This column was written by Michael Kao, CEO and portfolio manager of Akanthos Capital Management, a hedge fund specializing in convertible, capital structure and event-driven arbitrage strategies. It was originally published on RealMoney on Sept. 26.

The catastrophic turn of events in the financial markets this month were actually exacerbated by the Treasury's "fixes" themselves.

From my "front lines" perch as a hedge fund manager that traverses up and down capital structures (loans, bonds, convertibles, preferreds, equities, options, etc.), let me offer four key observations and solutions that the equity-centric media coverage may have missed:

Problem No. 1: The Fannie ( FNM)/ Freddie ( FRE) "bailout" eviscerated the preferred markets.

When Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship, he also eliminated the dividends on $36 billon of preferred stock, and that move sent formerly AA-rated securities to mere cents on the dollar overnight. Treasury's flawed assumption was that the agencies are special entities and that the treatment of their preferred shares ought not to affect the preferred securities of other financials. How utterly wrong and naive.

In the days following the "rescue" of Fannie and Freddie, the market for financial preferreds was essentially eviscerated, virtually eliminating any hope of recapitalization through public markets.

Why is this relevant? Aside from the direct consequences of many regional banks having to write their agency preferred investments to nearly zero and further eroding already-thin capital ratios, the overall market for preferreds is significantly larger than the amount of agency preferred outstanding. In fact, this market was one of the only capital markets that remained open to financial institutions in the last eight to nine months, and it raised nearly $80 billon during this period from straight and convertible preferred issuance.

It's one thing to "punish" common equity holders who arguably have lived off the "fat of the land" when Fannie and Freddie reaped abnormal profits, but it's entirely another thing to pull the rug out from under a class of investors (senior to the common) who stuck their neck out to recapitalize financial firms in need less than one year ago! This has caused preferred holders to hedge their exposure by heavily shorting the underlying stocks, further blowing out their cost of capital for the underlying companies.

Although Korea Development Bank walked away from purchasing a stake in Lehman for various reasons, the rapid erosion in financial preferred shares didn't help instill confidence in the prospective buyer.

Solution: Treasury should reinstate the dividends on Fannie and Freddie preferred shares and emphasize a renewed commitment to keeping the preferred asset class viable. The increased cost to taxpayers (roughly $644 million quarterly) is paltry compared with the hundreds of billions we're currently debating about in Congress, and it paves the way for private capital to re-enter the marketplace. This is ultimately what is needed to sustain any recovery.

Problem No. 2: Lehman's bankruptcy has severely eroded confidence between counterparties.

While it was arguably OK to draw the line and appease the "moral hazard" hawks by letting Lehman go, it was a disastrous mistake to not guarantee Lehman counterparty risk -- especially when Barclays was allowed to feast on its carcass. We have not even begun to see the shoes that are about to drop here, as Lehman was a very pervasive counterparty to innumerable sell-side/buy-side accounts.

While the face amount of credit default swap contracts has never been released, as of May 31, Lehman's net derivative position was $47 billon, cash collateral was $45.6 billion, and cross-product and counterparty netting was $43.3 billion. Keep in mind that the face amount of the derivative portfolio could be orders of magnitude greater than its net value. As a result of the bankruptcy, any over-the-counter trades done with Lehman have now been terminated.

To make things immeasurably worse, any associated profits from these trades have to be treated as senior unsecured claims in bankruptcy court. (By the way, Lehman's senior unsecured bonds are now trading at 15 cents on the dollar. This means that if I hypothetically had $1 million of profit in any over-the-counter trade I had on with Lehman, $850,000 of that "profit" just evaporated, and it would remain to be seen when I'd even get the remaining $150,000 back.

Furthermore, if I had cash collateral against any of these trades, or if I had prime-brokered my portfolio at Lehman (there is supposedly more than $40 billion of prime brokered assets that might be stuck), the cash and positions that are rightfully mine have yet to be returned, and the word is that it could take months. The knock-on effects of this disaster could be huge, and this will be widely felt, not only financially but also psychologically, because it undermines the validity of any and all transactions involving counterparty risk.

Ultimately, our financial system revolves around mutual trust, and not backstopping Lehman's counterparty obligations severely damages that trust. Perhaps the only good thing is that this debacle will speed up the move to a clearinghouse mechanism for the CDS market -- something that should have happened years ago.

Solution: Treasury should backstop Lehman's counterparty obligations. It may cost a lot now, but it could obviate future bailouts, since we don't yet know how widespread the damage is. They should have done this already by imposing counterparty guarantees as a condition for letting Barclays buy the assets for a song, but now it might be too late for that. Once again, Treasury needs to take on the mantle of leadership. The "moral hazard" problem should be dealt with, but not at the expense of confidence in the financial system as a whole.

Problem No. 3: The FDIC protection threshold is too low, and the FDIC is undercapitalized as it is.

With the collapse of IndyMac, "Main Street" mom-and-pop depositors already got a frightening dose of what a bank run could mean to their life savings. With Washington Mutual ( WM) on the brink, we are running the risk of overwhelming the FDIC, since WM's roughly $145 billion in retail deposits is three times the size of the FDIC's reserve. Obviously, depositors with more than $100,000 should be worried, but even much smaller, theoretically insured accounts are running scared in this environment.

Solution:To prevent bank runs, the feds must make it abundantly clear that the current limits on the FDIC should in no way mean that insurance is about to run out. Depositors must know that their cash is safe. In addition, the FDIC protection limit should actually be increased to multiples of the current $100,000 ( it seems Jim Cramer agrees with me). While it might cost more for existing thrift failures being processed by the FDIC, the psychological impact of knowing you have a bigger umbrella will prevent potential bank runs and obviate the need for a massive FDIC bailout of a giant bank or thrift failure.

Problem No. 4: Grudging incrementalism plus a short-sale ban equals death spiral

As the fallout from Fannie/Freddie cascaded into Lehman, which then careened into AIG ( AIG), the Treasury devised yet another incredibly punitive, confiscatory "bailout": taking 80% of the equity in AIG in return for making an $85 billion bridge loan at an interest rate of more than 12%. Wow. When did the U.S. government get into the loan-sharking business? Was this seizure meant to engender confidence in our free market system?

The mistakes that the Fed and Treasury have repeatedly made since the onset of this crisis have been ones of grudging incrementalism. Each time they act, the timidity with which they apply Band-Aids instead of the required tourniquets ultimately results in even lower confidence in the system. Even worse, these Band-Aids are laced with a toxic ointment that kills both good and bad cells, so that the wound is never allowed to heal cleanly.

The culmination of these actions led to the harrowing near-deaths of yet another two bastions of Wall Street, Goldman Sachs and Morgan Stanley. It was the fear of government-inspired intervention and seizure that caused the run on these companies, not the "evil shorts," as the SEC and Treasury would have everyone believe. Yet, incredibly, the response was to ban short-selling of financials (and the list is expanding).

This is yet another example of a ham-fisted response to a problem that the feds themselves created, and this particular action may have the most insidious unintended consequences. If one is not allowed to hedge one's exposure via short-selling of equities, one is forced to get creative in how to limit one's exposure.

The resultant creative hedging practices inspired by this ban on short-selling is leading to wholesale panic-selling in the rest of the capital structure (everything senior to the equity, from preferreds to bonds to even secured bank loans), not to mention countless equity indices, precipitating a self-fulfilling "death spiral" in many of the names that are ironically on the no short-sale list.

Not only that, the short-sale ban has effectively shut down one of the most important asset classes that was once available to the financial sector -- the convertible bond/preferred market - because its main participants are arbitrageurs who require the ability to short out their equity exposures for bona fide hedging purposes. Over the last eight or nine months, financial institutions raised close to $40 billion in this asset class, when almost all other financing avenues were effectively shut. The law of unintended consequences has obviously struck again with this short-sale ban, basically shutting down another public capital market.

Solution: Lift the short-sale ban, albeit gradually, by reducing ( not expanding) the list day by day. The old uptick rule could be reinstated as a compromise. Market participants must be allowed to hedge their exposures, or the resulting damage to other parts of the capital structure will force the underlying companies into a "death spiral."

Let the Pakistan ban on short-selling this year be a model for what not to do. After short-selling was banned on June 23, the Karachi SE-100 Index staged a massive 1,300 point rally for three days before collapsing 26% in the weeks and months after. Does the market response in the U.S. sound eerily familiar so far? Let's not wait for a 26% drop to find out.