Secret Weapon

The reason so few economists foresaw the crash is because hardly any of them were paying attention to global market participants and their motives. Warren Buffett hit close to the mark when he called the initial market plunge an “economic Pearl Harbor.”³ He had no idea how right he was. Just as with Pearl Harbor, America had fallen victim to a sneak attack. This time, however, the battlefield was the economy and we have yet to galvanize our defenses.

To quickly sum up, there were two phases to the collapse. The first phase, lasting from 2007 through June 2008, was a speculative run-up in oil prices that generated trillions of dollars of excess wealth for oil-producing nations, enriching their sharia-compliant sovereign wealth funds. Undoubtedly, this spectacular rise in oil prices stemmed from market manipulation. There is no other reasonable explanation why prices tripled over eighteen months even as the world entered a recession and as the supply-demand picture argued for lower prices. This manipulation was enabled by the spread of oil speculation over the previous five years, to the point that prices were effectively being set on the futures markets. This chapter will explain how that happened and who was behind it.

The second phase was an unprecedented manipulation of the stock market and credit markets. The goal was to bring down the U.S. economy by killing off the financial industry—the same goal held by the 9/11 plotters. This phase began in early 2008 with a series of bear raids targeting significant U.S. financial services firms. An initial bear raid against Bear Stearns brought the firm to near bankruptcy, but the danger was briefly averted when the bank was acquired by J. P. Morgan Chase. Similar bear raids were conducted against various other firms during the summer, each ending in an acquisition. The attacks culminated with the collapse of Lehman Brothers in mid-September. This created a system-wide crisis, completely froze the credit markets, and nearly brought down the global financial system.

The bear raids were perpetrated by naked short selling and manipulation of credit default swaps, both of which were virtually unregulated. The short selling was enabled by recent regulatory changes, including the repeal of the uptick rule, loopholes such as “the Madoff Exemption,” and other reforms described in chapter six.

To this day, the source of the bear raids has not been identified due to transparency gaps for hedge funds, trading pools, sponsored access, and sovereign wealth funds. What can be demonstrated, however, is that two relatively small broker-dealers emerged virtually overnight to trade “trillions of dollars worth of U.S. blue chip companies. They were the number one traders in all financial companies that collapsed or are now financially supported by the U.S. government. Trading by these two firms has grown exponentially while the markets have lost trillions of dollars in value.”⁴

Various Wall Street players may have had the knowledge and resources to pull off the attack. But who would do it? Wall Street traders don’t want the economy to collapse. Besides, they would be risking prison time as well as being wiped out if the market turned against them during their attack.

As this chapter will show, the 2008 meltdown stemmed from a willful act of economic destruction. The naked short selling volume was so large that it could not have been coincidental. And whoever did it used every trick in the book to avoid detection. But the perpetrators still left some clues and tell-tale signs that few people have noticed because hardly anyone has looked for them.

Some people believe the 2008 collapse was a natural result of corporate greed or incompetent regulators or bad government policy. These all certainly played a role, but they are also used as a smokescreen to hide the identities of our attackers. This is in line with the doctrine outlined in Unrestricted Warfare, in which the Chinese authors discuss how a financial terrorist could cause a stock market crash and then conceal himself “in the forests of free economics.”⁵

The most likely suspects in an oil price shock are those who benefit most from higher prices. While it’s possible hedge funds undertook such speculation solely for profit, the sheer size of the oil shock indicates otherwise—previous large-scale oil shocks invariably stemmed from deliberate acts by oil producing states meant to influence U.S. foreign policy.

When oil producers were not targeting America, they kept prices remarkably stable. Even during the 1991 Gulf War, oil prices were maintained at reasonable levels despite lost production in both Kuwait and Iraq. Thus, from the Iranian revolution of 1980 until 2004, hedge funds and other traders refrained from trying to drive oil prices higher through speculation, believing their efforts would fail in light of the massive market power of oil producing states.

But around 2004 something changed: Islamic oil-producing states, which had kept oil prices stable for some time, were angered by the U.S. occupation of Iraq. In light of the fierce denunciations of our Iraq policy that echoed throughout the Middle East, it’s reasonable to suspect oil producers abandoned their commitment to reasonable oil prices and began trying to maximize their profits. If they wanted to do this without being punished by the United States, they could have acted secretly through over-the-counter markets and hedge funds, using speculative tools to push prices up.

The price spike was big money for the Middle East; at the peak price of nearly $150 per barrel, the world would be paying $3 trillion per year more for energy than it did at $50 per barrel, earning OPEC an additional $1 trillion. Even taking into account the drop in prices at the end of 2008, it is reasonable to assume that the price spike earned hundreds of billions of dollars for Middle Eastern sovereign wealth funds.

Dr. Walid Phares, a Fox News analyst and teacher of Global Strategies at the National Defense University, identifies the geopolitical forces behind the rise in oil prices: “Combined Salafist-Wahabi and Muslim Brotherhood circles in the Gulf with consent from the Iranian side on this particular issue, used the escalating pricing of oil over the past year to push the financial crisis in the US over the cliff.... The ‘oil-push’ put the market out of balance, hitting back at Wall Street. Basically, there was certainly a crisis in mismanagement domestically . . . but the possible OPEC economic ‘offensive’ crumbled the defenses of US economy in a few months.”⁷

Of course, oil prices don’t rise in a vacuum. Yes, OPEC is a cartel dominated by Islamic states and other problematic regimes such as Venezuela. And yes, the cartel has shown the ability to set the price over the short term both through political means and by increasing or decreasing supply. But what happened in 2007–2008 was something different—oil prices tripled largely due to the financial markets. As previously discussed, in 2008 “paper oil” traded at a daily volume 27 times greater in New York than all of America used in an average day.⁸ And that is just the U.S. NYMEX trading of paper oil based on West Texas Intermediate Crude. A relatively new phenomenon, trading in paper oil grew 2,300 percent in the five years leading to the peak, the vast majority of which was not hedging but rather speculative efforts to profit from higher prices.⁹ The paper oil market also operates in Europe, in the Middle East, and in dark markets, with serious price implications. Conveniently for OPEC, neither the United States nor anyone else could pressure or threaten the cartel over high oil prices, since blame fell at the feet of anonymous speculators.

So who was buying all this paper oil? There is no way to definitively say due to the dark markets, unregulated derivatives, and other impediments to transparency. But threading together the strains of evidence suggests a jihadist purpose. Obviously, oil producers have an economic interest in achieving the highest sustainable price for oil. But what if their interests go beyond simple economics? We have already seen that OPEC nations have repeatedly used oil as a political weapon, and we have also established that their sovereign wealth funds serve a geopolitical purpose. Finally, we have documented that serious global players including Venezuela, Iran, and various Islamist groups favor once again wielding higher oil prices as a weapon against the West.¹⁰

So, how did they do it? Dr. Gal Luft, Executive Director of the Institute for the Analysis of Global Security (IAGS), explained to the House Committee on Foreign Affairs how sovereign wealth funds can be used for this kind of speculative activity:

One of the dangers here is that through their investments SWF can shape market conditions in sectors where their governments have economic and/or political interests or where they enjoy comparative advantage. In recent months, for example, commodity futures have increased dramatically largely due to astronomical growth in speculation and bidding up of prices while actual deliveries are far behind. Commodity markets are easily manipulated and the impact of such manipulations could often reverberate throughout the world as the current food crisis shows. While U.S. companies are not allowed to buy their own products and create shortage to increase revenues, foreign governments with economic interest in a particular commodity face no similar restrictions bidding on it, via their proxies, in the commodity market. Under the current system, oil countries can, via their SWF as well as other investment vehicles that receive investment from SWF, long future contracts and commodity derivatives and hence affect oil futures in a way that benefits them.¹¹

And indeed, in the lead-up to September 2008, there was intense and focused investment in the commodity markets both directly and via proxies coming from oil producers and sovereign wealth funds.¹² There was a spike in trading of the leveraged oil ETFs, a jump in sharia-compliant oil buying, and a rush into oil futures and commodity derivatives. Much of this can be traced to those we have identified with motive.

While paper oil speculation pushed prices ever higher, the producers enjoyed the benefit. Prices were pushed so far beyond levels that could be justified by supply and demand, however, that prices ultimately collapsed, plunging from the peak of nearly $150 per barrel to below $40 per barrel by year’s end. It’s hard to believe oil producing states would be so foolish as to engineer this outcome if their goal was simply to maximize their long-term oil income. But that wasn’t the only goal. For some, the purpose of the oil run-up was to weaken the capitalist economy while generating the funds needed to carry out the coming financial attacks.

Taibbi says this was clearly a case of insider manipulation. He isn’t alone. Thomas Haugh, general partner of PTI Securities & Futures LP with eighteen years experience as an options market maker, expressed the majority view on Wall Street: “Even if I was the most bearish man on earth, I can’t imagine buying puts 50 percent below the strike price with just over a week to expiration. It’s not even on the page of rational behavior, unless you know something”¹⁴ (emphasis added). Another trader compared the trade to buying $1.7 million worth of lottery tickets, all with the same number.

Naked short sellers moved in almost immediately after the mysterious $1.7 million trade was made. Prior to March 11, there wasn’t any problem with Bear stock being sold but not delivered—the hallmark of naked short selling. According to Taibbi, however, on March 12, “the number of counterfeit shares in Bear skyrocketed . . . . On March 11, there were 201,768 shares of Bear that had failed to deliver. The very next day, the number of phantom shares leaped to 1.2 million. By the close of trading that Friday, the number passed 2 million—and when the market reopened the following Monday, it soared to 13.7 million.” This was, Taibbi says, “one of the most blatant cases of stock manipulation in Wall Street history.”¹⁵ Experts believe all this likely started with activity by just 10 to 15 people—that’s all it took to draw sufficient blood and attract sharks.

It’s clear something criminal happened, yet authorities could not trace it. Senator Christopher Dodd, chairman of the Senate Banking Committee, asked SEC Chairman Cox whether he was “looking at this,” suggesting that there must have been “some sort of bells and whistles at the SEC. This goes beyond rumors.”¹⁶ Despite Dodd’s pressure and the feds’ access to the trading record, however, there have been no convictions for insider trading or for illegally spreading rumors in connection with the Bear collapse. We know why. It was financial terrorism and was designed to be untraceable.

Six months later, as Taibbi explains, the same thing happened again at Lehman Brothers.¹⁷ George Soros then wrote an op-ed for the Wall Street Journal explaining what was really going on. According to Soros, “It’s clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination.”¹⁸

Even the SEC eventually seemed to agree, as evidenced by its Emergency Order dated July 15, 2008. The order stated, “False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by ‘naked’ short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, this chain of events can threaten disruption of our markets.”¹⁹

Another major event in the market meltdown was the destruction of mortgage giants Fannie Mae and Freddie Mac. During the summer of 2008, short sellers began attacking the two government sponsored entities (GSEs), which were overextended in the housing bubble. Fannie stock, which exceeded $60 in late 2007, plunged below $1 per share by September 2008. Freddie stock followed a similar pattern, provoking the Treasury to inject tens of billions of dollars to prop up the ailing companies.

The collapse in Fannie and Freddie’s stock price was accompanied by a massive rise in the cost to insure their debt. This hampered their ability to raise capital, creating a situation of near chaos and exacerbating the housing market’s woes. The situation was dire—together, the GSEs held loans of $5 trillion, the “largest debt ever held by any private company in history... larger than any other country’s debt, with the exception of that of the United States,” NPR reported. “Allowing Fannie Mae and Freddie Mac to collapse would have been akin to letting Japan or the United Kingdom go bankrupt. Global economic leaders say even those unimaginable scenarios would have paled beside the fallout from a Fannie/Freddie implosion.” Domenico Siniscalco, former finance minister of Italy, said that Fannie and Freddie’s bankruptcy “would have meant Armageddon. Meltdown of the financial system, the global financial system.”²⁰ Unsurprisingly, the federal government bailed out both institutions at enormous expense to the taxpayers.

In his memoirs, former Treasury Secretary Henry Paulson reveals some key details about the Russians’ attempts to carry out a “disruptive scheme” against Fannie and Freddie by encouraging the Chinese to join them in dumping their holdings in the GSEs. Their intent, according to Paulson, was to force our government into a costly bailout that would have harmed our economy.²¹ This was a textbook case of economic warfare.

Paulson claims the Chinese told him they turned the Russians down, although the Russians seem to have liquidated their own shares anyway. So did the Russians ultimately act alone, or were they coordinating their actions with financial terrorists? Credible, independent sources have confirmed to me that the Russians knew all about the financial attacks that were taking place. As far as we can tell, they were not organizing the onslaught but rather “piggybacking” on the attacks of others.

Once the government saved Fannie and Freddie, short sellers moved on to other targets. Beginning on September 11, 2008, in rapid-fire fashion, financial firms once again came under attack. This was six months to the day after Bear Stearns was attacked and on the seventh anniversary of the 9/11 attack. Lehman Brothers was first on the list. The FBI received an early tip that something suspicious was going on from Erik Davidson, now Deputy Chief Investment Officer at Wells Fargo. I’ve known Erik for a long time. We worked together at Templeton and were business partners in a start-up a decade ago. He is not someone given to conspiracy theories or panic. But he was so concerned by the huge spike in short selling on Lehman Brothers that occurred on September 11 that he notified the authorities. As the attack on Lehman gained pace, Wall Street panicked—even the best hedge funds were shocked. The credit markets collapsed.

As with Bear Stearns, the move against Lehman was a full bear raid using naked short selling, rumor spreading, and the manipulation of credit default swaps. According to a Bloomberg report by Gary Matsumoto, 23 percent of the trading in Lehman on September 17, 2008 comprised failed trades, a strong sign of naked short selling. The Bloomberg report maintained, “The biggest bankruptcy in history might have been avoided if Wall Street had been prevented from practicing one of its darkest arts.”²²

The bear raid on Lehman came on the heels of two false rumors that hurt the firm that summer. In both cases, naked short selling spiked as the rumors circulated. On June 27, naked shorting jumped 23-fold. The next trading day, June 30, a rumor circulated that Barclays would buy Lehman at a price 25 percent below the market price. The stock fell 11 percent despite adamant denials by both Lehman and Barclays. Over the next six trading days, the number of failed-to-deliver trades—indicative of naked short sales—occurred at a rate forty-six times greater than the level of June 26. Then on July 10, another rumor began spreading that two significant clients had stopped trading with the firm. Despite denials by all parties, Lehman’s stock dropped an additional 27 percent.²³

On September 15, Lehman Brothers collapsed. That same day, Congressman Paul Kanjorski made a shocking announcement—more than a half trillion dollars had vanished from U.S. money market accounts:

At 11 in the morning the Federal Reserve noticed a tremendous draw-down of money market accounts in the United States, to the tune of $550 billion was being drawn out in the matter of an hour or two. The Treasury opened up its window to help and pumped a $105 billion in the system and quickly realized that they could not stem the tide. We were having an electronic run on the banks. They decided to close the operation, close down the money accounts and announce a guarantee of $250,000 per account so there wouldn’t be further panic out there.... If they had not done that, their estimation was that by 2 o’clock that afternoon, $5.5 trillion would have been drawn out of the money market system of the United States, would have collapsed the entire economy of the United States, and within 24 hours the world economy would have collapsed.... It would have been the end of our economic system and our political system as we know it.²⁴

By the time Lehman failed, false rumors and naked short selling had driven its stock price to nearly zero. The amount of naked short selling was more than 1,600 times greater than the amount just three months earlier. As with Bear Stearns, Lehman had sufficient capital to meet regulatory standards almost until its final collapse. In testimony to Congress, Lehman CEO Richard Fuld noted that Lehman’s leverage had been reduced to a remarkable 10.5, one of the lowest ratios on Wall Street at the time and well below levels most analysts typically viewed as dangerous.²⁵ The constant rumors, prohibitively high credit default swap rates, and the stock decline combined to destroy the firm’s ability to access capital or conduct business. Without the rumors, Lehman likely could have continued operating or at least found a business partner and retained some shareholder value. This, in turn would probably have eliminated the need for the TARP bailout and avoided much of the ensuing turmoil. Instead, in the course of a week, a 158-year-old firm disappeared.

Former hedge fund manager Andy Kessler wrote in the Wall Street Journal that this was all a “bear-raid extraordinaire.” He explained,

In a typical bear raid, traders short a target stock—i.e., borrow shares and then sell them, hoping to cover or replace them at a cheaper price. Once short, traders then spread bad news, amplify it, and even make it up if they have to, to get a stock to drop so they can cover their short. This bear raid was different. Wall Street is short-term financed, mostly through overnight and repurchasing agreements, which was fine when banks were just doing IPOs and trading stocks. But as they began to own things for their own account (mortgage-backed securities, collateralized debt obligations) there emerged a huge mismatch between the duration of their holdings (10- and 30-year mortgages and the derivatives based on them) and their overnight funding. When this happens a bear can ride in, undercut a bank’s short-term funding, and force it to sell a long-term holding.²⁶

Now, these banks did have insurance for their long-term debt. Unfortunately, that insurance was in the form of credit default swaps, mostly issued by AIG, itself a target of bear raids. Those CDSs were empty vessels—there was no money to back them up in case they had to pay out. And they were sliced and diced so much that nobody really knew who would have to pay up if insurance was invoked. Kessler compared the CDS market to “buying insurance from the captain of the Titanic, who put the premiums in the ship’s safe and collected a tidy bonus for his efforts.”²⁷

The banks bought the insurance and then stuck it in their vault, as if it made their risky debt acquisition safer. But the price of that insurance impacted the value of the other bank-owned assets. When insurance prices went up, for example, the value of collateralized debt obligations (CDOs) and mortgage backed securities (MBSs) went down, since the insurance prices would only rise if CDOs and MBSs were found to be risky. Because of mark-to-market rules, if the price in the general market rose for the insurance, the banks would have to write off a loss on CDOs and MBSs. Then they’d need more money in order to replace the lost cash on their balance sheet. That meant, said Kessler, that “Wall Street got stuck holding the hot potato making them vulnerable to a bear raid.”²⁸

As Kessler further noted, GE CEO Jeff Immelt worried that “by spending 25 million bucks in a handful of transactions in an unregulated market,” traders in CDSs could destroy the market. “I just don’t think we should treat credit default swaps as like the Delphic Oracle of any kind. It’s the most easily manipulated and broadly manipulated market that there is,” Immelt averred. Kessler wryly observed, “Complain all you want, it worked.”²⁹ Aggressive buying of credit default swaps was itself a secret weapon, unregulated and virtually undetectable, but with catastrophic consequences. As Immelt noted, this weapon didn’t require much in the way of resources. In conjunction with naked short selling, CDSs were dangerous weapons that a few people could launch in secret.

After Lehman failed, the SEC appeared to get religion. On September 18, 2008, the commission issued another emergency order, this time banning all short selling in nearly every financial services firm in America.³⁰ The initial ban, covering 799 stocks, was quickly increased to nearly 1,000. The ban was slated to last until October 2, but was extended until a bailout package could be put in place. In making the ruling, the SEC announced,

In our recent publication of an emergency order under Section 12(k) of the Exchange Act (the “Act”), for example, we were concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers exacerbated by “naked” short selling. Our concerns, however, are no longer limited to just the financial institutions that were the subject of the July Emergency Order.... Given the importance of confidence in our financial markets as a whole, we have become concerned about recent sudden declines in the prices of a wide range of securities. Such price declines can give rise to questions about the underlying financial condition of an issuer, which in turn can create a crisis of confidence, without a fundamental underlying basis.³¹

That last sentence is significant, affirming the self-reinforcing nature of bear raids. In fact, the whole ban is significant, as the SEC acknowledged that short selling was the trigger. The problem is that the weapon had already been fired. Once the bear raid had begun via abusive naked short selling and credit default swaps, panic spread quickly—a ban on short selling could no longer contain it. In fact, even with a ban, synthetic short selling occurred with similar detrimental effects.

Lehman’s collapse precipitated a domino effect, with panic spreading to virtually every financial firm including Merrill Lynch and Washington Mutual (which were eventually merged into other banks), Citigroup, Bank of America, and even Goldman Sachs. All of this, in turn, put AIG on the brink. Norway immediately lost almost $1 billion from its pension fund. Books around the globe were weighed down by billions’ worth of uncollectable debts for hedge funds and banks where Lehman was the counterparty. LIBOR—the intra-bank lending rate—realized the sharpest spike in its history, blowing up from 1 percent before Lehman’s failure to 6.44 percent afterward. The Reserve Primary Fund, which held Lehman debt, “broke the buck,” the first time a money fund fell below $1 per share in fourteen years—and that was once considered a solid fund.

As firms encountered trouble, they were forced to sell assets to raise capital. Each sale brought a lower “market” markdown as required under mark-to-market rules. The markdowns forced the firms to raise additional capital at even lower sale prices, creating a death spiral in the pricing of virtually all financial assets.

This led to a virtual shutdown of the credit system, making it difficult for consumers to get loans to buy big-ticket items and for businesses to get capital needed for operations and expansion. This, in turn, severely impacted economic activity, causing a direct downturn in GDP, sparking depression and deflation fears.

The stock market plunged more than 50 percent from its peak by early 2009. The government undertook various rescue measures including the $700 billion TARP program and a total of $12.8 trillion in rescue packages plus fiscal/monetary stimulus through mid-2009 alone. The ultimate impact went far beyond Wall Street, with historic failures such as General Motors and major retailers. Unemployment skyrocketed from historic lows to levels unseen since the early 1980s. Tax collections dropped sharply, and government debt rose dramatically.

Economists, analysts, and leaders across the political spectrum in both the United States and in Europe agreed Lehman’s collapse was the catalyst of the chaos. Economist Paul Krugman declared, “The collapse of Lehman Brothers almost destroyed the world financial system.”³² James Surowiecki called the Lehman failure “the first, and crucial, moment in [the 2008] market panic.”³³ French Economy Minister (now IMF head) Christine Lagarde said that Lehman’s failure threatened “the equilibrium of the world financial system.” Federal Reserve Bank of San Francisco President Janet Yellen called Lehman’s failure “devastating,” adding, “That’s when this crisis took a quantum leap in terms of seriousness.”³⁴ The consensus view was summed up in the title of an October 2008 Insurance Journal article: “The Lehman Failure Seen as Straw that Broke the Credit Market.”³⁵

George Soros also agreed. He explained, “The financial system as we know it actually collapsed. After the bankruptcy of Lehman Brothers on September 15, the financial system really ceased to function. It had to be put on artificial life support. At the same time, the financial shock had a tremendous effect on the real economy, and the real economy went into a free fall, and that was global.”³⁶ Soros blamed the situation on wild short selling enabled by the abolition of the uptick rule and the infected CDS market.³⁷

Many people view Soros’ expressions of concern for the market as hypocritical. At a minimum he was a piggybacker on the attacks, raking in $1.1 billion as the markets collapsed.³⁸ Others theorize, without sufficient evidence, that Soros was a driving force behind the market collapse, noting that the meltdown occurred just before the 2008 presidential election. Soros clearly favored Barack Obama, and John McCain was leading 54–44 in the polls of likely voters as late as September 7, just prior to the attack on Lehman. McCain’s lead rapidly vanished amidst the ensuing economic turmoil.³⁹

This implies a shocking centralization of market action that could conceivably be used to take down the entire market. The report states that those two firms traded trillions of dollars’ worth of U.S. blue chip companies; they were the top traders in all financial companies that collapsed or are now financially supported by the government. Trading by these two companies grew exponentially while the markets have lost trillions of dollars in value. The report also states that the firms owned almost no shares in the companies in which they traded, implying that their market maker status was used to facilitate naked short selling under the Madoff Exemption.

According to “Red Flags,” the firms had a combined seventy-six different symbols under which they acted as market maker. (Citigroup, by contrast, had just six.) Both firms offer naked sponsored access—allowing unknown parties to invest at breakneck speed—as well as access to dark pools. From June through September 2008, the two firms appeared to concentrate on Lehman Brothers, trading 1.04 billion shares as the stock price collapsed from $33.83 to $0.21 on September 15. This pattern seemed evident in every other major financial stock. According to the report, the two firms completed as many as 641,000 trades per hour in October 2008 (based on market participation statistics and average trade size from the last available data). Total trading volume by month in the financial sector listed for these two firms grew from around 350,000 shares (less than 1 percent of all market participant trading) in September 2006 to roughly 600,000 shares in the sector (about 6 percent of all market participant trading) in September 2007, to over 8 billion shares in the sector (about 19 percent of all market participant trading) by September 2008—a total increase of 2.4 million percent in two years.

During the period when stocks were collapsing (generally September or October 2008, but earlier for Bear Stearns), the two firms seemingly dominated trading. That was true for trading in AIG, American Express, Bank of America, Bank of New York Mellon, Bear Stearns, Citigroup, Countrywide, Comerica, Capital One, Discover, Fannie Mae, Freddie Mac, JP Morgan Chase, Lehman Brothers, Moody’s, M&T Corp., Nat City, Provident, PNC, Regions, Royal Bank of Canada, Sovereign Bancorp, Suntrust, State Street, Toronto Dominion, UBS, Wachovia, Wells Fargo, and Washington Mutual. In short, it was true for all the big financials that collapsed or nearly collapsed.⁴¹

“Red Flags” further notes that the firms appeared to work in concert. Combined, they traded 203 billion shares, mostly concentrated in major financial services companies. This compares to a total of 427 billion shares outstanding of all issues on the New York Stock Exchange. From July 2008 through September 2008, the two firms “traded more shares of Fannie and Freddie than were issued,” even as the share prices were collapsing. They were also the largest traders in the UltraShort leveraged ETF during that period.⁴² The UltraShort is among the leveraged ETFs blamed for much of the volatile trading in recent years.⁴³

The names of the two firms were withheld from my original report for several reasons, though all the underlying data was provided to law enforcement and intelligence agencies. I had hoped that a covert investigation could be undertaken to determine precisely who was behind the activity and why. I was also afraid that naming the firms might cause the authorities to launch a showpiece raid on the companies. That is what appears to have happened with Ponzi scheme operative Allen Stanford, as the SEC and the FBI made a big show of arresting him after they were stung by criticism for taking so long to discover Bernie Madoff’s crimes.⁴⁴ We now know that Stanford was connected to both Qaddafi and Hugo Chavez, and his splashy arrest and very public “perp walk” tipped off all his associates that they needed to get rid of any evidence connecting them to Stanford’s illegal activities. Chavez even nationalized the Stanford bank, depriving authorities of any insight into whatever nefarious activities were occurring there.⁴⁵ While in jail, Stanford was beaten so badly he was declared unfit for trial. He also developed a chemical dependency and suffered from delirium, according to reports.⁴⁶ By withholding the names initially, I was planning to gather interest from the trading data first and then formulate a strategy to investigate further.

I had to change my strategy when my research was made public. But in every interview, I still declined to name the two firms identified in the “Red Flags” report, hoping to give authorities just a little more time to quietly investigate. Today, however, the story is out, and those who were trading there have no doubt withdrawn back to the shadows. Before naming the firms, it is important to understand that trades placed through a company, especially under the sponsored access rules at the time, do not by themselves indicate any wrongdoing by the company, even if the traders had malicious intentions. But there is compelling evidence showing that these two firms were used as a conduit for orders placed by others.

Due to a lack of transparency, it is impossible to trace all the orders and determine with certainty who was pulling the trigger at the time. The data suggest that most of the naked short selling was conducted in hidden ways such as through naked sponsored access (also called “unfiltered access”). That being the case, the two brokerage firms did not initiate the massive flow of trades that went through them. In other words, they seem to have been unwitting tools of financial terrorists. Only after the collapse did the SEC realize the risk of allowing unidentified parties to execute unfiltered trading activity through other firms. “Unfiltered access is similar to giving your car keys to a friend who doesn’t have a license and letting him drive unaccompanied,” SEC Chairman Mary L. Schapiro said later as the agency proposed new regulations to curb the practice. “Today’s proposal would require that if a broker-dealer is going to loan his keys, he must not only remain in the car, but he must also see to it that the person driving observes the rules before the car is ever put into drive.”⁴⁷

Actually, the situation in 2008 was far worse than that. Naked sponsored access can be as bad as allowing your drunk friend to loan your keys to total strangers or to sell them to the highest bidder. Until the recent SEC ban, naked sponsored access accounted for 38 percent of all trading in 2009 (up from just 9 percent in 2005) and likely much more during the market collapse.⁴⁸

The growth of naked sponsored access coincides closely with the rapid growth of the two firms identified in the “Red Flags” report: Penson Financial Services, Inc. of Dallas, Texas, and Wedbush Morgan Securities, Inc. of Los Angeles.⁴⁹ These two firms were both pioneers in developing naked sponsored access prior to the 2008 crash, and both lobbied heavily to keep the practice legal.⁵⁰ That’s a key point: before the 2008 crash, naked sponsored access was completely legal, meaning there is no real way to track who was ultimately behind the trading given “cutouts, or front companies, such as trusts, managed accounts, private Swiss banks, and hedge funds” as well as many other forms of obscurity available to sophisticated investors.⁵¹ In other words, there’s no way to demonstrate that specific trades were placed by Osama bin Laden or any other terrorist through a particular broker.

There have been reports of unusual “associations” for Penson and Wedbush by the website “Deep Capture,” considered by some to be a leading source of information on the dark art of naked short selling. Others detest the site and accuse it of all sorts of misreporting. Interestingly, the Deep Capture website, founded by Overstock’s Patrick Byrne, was shut down by an order from a Canadian court at the request of Vancouver stock promoter Altaf Nazerali, who reportedly did not appreciate the way the site portrayed him or his associations.⁵² That was not the first attack on Deep Capture or on Patrick Byrne, who has been fiercely criticized for his denunciations of naked short selling. He is clearly controversial and has made many enemies on Wall Street.⁵³ However, several of his warnings have proven true and some have been echoed in the Economist.⁵⁴ As Chairman of the Board for Milton Friedman’s Freidman Foundation for Educational Choice, he is a serious man who deserves a hearing.⁵⁵ At any rate, the stakes of financial terrorism are too high to dismiss compelling evidence based on one’s opinion about Patrick Byrne.

Deep Capture published a 20-installment series that used Penson and Wedbush as the subject of the “Kevin Bacon” game (aka, the “degrees of separation”). The Deep Capture reports suggested links between one or both of the trading firms and other companies connected to the May 2010 “flash crash” that were accused by the NYSE of allowing large volumes of erroneous orders to flow to the market. The reports further suggested the firms had connections to a wide range of suspicious individuals, including individuals identified by authorities as “Specially Designated Global Terrorists” as well as al Qaeda financiers, an investment manager once accused by the FBI of handling an account for Osama bin Laden (with advance knowledge of the 9/11 attacks), Hamas financiers, the Russian mafia, Chinese traders, and various jihadist foundations. Connections were also identified with B.C.C.I. (called “the dirtiest bank of all” by Time magazine), Refco (a financial services company that collapsed in 2005 amidst a fraud scandal), and the “Golden Chain” (thought to be a group of billionaires funding al Qaeda).⁵⁶

Of course, we can’t pronounce guilt exclusively by reports of association. What we can say is that naked sponsored access made nefarious trading possible and impossible to trace. It was a mechanism seemingly tailor-made for exploitation by financial terrorists. As noted by “Red Flags,” Penson and Wedbush were among the largest traders of the specific securities under financial attack. They also were huge players in the naked sponsored access world, even lobbying for its continuance. While we can’t definitely verify the associations cited by Deep Capture, I believe something untoward was happening, though the two trading firms undoubtedly did not know who was ultimately trading through them. They were just legally filling orders according to the naked sponsored access rules in place at the time.

Ritholtz is no novice. He’s a respected journalist and market strategist who is well-connected on Wall Street and was named one of the “15 Most Important Economic Journalists in 2010.” And he was right: it was not the traditional hedge funds that were furiously selling U.S. financials. Unsurprisingly, much of the trading did come from London and Dubai and appeared, even to a seasoned pro, to be financial terrorism.

Ritholtz concluded his column by noting, “If you want to know who to blame for the past five years of naked shorting, you only have two places to look: The Financial brokers themselves, and the nonfeasance of a feckless SEC.” Once again Ritholtz nailed it; the SEC—and indeed the whole of Wall Street—had been blind to the possibility of naked short selling being used as a weapon.

Jim Cramer of CNBC fame also commented on the theory of financial terrorism as noted by the National Terror Alert in October 2008:

Cramer suggests the damage being done to stocks through short selling, where Wall Street’s most legendary institutions are losing value at alarming rates, could be the work of financial terrorism.

Cramer’s been talking to the short sellers he knows, and that’s the theory they’ve been putting forward. His sources said that it’s doubtful that the market’s traditional short sellers are behind the negative action we’ve seen lately. So there is the possibility that someone else has been trying to wreak havoc in the markets rather than just profit from the problems of Goldman Sachs.

Cramer, who was merely relaying what he heard, did say that, given the fact that the U.S. is in a “financial nationally emergency,” [sic] the “financial terrorism thing, to me, has to be put on the table just because the regular short sellers are not doing this.”⁵⁸

Even with all this, Lehman and the broader economy still might have been saved, as was the case six months earlier when Bear Stearns was sold to J. P. Morgan Chase. But Lehman instead went down thanks to a decision made by British-based Barclays, a bank that, at the time, was heavily dependent on capital from the Middle East and China.

Barclay’s contribution to the collapse of 2008 is largely unknown, but the story can be pieced together from a few key sources. In his book On the Brink, former Treasury Secretary Henry Paulson recounts the collapse of Lehman. Apparently, many of the world’s major banks had acquiesced to the American proposal that Barclays buy up Lehman while dumping its $52 billion pile of bad assets. The result would have devastated Lehman shareholders but kept the firm operational and prevented further economic contagion. But in a fateful phone call, British Finance Minister Alistair Darling told Paulson, “without a hint of apology in his voice, that there was no way Barclays would buy Lehman. He offered no specifics, other than to say that we were asking the British government to take on too big a risk, and he was not willing to have us unload our problems on the British taxpayer.”⁵⁹

Darling’s authoritative decision is odd considering the British government did not own Barclays. In 2008, two sovereign wealth funds, from Abu Dhabi and Qatar, invested billions in Barclays, ultimately owning enough stock and warrants to take controlling interest under certain conditions. This explains why Barclays was the only major bank in either the United States or the United Kingdom allowed to reject government bailout funds—the bank’s agreements with the SWFs required it.⁶⁰

If the SWFs had this much leverage in the bank, they were probably strong enough to force the bank to refrain from rescuing Lehman. Barclays, in fact, had already stated that it would be advised by the Qatar Investment Authority. Furthermore, Barclays had other investors who were unlikely to favor rescuing the U.S. economy. These included Challenger, a company owned by Sheikh Jamad Bin Jassim Bin Jabr Al-Thani, prime minister of Qatar and chairman of Qatar holding, and the China Development Bank.⁶¹ This is the same Barclays, of course, that helped develop arboon as a means for sharia-compliant short selling.

The meltdown caught most of the traditional hedge fund community off guard. In fact, the hedge fund industry as a whole lost a record 21.44 percent in 2008, with the vast majority of established funds losing money.⁶² Interestingly, the hedge funds that performed best during the carnage were new, large ones. Under normal circumstances, this would seem bizarre, since smaller firms are typically more nimble. However, given the theory under consideration—namely, that one or more entities invested in such a way as to deliberately harm the U.S. economy—it does make sense that larger and newer funds would outperform. That’s because larger funds would be required to have the market impact, and newer funds would be more eager for cash. For a fund to be both large and new would require a serious recent investment. Large influxes of secret cash into new enterprises are seldom innocent, and they were not here. It is reasonable to conclude that a large amount of money moved into newer, lesser known, offshore hedge funds focused on shorting the market.⁶³ From there, the money could have been funneled through Penson and Wedbush as decribed in the “Red Flags” report.

This fits perfectly with analyses of how a financial terrorist attack would operate. According to Jim Rickards, “If terrorists or countries wanted to send US financial markets into a tailspin, they would not need an explosion. Several financial doomsday scenarios have circulated in intelligence and financial circles. One goes like this: A foreign government or a terrorist group with substantial financial backing sets up several overseas hedge funds. Acting together, they dump US stocks, perhaps by short-selling a major financial index or by targeting key US companies. The attack begins slowly, picking up speed over several hours as it creates panic and confusion in the market.”⁶⁴ The key point is that “weaponized” hedge funds would tend to be new, offshore, and presumably large.

Our enemies picked the right target and the right time. They precipitated an old-fashioned bear raid using naked short selling and credit default swaps—both instruments in which you can make a profit without having to own anything. These are the instruments Warren Buffett called “financial weapons of mass destruction.” State sponsors of Islamic terrorism, jihadists, and their Chinese benefactors learned well, and they used these instruments just as Buffett had feared. By shorting the market, our enemies shouted “fire” in a crowded theater, prompting market actors to all “de-risk” at once. They were piggybacked by a few market traders like George Soros, who made a bundle. And the entire U.S. economy paid the price.

Due to the presence of dark pools, dark markets, sponsored access, and leveraged ETFs, the identification of the perpetrators is difficult to prove definitively. As Taibbi writes in Rolling Stone, “Without a bust by the SEC, all that’s left is means and motive.”⁶⁵ He’s right. But as we’ve shown, the means and motive belong to America’s enemies. A mountain of evidence points to them even if absolute proof is elusive. Although some observers have pinned the blame on Goldman Sachs, noting various ways the firm positioned itself to profit from the meltdown, the financial giant in fact saw its shares collapse near the end of 2008, dropping to a price of $53 on November 21, 2008 from a previous high of $233 in October 2007. Even as of late 2011, when Goldman has supposedly recovered, the share price is well below $100. Although Goldman is often rightfully denounced by both the Left and the Right for assorted corporate sins, it was much more a target of the 2008 financial attack than a perpetrator.

PHASE ONE: THE OIL RUN-UP

PHASE TWO: THE BEAR RAIDS

WHODUNNIT?

NOT BUSINESS AS USUAL