Today was the worst day in the stock market since the decline of the market after 9-11. I was fixated all this week on trying to understand how and what happened to our economy so quickly. We keep hearing the headlines about how much the subprime market has hurt us – but how bad really is it and what else is to the story? So, here’s what I’ve learned. In short – I believe we have a lack of “governance” problem rather than just an “economic problem.”

·         Commercial and Investment Banks need to borrow money in order to leverage themselves against the assets they want to buy.

·         All banks and companies have a credit rating. The higher the rating – the cheaper it is for them to borrow money. The leverage ratio is determined based on the investment grade of their paper through third party agencies that exist: S&P, Fitch, and Moodys.

·         Commercial banks have a cheaper way to borrow money since they have deposit accounts vs. Investment banks. Investment banks and other Companies have to borrow from the outside markets based on their credit rating.

·         Most Banks have been hit hard due to holding poor performing mortgage backed securities (subprime). Thus, causing a liquidity problem in some of their assets.

·         Now here’s how the “bear raid” begins and takes down these companies:

1.       First – there is a market called “credit default swaps” (CDS). It is a credit derivative contract between two counterparties, whereby the “buyer” or “fixed rate payer” pays periodic payments to the “seller” or “floating rate payer” in exchange for the right to a payoff if there is a default or “credit event” in respect of a third party or “reference entity”. Until recent, you only needed to put 5% of the money when making a specific bet in the CDS market. It’s now just recently changed to 50%.

2.       Hedge funds have basically come in and made bets that caused a huge spread in the CDS for individual companies to cause speculation that these companies may go out of business. Some of them have been exacerbated since some of them like AIG have solvent businesses.

3.       This volatility then transcends to the equities of that particular stock. It causes people to short sale a specific company to drive the stock price down. And, until recently has caused people to take advantage of naked short-selling – where the person does not need to borrow the actual stock before they sell it.

4.       With increased naked short-selling and the no “uptick rule” in place this causes the stock to get slaughtered in a very short period of time (much faster than just a normal short sale). The uptick rule was in place in 1938 to regulate short selling in the financial market. A listed security may be sold short at a price above the price at which the immediately preceding sale was affected, or at the last sale price if it is higher than the last different price.

5.       Next, the volatility from the CDS and the naked short-selling of the stock - drives the value of the stock down like a roller coaster.  Then, the independent third party agencies begin to evaluate the credit worthiness of the Company and make a decision to downgrade the debt of that firm – causing a “capital call” for that Company. For, AIG’s case – forcing a Company to raise capital overnight or look into filing for bankruptcy protection like Lehman did.

6.       This was generally the strategy used to bring down Bear Stearns, Freddie Mac, Fannie Mae, Lehman Brothers and AIG in a short period of time. This is what is called a “bear raid” – where all the short-sellers took advantage of the process and loophole in the system. Some may argue the above Companies deserved it based on the assets they held – but this process allowed them to have a shorter lifespan rather than to react to the market changes they faced. It was done by force. The economy thrives when the stock market goes up - it doesn’t thrive when it goes down. But, with this tactic - people still profit. That’s not what being a true capitalist or being an American is all about.

·         Today, the Dow fell 449 points and the NASDAQ fell 109 points after the Fed was forced to bail out AIG and stop a world economic crisis. We’re now seeing the next phase of a “bear raid.” It a tactic now being used on good companies that are profitable, making money, with little or no exposure to the credit crisis that are becoming victims of this loophole. Goldman Sachs and Morgan Stanley are two companies that reported positive earnings and today got dragged into a bear raid.

·         Their volatility in the credit default swap markets skyrocketed – causing the hedge funds to naked short-sell the stock today – and hoping that causes one of the three independent agencies to lower the credit rating for Goldman Sachs/Morgan Stanley – thus forcing them to find capital overnight or also eventually file for bankruptcy.

·         It’s worked for Bear Stearns, Freddie Mac, Fannie Mae, Lehman brothers, and AIG – where the short sellers milked huge profits and caused these companies to become illiquid too soon.

·         We can also blame the independent agencies (S&P, Moodys & Fitch) for too quickly causing these companies to be downgraded. Had they waited – rather than react to the noise – Lehman and AIG could have shored up enough capital from selling their assets and saved each other from their demise. Or could have avoided the Fed from needing to step in and loan $85 billion to AIG. In all of these situations – it eliminated jobs, diminished the equity that employees spent a lifetime creating, and wiped out all of the equity from stockholders.

·         It’s also shocking that the SEC Chairman, Christopher Cox, decided finally to do something about the “loopholes” today.  He put a ban on naked short selling (finally). Now, only if he would have imposed this several weeks ago – you can imagine that the above securities mentioned above could have still been surviving. As, it would have given them time. He also needs to bring back the “uptick” rule to provide further stability against the “bear raid.”

·         What’s worse – our politicians are playing the blame game – in a time of despair. We’re in a election year – Republicans hate Democrats – and Democrats hate republicans. No one can put their party hats aside and focus on creating rules and regulations that can save us from situations created by “bear mafia” and avoid further ruin in our financial system.

·         What’s worse? Remember that $600 stimulus check that we received – it was financed from China. And looking at what we saw this summer in oil prices – it looks like the $150 billion stimulus package went from China to America and then back to the Middle East. I sincerely, hope the government does get its act together as we do live in this great country but we deserve a lot better governance from it.