Market Meltdown, What went wrong

Global Markets June 2007 – Oct 2008 what went wrong?

The debacle in Global equity and financial markets which unfolded between June of 07 and October of 08 was brought about by four major fundamental problems. The problems during this cyclic event series were not new.

The fundamental problems were a hyper inflation of energy costs due to speculation; Failures in regulation by local, state and federal regulators in the United States and elsewhere; Unmitigated and unregulated risks in the trading of long term ( mortgage backed) securities financed with short term paper and pressure on the American economy from deficit spending and the Iraq war. These primary factors played out in the market to bring about a once in a century financial debacle in global markets.

The global media effectively stood in the theatre yelling fire adding their own hysteria to spreading panic and mayhem, ensuring that the conflagration would spread to grip as broad a population as possible. There is no news value like blood in the street.

“Deregulation at any cost; political dogma left markets vulnerable… and the wolves watching the sheep.”

Conservative thinking has long favored unfettered competition and insists that the government should maintain a minimalist approach to any intervention in the “free market” economy. Deregulation at any cost; this political dogma unfortunately left markets vulnerable, and the wolves in charge of watching the sheep.

A dogmatic anti government and regulatory environment fostered by the outgoing Bush (league) Administration has left segments of the U.S financial markets virtually unregulated. The non bank players in the capital commercial paper and bond trading markets are almost completely unregulated. Changes in the capital requirements for Investment dealers and investment bankers during 2005 allowed for dramatic increases in leverage while reducing capital requirements. At the same time financial institutions were allowed to begin monitoring their own compliance with capital requirements and risks to their capital position rather than being subject to government staff audit.

Investment dealers and investment bankers suffering pressure on revenues from online trading, low cost brokers and banks entering the trading business, turned to securitizing mortgages and other long term income securities packaging, selling and trading the resulting derivatives. The distribution of these securities throughout the global banking and investment banking system multiplied the leverage on already higher risk securities.

Huge portfolios of increasingly risky subprime securities were held as an increasing component of more heavily leveraged capital of investment bankers, hedge funds and other market participants. Investment bankers and other market participants financed these long term securities with inexpensive 30 and 90 day short term commercial paper. Doubling up on the underlying leverage in the securities and compromising the capital of every institution holding the securities. Due to negligent regulation this increasing risk was neither recognized nor disclosed.

“Borrow and spend economics has led to record deficits and has put the American economy under continually increasing inflationary pressure and economic drag across the past five years.”

Conservative rhetoric would suggest that when Republican governments have control the government would lower taxes, control speeding and govern over a favorable economy with expansionist tendencies which in turn would be self-regulating and bad actors in the economy would be punished with economic pin or failure.

Unfortunately Republicans also favour huge military budgets and of course this also allows, or causes military adventurism which has been exhibited almost constantly during the last five republican presidencies. While Republicans accuse Democrats of tax and spend economics, the outgoing Bush regime actually drove through tax cuts while presiding over and unprecedented increase in military and other federal government spending. As a result, borrow and spend economics has led to record deficits and has put the American economy under ever increasing inflationary pressure.

As the cost of the war and other negative effects of the “borrow and spend” driven deficits were applying increasing drag on the US Economy. To prevent or defer the damage from these policies the US federal has pursued a low interest rate policy to overcome the increasing economic drag by supplying high levels of liquidity to the financial markets though the sale of US Treasury bonds in addition to maintaining very low overnight lending rates. While added liquidity normally will spur growth it also expands the money supply and adds to the inflationary pressures in the economy.

“The speculation based oil price spike removed all elasticity from economies round the globe.”

Though the global economy appears to be a series of unrelated events and activities, in reality billions of participants engage in economic activity based on the inter-relationship of a large number of related factors and drivers.

Energy costs are a primary factor of all economic activity. When energy costs rise far enough outside a normal trading range, the global economy cannot sustain growth and begins to slow. If the cost of energy rises far enough the global economy will go into shock and rapidly contract.
Whether a price shock is caused by supply constriction, (such as during the Oil embargo and the formation of the OPEC oil cartel during the 1970s) or with rampant speculation, (as occurred during the run up of oil prices during 2007-08 from $75 per barrel to $140 per barrel) the results will be the same.

Over the past eighteen months the inflationary pressures on food supplies and all other commodities were driven in large measure by energy costs. The speculation driven oil price spike removed all elasticity from economies round the globe as resources were redirected from growth and investment to consumption as the costs overtook free cash flow in the economy bringing the threat of a recession to the US economy. Any recession in the US economy will normally result in a global slowdown.

This is not unprecedented. During the early 1970’s a similar oil price shock shook the world’s economy and ushered in an era of rapid inflation, economic dislocation, high unemployment, followed by a stagnant global economy combined with inflation ( stagflation) and huge increases in government spending and deficits.

“The spike in the cost of oil was the trigger bringing down the house of cards.”

The problems in the mortgage and housing market and the underlying economy in the US were the result of deficient regulation and the constant increase in the money supply required to maintain growth in the face of the increasing drag on the US economy caused by “borrow and spend” economic policy and military adventurism. A triggering event was required to begin the slide. Over the past 18 months the spike in the cost of oil was the trigger bringing down the house of cards.

The US economy was already under severe stress and, as a result of high mortgage debt loads there was very little elasticity left in the economy. When the dollar fell and high gas prices began to impact American consumers, the economy immediately began to lose steam.
Once the slide began the underlying problems in the economy impacted consumers and began to trigger defaults and foreclosures of mortgages the housing market prices softened sharply. Predictably the riskier mortgages were the most subject to failure and the sub-prime mortgage meltdown was underway.

As the number of foreclosures rose, the number of distressed sales in the market undermined real estate prices dramatically. This resulted in more borrowers walking away from mortgages where the property was suddenly worth less than the mortgage. Due to the combination of high debt loads and falling prices, consumers could no longer finance their way out of trouble. The situation reached a threshold where the rising number of foreclosures and falling real-estate prices undermined the value of sub-prime mortgages as a class.

Prior to large scale securitization of mortgages which began during the past decade, mortgages tended to be traded only between industry participants and mortgage backed securities were traded on a much more limited basis, primarily between institutions involved in the market. With the aggressive securitization of mortgages a greater specter was unleashed. The securitized mortgage investment products were sold far and wide as being low risk mortgage investments rather than the highly leveraged derivatives they really were.

“A progressive collapse of global financial markets, stopping this juggernaut will require the sustained and combined efforts of governments on a global basis…”

The regulatory shortcomings and unforeseen and undisclosed increasing risks of derivate trading combined with aggressive increases in liquidity as a monetary policy to combat the slowing effects all combined to weaken the US Economy and set the stage for a collapse. When the price of oil and other commodities began to spike the US economy began to stall. A progressive collapse of global financial markets triggered the stall and near collapse of the global credit and banking system. Stopping this juggernaut will require the sustained and combined efforts of governments on a global basis.

When the stalling US Economy exposed the underlying problems in sub-prime mortgages and the resulting foreclosures began to climb in earnest, this stall initiated freefall in the mortgage and housing markets causing increased foreclosures of prime mortgages as more and more properties were valued at less than the mortgaged amount. Even in the case of prime mortgages. As the number percentages of foreclosures caused massive write-off’s the entire class of mortgages and real-estate backed securities came under threat. In the global financial system real-estate, mortgages and mortgage backed securities are the most widely-held securities because they are generally the most secure of investments other than gold. Thus the very foundation of the global financial system was brought to the edge of a cliff.

“At this point, accounting rules and banking capital rules designed to protect the system actually became the engines powering the nosedive.”

To protect depositors and investors, worldwide banks and financial institutions make daily calculations of their capital position and are regulated on minimum capital requirements, they must report any deficiency. Accounting rules require that any publicly traded security must be included in these calculations (marked to post) at the market closing price on a daily basis.

As a result of massive holdings of these securities in the underlying capital of banks, insurance companies and other financial institutions, when the weakest of the players were forced to liquidate portfolios for pennies on the dollar, all of the players saw the immediate vaporization of the value of the underlying mortgage securities in their portfolios.

As the shares of financial institutions are traded on the basis of their capital strength and resultant earnings ability, the value of the shares of these institutions fell dramatically aat the same time as they were in a position needing equity to shore up their balance sheets and finding it increasingly difficult to raise.

In a global trading environment, US mortgage backed securities are held in large positions all over the world. As the US is the largest economy in the world, the size of these securities

holdings represented a very significant percentage of the portfolios of financial institutions. This was especially true of the British and European institutions Further. Britain and the EU have pursuied similar economic and deregulatory policies under conservative governments following the American lead over the last decade. As a result, although the underlying economies of EU and British economies seem sounder their financial systems were under the same threat as the US system.

“If Lehman brother’s could be allowed to fail, no institution was safe”

After the collapse and sale of Bear Stearns the financial system was dangling by a very thin thread. Although the capital of many institutions was under threat, the markets generally remained confident that The US Government would prevent the collapse of major financial institutions. When the US government stood by over that fateful weekend and neglected, failed or otherwise, made the decision not to prevent the bankruptcy of Lehman Brothers a new element was introduced, terror.

If an institution as large as Lehman Brother’s could be allowed to fail, no institution was safe, as the underlying market for securities continued in a full power nosedive. In this moment confidence in the major banks was shattered and the credit system which underwrites world trade stalled and was nearly shut down as banks could no longer trust each other to complete credit and loan arrangements between themselves. This was an unprecedented moment indeed!
How the American authorities could have failed to recognize the effect of their inaction is unfathomable. It was not the first ,and by no means the last evidence of stupidity, cupidity and political dogma blurring reality on the part of the US Government.

Had they stepped in and prevented the Lehman bankruptcy they probably could have avoided or reduced the size of the various bailout packages which governments have needed to apply globally to recover confidence in the system. If you stop a fire quickly it avoids it racing out of control. On that weekend the US government failed even to make the attempt to snuff out this blaze.

The incredible volatility, the temporary stall in the credit markets, the deepening prospect of global recession as a result of the loss of trillions of dollars of wealth by billions of individuals and the requirements for massive interventions are the price we all pay for the failure to prevent the collapse of confidence in the financial and credit systems.

It is not useful here to further detail the technical processes by which the market was turned on itself and, in a fit of panic, completed the work of undermining confidence generally. It is enough to say that when the pillars of the economy were tossed and shaken in the dark moments on the trading floor it was every man for himself. Like a flock of lemmings the brokers, managers and traders followed each other into the drink. Valuations and fundamentals have been completely ignored during the carnage.

In order to support values at the current there would need to be a drop of profits a magnitude greater than there is any realistic probability of seeing. In fact solid blue chip companies often bear the brunt of damage in a panic because these are the companies with sufficient liquidity to be able to be sold in a panic.

“The global media effectively stood in the theatre yelling fire, adding their own hysteria to spreading panic and mayhem, ensuring that the conflagration would spread to grip as broad a population as possible. There is no news value like blood in the street.”

What passes as financial news is really nothing more than sensational editorial and analysis of sort term and day by day trading trends which are irrelevant to anyone who is not in the market selling on a given day. I suppose it is useful to know when there is a sale on the shares of good companies, however we really don’t need people yelling fire in crowded theatres panicking the crowds, raising hysteria and turning the crowd into a mob.

Looking on the bright side of the financial storm we have suffered, and still are enduring, for long term investors economic and market fundamentals will eventually win out. Companies of value will continue their march forward recovering lost ground and move on to new highs. There will be both winners and losers as a result of this period and the winners will be the ones who own the stock as the markets recover.

If there we a single piece of advice I would offer to the average investor it would be shut off the economic news, there is little entertainment value in the editorializing and short term thinking which passes for analysis and dominates this segment. It will at best give you heartburn and at worst spur you into doing something stupid. Yes if you really need to sell you need to be paying attention, however it is more than a little late to be selling now.

If your investment horizon is less than five years, you generally should not be investing in the stock market because you are gambling rather than investing. The problem is that hindsight is always 20/20. Yes it is possible to see the causes of the market debacle we have been enduring, after the fact. Yes it is useful to understand why it happened. I t may help you to see the signs at some future time.

Looking forward however is probably more useful. Remember, over the long haul fundamentals will win out, they always eventually do. Your best course of action as an investor is to buy value in investments, whenever you can afford to, with moneys you can afford to leave untouched for periods of at least five years.

“The fundamentals for continued global economic expansion in the long term remain in place and, as always, fundamentals always win out in the end.”

What went wrong? The adage “those who refuse to learn history are destined to repeat it” is as apparent as ever. When governments and regulators ignore their responsibility to act as referee’ end ensure prudent policies of disclosure and oversight; when fraudulent and deceitful practices are tolerated as in the granting of mortgages beyond the value of properties and there is no enforcement of existing rules; when speculation is allowed to run unfettered even as the market participants recognize that speculation rather than value is driving the market; and when governments and regulators take no steps to reign in the speculators and protect the general societal interest., the results in the market are carnage, mayhem, panic and yes in economic terms “ blood in the street”.

Another result is unprecedented opportunity for every one left standing. The fundamentals for continued global economic expansion in the long term remain in place and, fundamental value always wins in the end.