When the US Treasury and the Federal Reserve were able to save both Fannie and Freddie, two of the largest and most financially unsound mortgage lenders in the United States back in July 2008, most of us thought that the worst was over. We knew that Lehman Brothers had a balance sheet that was worth a fraction of the paper it was written on and we knew that American International Group (AIG) had made some very bad bets over the years.

We even knew that the Lehmans of the world would probably not survive for long and that other regional banks would most certainly disappear or be bought out by larger banks. So then, how could most of us have thought that the worst had passed when we have been a ticking time bomb away from total disaster? Being far away from it all, Mauritians have read with amazement about this crisis. The problem is that all the analysts and traders of the western world never realized that they would be the ones to finally pull the trigger.

How did the global financial crisis happen?

Short selling is a perfectly viable and sound investment policy. In the not so recent past, before you would short a stock (sell high and buy low strategy), you had to borrow it from someone who actually owned the stock. You also had to wait for an uptick of the said stock before you could short it. About ten years ago however, in the name of 21st century capitalism, a few Princeton professors (who later made their way to the Securities and Exchange Commission) concluded that the old way to short sell a stock was outdated and in the name of price discovery, naked shorting would be much more effective.

In the world of naked shorting, you do not have to borrow a stock or wait for the stock to uptick before you can short it. Shorting a stock is as easy as buying a stock. The simplest strategy to short a stock can be summed up as follows. Buy the stock when it crosses its 30 day moving average; sell the stock when the latter crosses below its five day moving average and short the stock when it crosses its 30 day moving average and continue to do so until it crosses above its five day moving average.

Traders also look at other technical signals such as the RSI, MACD and so on, but the basic rule remains the same. You can even program this rather easily on MATLAB or even Visual Basics and the computer can do it for you. In the world of the naked shorts, shorting became easier than being long a stock especially when one considers the amount of money hedge funds have been blessed with in recent years.

Now Lehman Brothers badly managed the situation and it was simply not transparent enough. Eventually the company, as expected by the market, got downgraded and its stock price plummeted. The price first crossed the five day moving average and all the traders and investors of the world began to sell the stock which pushed the price even lower until it crossed its 30 day moving average. Once that happened, in a systematic way so to speak, everybody shorted it.

This happened on the 9th of September 2008 when Lehman Brothers was trading at USD 12.92 a share. By the 15th of September 2008, naked shorting had enabled investors to take the stock down to USD 0.26 cents a share. In finance, this phenomenon is known as beta expansion risk or crowded shorting. This is what created the panic and the credit market which is not to be confused with the stock market completely frozen. Other Investment Banks such as Goldman Sachs and Merrill Lynch could not even fund their operations anymore because no one wanted to lend to them. Once investors realized that, they began to short these stocks too.

That same week AIG got a downgrade and as usual, the computers shorted the stock like there was no tomorrow and of course this created even more panic in the credit market. Investment banks do not have a deposit base. If they cannot get funding through the credit market, they go down. The problem with naked shorting is that it never gave any time for Lehman and others who fell to find buyers or do anything to gain confidence back. Despite a downgrade, a large insurance company like AIG should not have had to pay LIBOR + 8% to get credit from the Federal Reserve to fund its operations. AIG had a less than stellar balance sheet with all those credit default swaps but it was not that bad. Merrill Lynch had to scramble to find a buyer in two days or risk collapse for no good reason beyond a stupid shorting rule. Goldman Sachs was fortunate enough to get a USD 5 billion preferred stock purchase (and warrants too) from legendary Warren Buffet.

The funny thing is that it was not only investment banks and insurance companies that could not get funding, nobody could. Even today credit spreads are enough to make you want to stay home. The state of California could not get any short term credit to fund operations. Triple A rated companies like General Electric were issuing short term bonds at between 8-9%.

That may not sound too high in 9.8% inflation suffering Mauritius but that is very high in the US. If you were in the export sector and needed short term credit, you had to pay a ridiculously high interest rate. Whatever liquidity that was being provided by the Federal Reserve and later by the European Central Bank was being stored in the vaults of banks, only to be leant at very high interest rates.

It took decades to build a modern financial system but it took two days to bring it down to its knees. Historians will look at the implementation of the now banned (at least temporarily) naked shorting rule as one of the dumbest rules in world financial history. Now it is true that when you get a downgrade, it tends to act as a trigger event on the default swap but that was not the main problem, naked shorting was. Credit derivatives also suffer from high and often underestimated counterparty risk. We are likely to see the setup of a credit derivatives market in the coming years.

Sameer Sharma is a Financial Analyst working in Canada.