Big Lies About Those Big AIG Bonuses #1 - How Trading Works

We're all aware of the public outrage at the bonuses given to employees of AIG, a financial conglomerate which has been propped up by the biggest taxpayer bail-out in history.  This outrage is a reasonable and healthy reaction to outrageous behavior and outlandish waste of taxpayer money.  Unfortunately, this outrage is aimed at the wrong target.

The trouble is that most Americans haven't been told enough to understand what actually happened.  They can understand that some employees of a company that got billions in taxpayer dollars were given million-dollar bonuses, so that's what they're mad about.

What took place isn't particularly complicated, but it's outside most people's experience.  In order to reveal the truth and explain why the AIG traders earned their bonuses the same way waitresses earn their tips and salesmen earn their commissions, there first has to be some explanation of the underlying facts.

Thus, the first article in this series defines basic terms, explains buying and selling stocks and discusses other financial instruments so you can understand how the AIG traders worked.  The second article explains how these definitions apply to AIG and tells why what you've been told on the news is the exact opposite of the truth: Paying the bonuses to AIG executives, far from being "waste, fraud, and abuse," is not only both legally and morally right but is in fact best for us taxpayers.

But first, the explanations and definitions.

Buying Stocks on Margin

Suppose a stock is selling for $100 a share and you're sure it's going to go up.  You buy a share for $100.  It doubles.  You sell the share for $200; you've made $100 minus transaction fees, taxes, and broker's commissions.  Yay for you, you not quite doubled your money.

If you're really convinced it'll go up, you can make more money.  Instead of just paying for the stock, you buy on margin.  You put up some money and borrow the rest.

In a normal economy, a stock broker like Merrill Lynch will lend you, say, 2/3 of the price.  You put up $100, borrow $200, and buy three shares.  It doubles.  You sell the 3 shares for $200 each, or $600, repay the broker the $200 loan leaving you $400.  You had to put in $100, so your profit is $300 minus fees and interest on the loan.

By buying on margin, you made three times the profit you'd have made if you just bought the stock with your own money.  This is called "leverage."

Leverage works both ways, unfortunately - if you win, you win more, but if you lose, you lose more.  Every time someone buys a share, someone else sells it.

The guy who buys thinks it'll go up.  The guy who sells thinks it'll go down; if he thought it would go up, he'd borrow money against it instead of selling.  Whenever a share trades, exactly half the people involved in the trade are wrong about what the stock will do.

The only reason the masses make money in the stock market is that over time, stocks go up more than they go down because the economy grows.  When the economy shrinks as in the Obama bear market, stocks go down more than they go up.  Most people lose, even the ones that just hold their shares and make no trades at all.

Suppose your stock halves instead of doubling as you'd expected.  If you buy one share for $100 and sell it for $50, you lose $50.  If you buy three shares for $300 by putting up $100 and borrowing $200, then sell them for $150, you still owe the broker $200.  You give him the $150 and another $50 besides.

Instead of losing $50 which would happen if you bought 1 share, you lost the entire value of the shares and you paid loan interest on top of the fees, and... you've not only lost all the money you invested, you've lost more, and have to come up with the difference somewhere else.

Where else, exactly?  This brings us to the concept of the margin call.

Margin Call

When you set up your brokerage account, you write a check so the broker has your money.  When you tell him to buy shares for you, he takes the money out of your account.  When you empty your account to buy stocks on margin, the stock is the broker's only collateral.

If the stock drifts down by half over a couple of weeks, is the broker going to sit idly by while his collateral loses so much value that it's worth less than his loan to you?  Not hardly: you need to pony up more cash to reduce his exposure.

Suppose the broker has a loan limit of 2/3 of the value of your stocks and your stock goes down $10.  Your three shares are now worth $270.  Your collateral is worth less than 2/3 of the $200 loan; you must reduce the loan.  2/3 of $270 is $180; the loan is $20 over the broker's limit.  You give him $20 to reduce your loan so that it's below his limit.

In the old days, your broker telephoned you and told you to send him money, known as a "margin call."  Nowadays, his computer calls your computer.  The result is the same, you're out $20.

Loan Covenants

The contract you sign with your broker before he'll let you buy on margin is called a "loan covenant."  The greediest lawyers on Wall Street have spent almost 200 years honing and refining the fine print.  Loan covenants specify when the broker can ask you for more money, and if you don't pay fast enough, he can sell your stock, wipe you out, and still ask for more money.  The guy with the gold makes the rules; the rules favor the broker.

There's generally a catch-all paragraph that says that if a "material change in circumstances" makes the broker nervous, he can "call the loan" and force you to pay 100% right now.  That'll make you mad and you won't deal with him again, but losing a customer is better than losing money.

To protect himself against the stock going down faster than you can meet margin calls, the broker puts a "stop loss" trigger in his computer.  His computer automatically sells your stock if the price gets below, say, $85.  $85 per share for 3 shares is $255, enough to pay the broker back his $200 along with interest and extra fees for making him do a stop-loss sale; you get whatever's left.

It's like foreclosing a house - the broker sells your stock, takes care of himself and his fees first, you get leftovers.  That's called being wiped out.

Suppose you're a rich guy instead of a peasant.  You've got assets - CDs, treasury bonds, real estate - that you don't want to sell but you could sell if you had to.  If you'll put up enough assets, the broker will lend you, say, 90% of the value of the stock; the more money he loans you, the more interest you pay him; he likes high leverage, too.

Instead of buying a mere 3 shares for $100, you get 10 shares.  Instead of the peasant's return of $300 on your $100 investment, you get a princely $1,000 on your $100 investment, or 10:1.  Not as profitable as buying politicians, but not shabby either.  See how much fun leverage is when you guess right?

Counterparties

The broker watches you make 10:1 returns time after time, gets greedy, and wants in.  He may loan you a higher percentage of the price if you share the profits.  The more he loans you, the tighter the loan covenants he'll write to protect himself, of course, but the extra leverage more than makes up for his cut.

Cutting himself in on your profits makes him a "party" to your investment which might cloud his judgment when he's thinking about whether to make a margin call.  If he cuts himself in on the gains, you'll want to cut him in on any losses, this must all be spelled out in the contract.  Margin contracts get complicated very fast.

Suppose you don't have enough assets to support 10:1 and your risk-averse broker won't lend you that much even if you cut him in.  You can still play with the big boys by persuading some other bank, brokerage, or financial institution to guarantee your loans.

They don't have to lend you the money, they simply promise that they will lend if you need it.  This is called a "standby line of credit;" banks charge fees for setting them up.  If you never need the money, the bank keeps the fee but doesn't do anything, they get fees for doing nothing, a very profitable line of business indeed.  If you need the money, the bank coughs up the cash; it then charges you interest and an activation fee.

Now your trading profits have to cover brokerage commissions, taxes, interest on the margin loans, and credit line fees, but you're playing in the big leagues.  The issuer of your guarantee is called a "counterparty;" they promised to put up the money if your trades go sour, but this promise is only as good as their word and their ability to fulfill it.

Banks who issued these guarantees assumed that most people would never need their credit lines, just a few every now and then; bank management wanted fees to pump their bonuses.  They issued lots of standby credit lines which supported lots of margin trading and made everybody a counterparty to everybody else.

As long as stocks kept going up, everything was just peachy - the banks got money for nothing because they never had to come up with the cash behind the lines of credit they'd promised.  Their promise of money let everybody have a lot more leverage and the profits rolled in; everybody went home happy for many years.

Until one day they didn't.

How The Sky Falls

There's many ways the music can stop.  Suppose lots of people thought your stock would go up, they all bought at $100, and all their brokers have stop loss triggers set at $85.  If the stock drifts down to $84.99, all those brokers' computers issue "sell" orders at the same time.

There aren't enough buyers - after all, the stock is going down.  When all those shares hit the market, the stock goes down more.  This triggers other brokers' stop losses, more shares hit the market, and the stock goes down lots more.

When it gets really bad, the stock exchange suspends trading in the stock to give things time to settle out, but you have to meet your margin calls and your broker has a nervous eye on the rest of the collateral you used to guarantee your loan to buy the stock in the first place.

There's another way you can get hurt - the market might turn volatile, which means it moves faster than anybody can meet margin calls.  You set it up with the broker, he puts in his stop loss at $85.  The market opens the next morning and the stock is at $50.  The broker's computer panics, dumps the stock, wipes you out, and hits you for another $50.  You find out about this by e-mail a few minutes after it's all over.

The next day, the stock hits $200.  You'd have hit really big if the broker had been more patient.  Timing is everything, especially in a volatile market.

A Collateral Fall

Suppose the stock is OK but your collateral drops, it isn't worth what it was when you got the loan.  You originally put up $10 per share; your $100 bought you 10 shares.  The broker loaned you $90 per share; the loan covenant says he can call for cash or sell your other assets if the collateral drops or the stock drops.  As we know, the values of real estate, a very common collateral, have been doing exactly that all across the country.

So, the stock doesn't move but your other assets go down enough to trigger the covenant.  Now the broker is only willing to lend you $80 because your collateral no longer covers him loaning $90.  You have to come up with another $10 per share, the same amount you put up in the first place.

The stock didn't move but you must double your original investment or get wiped out.  You don't want that to happen, but there isn't time to sell your real estate even if you could.  To avoid wipeout, you and your broker turn to your line of credit, your last source of quick cash.

So does everybody else in the same situation, all at the same time.

The broker calls your counterparty to activate your line of credit as the loan covenant allows him to do; the bank computer is set up to handle his margin call.  The bank should pay, but the bank issued too many lines of credit and too many other people hit them at once.  The bank can't pay without lowering its ratio of assets to loans, which violates its covenants with its counterparties.

The bank doesn't pay your broker so your broker wipes you out; you sue both the bank and your broker.  Your stock hits the market at a bad time, driving everything down even more and more covenants are triggered.

When it's good, which it generally is in a rising market, leverage is very very good, but when it turns bad, everybody, small and large, gets wiped out!  Anything that can wipe out the whole system is called "systemic risk."

That's the Basics

We've covered the basics of trading.  Stocks, bonds, mortgages, used cars, commodities, pretty much anything can be traded in more or less the same ways.

The next article in this series explains how AIG used these trading techniques to make billions of dollars of profit in good times, then we'll explain what went wrong.  Once you understand that, you'll see why it's in your best interest as a taxpayer not only to pay the AIG bonuses, but to hope that their bonuses are even bigger next year.