market catalyst: the government decided to nationalize Fannie/Freddie, removing their management, seizing assets and eliminating all dividend payments [18]. At the close of the next market day, September 8, Fannie/Freddie stock lost most of their value [15]. Lehman closed down almost 12% lower on the day, and its sharp slide continued the entire week, until it declared bankruptcy. AIG, heavily levered on both collateralized debt obligations (CDOs) containing shriveling mortgage assets and CDSs underwritten on Lehman solvency, was issued a massive $85 Billion bailout by the N.Y. Fed (a.k.a. Tim Geithner) [19]. As it turns out, AIG risk mismanagement was key in its catastrophic failure [20], and has required almost $200 Billion in Fed and Treasury bailouts, with brisk debate as to whether the government and taxpayer would have been better off if AIG had been allowed to fail along with Lehman.

Blame for the Lehman failure has extended to a combination of naked short selling and rampant street rumors regarding its demise [21]. However, whether or not naked short selling is the guilty factor has not been substantiated. Remember that intentional naked short selling is illegal and prosecutable. And so yet another theory has surfaced that the “fails-to-deliver” status of heavily shorted stocks may have been caused by computer or system overflow glitches. Whatever the source, analysts [21] have found an unconvincing 30-70% correlation of “fails-to-deliver” with price declines, and while the SEC logged a 57-fold increase in failed trades on September 11, 2008 from the year prior for Lehman alone, that could be a non sequitur given the massive increase in the volume of trades and a systematic level of failed trades. The conclusion here is that the SEC and/or the securities industry has to quantitatively substantiate an incidence of naked short selling, attribute cause and effect, and make systemic changes if indeed there existed either intentional fraud or unintentional system glitches. The same applies to mass collusion of short sellers to enable a cascade effect in a stock’s price decline, another conjecture that remains unproven. If this cannot be accomplished with the data available, then obviously our markets do not have enough transparency and disclosure.

Back to the SEC: did it learn anything from banning naked shorting in July/August 2008? No. In reaction to the panic of the week, the SEC instituted a ban on all short sales of nearly 1000 financial institutions and companies from September 19 – October 8 [22]. Market makers for the options markets were exempted from the ban – allowing investors to continue to buy puts, but the confusion reduced the volume in the options markets by almost 30%, decreased liquidity (increased bid-ask spreads) and increased options premiums [23]. The consensus is nearly unanimous that this ban did little or nothing in stabilizing the markets – the market slide resumed on October 1, a full week before the end of the ban. The likely reason? The credit markets, particularly the commercial paper market, began to seize and consumer credit spreads widened dramatically [24]. With businesses and consumers dependent on credit markets for short-term finance, the threat to the equity markets was a direct correlation.

The Bottom Line

Terrorism is defined by Merriam-Webster as “the systematic use of terror, especially as a means of coercion.” Terror is defined in a range as “a state of intense fear”…”violent or destructive acts committed by groups in order to intimidate a population or government into granting their demands.”

So did we endure “economic or financial terrorism?”

We’ve looked at the range of sources, with some that seem to fit the definition more than others. Mr. Soros remains a compelling case – but unless hard evidence emerges that implicates a particular incidence the calls remain unsubstantiated conjecture.

We must not ignore the damage that has been caused by the chaotic actions of our own government in contributing to and handling the financial failures. From the Bear-Stearns failure and Fed bailout, to the nationalization of Fannie/Freddie, to the AIG failure and Fed bailout, to the forced government equity stakes in major banks through Treasury’s TARP. Add to that the market interruptions and manipulations caused by the SEC by their own short sale bans. Add to that the lack of a formal clearinghouse structure for CDSs and CDOs – which contributed to the risk pricing of these derivatives (think of the decades-functioning options markets and you’ll get what I mean). Add to that the range of credit rating agencies that made the assumption that housing prices were not inflated and would continue to rise. And let’s not forget the ‘independent’ Federal Reserve that first handed us cheap money and credit, which combined with industry and GSE lax lending standards and fantastic over-leveraging provided a ripe environment for outlier price instabilities and market dislocations. Can we make the argument for economic or financial self-terrorism? You bet.

Though Bush/Cheney deserve considerable credit in their efforts to keep our nation safe and secure through conventional national security measures against violent foreign terrorist threats, the fact is they didn’t place as much emphasis on economic security, and hence ceded considerable ‘leverage’ to the likes of Hank Paulson and others in allowing an extreme form of government intervention in dealing with large institutional failures. Obama, et al. show little difference in their handling of such issues, and have weighted the burden considerably through massive spending, onerous federal regulation and tax policies that are antagonistic to business. It appears that GDP growth will suffer indefinitely – inevitably reducing the influence and prosperity that the U.S. may otherwise have.

Finally – what our venerable capital markets scream for is more transparency and disclosure. Without it, markets are not as efficient and ‘free’ and we may be destined to repeat the same mistakes in the future.

References and Endnotes:

[1] “U.S. to Buy Stakes in Nation’s Largest Banks,” D. Solomon, et al., Wall Street Journal, October 14, 2008.

[2] “How TARP Began: An Exclusive Inside View,” R. Newman, U.S. News & World Report, May 14, 2009.

[3] http://www.thestreet.com/story/10438230/cramer-feels-like-financial-terrorism.html; http://www.thestreet.com/story/10438538/raising-the-specter-of-financial-terrorism.html.

[4] http://www.businessinsider.com/2008/10/mike-huckabee-blames-economic-terrorism-for-market-troubles.

[5] “The Capitalist Threat,” George Soros, Atlantic Monthly, Volume 279, No. 2, February 1997. Some selected excerpts: “I contend that an open society may also be threatened from the opposite direction — from excessive individualism. Too much competition and too little cooperation can cause intolerable inequities and instability.”…” Wealth does accumulate in the hands of its owners, and if there is no mechanism for redistribution, the inequities can become intolerable.”

[6] “The Bubble of American Supremacy,” George Soros, The Atlantic, December 2003.

[7] “A Soros Slush Fund,” M. Malkin, New York Post, August 20, 2008.

[8] “Insider trading conviction of Soros is upheld – Business – International Herald Tribune.” Also: “He’s Seen The Enemy. It Looks Like Him,” T. L. O’Brien, New York Times, December 6, 1998.

[9] “China Slows Purchases of U.S. and Other Bonds,” New York Times, April 12, 2009.

[10] “Wen Voices Concern Over China’s U.S. Treasuries,” Wall Street Journal, March 13, 2009. Some excerpts: “We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. I do in fact have some worries…[we urge the U.S. to] maintain its credibility, honor its commitments and guarantee the safety of Chinese assets.”

[11] “China Takes Aim at Dollar,” Wall Street Journal, March 24, 2009.

[12] “Putin Speaks at Davos” (Speech transcript), Wall Street Journal, January 28, 2009.

[13] Putin at Davos: “In the 20th century, the Soviet Union made the state’s role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly. I am sure nobody wants to see it repeated. Nor should we turn a blind eye to the fact that the spirit of free enterprise, including the principle of personal responsibility of businesspeople, investors and shareholders for their decisions, is being eroded in the last few months. There is no reason to believe that we can achieve better results by shifting responsibility onto the state.”

[14] Putin at Davos: “Apart from cleaning up our balance sheets, it is high time we got rid of virtual money, exaggerated reports and dubious ratings… Excessive dependence on a single reserve currency is dangerous for the global economy. Consequently, it would be sensible to encourage the objective process of creating several strong reserve currencies in the future.”

[15] Fannie/Freddie stock declined by nearly 65%/68% respectively from June 30 to July 15, to $7.07/$5.26 per share. By September 8, each stock closed at 0.73c/0.88c per share. Fannie Mae and Freddie Mac are government-sponsored entities (GSEs) that buy and sell mortgages. As of 2008, Fannie/Freddie owned or guaranteed approximately half of the $12 trillion U.S. mortgage market.

[16] SEC Short Ban Ruling, July 15, 2008.

[17] “Naked Short Selling Ban,” M. Steinhardt, Seeking Alpha, August 28, 2008.

[18] “U.S. seizes Fannie and Freddie,” CNNMoney, September 7, 2008.

[19] “U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up,” M. Karnitschnig et al, Wall Street Journal, September 16, 2008.

[20] “An AIG Unit’s Quest to Juice Profit,” S. Ng and L. Pleven, Wall Street Journal, February 5, 2009.

[21] “Naked Short Sales Hint Fraud in Bringing Down Lehman,” G. Matsumoto, Bloomberg News, March 19, 2009.

[22] SEC Short Ban Ruling, September 18, 2008.

[23] “Short Selling Ban Sends Chills Through Options Market,” Seeking Alpha, October 8, 2008.

[24] “Uncertainty Over Rescue Intensifies Credit Crisis,” Wall Street Journal, October 3, 2008.