Doom! DOOOOOOOOOOOM!
Seriously though, the market is working. Markets ebb and flow. You have to remain optimistic in the U.S. because we’ve always found a way to recover.
Do you even know how the stock market works? Yes, we took a beating. Guess who else takes a beating if it gets worse. Not us. I’ll let you figure that out for yourself.
Because these Z trances behaved so unpredictably and were maginfiers of risk you could make a lot of money with them over a very short period time. At about the time I left people had the bright idea of making a Z squared tranche. What that means is that you take a pool of these Z tranches, and put them together and then cut them up in new and different ways to get yourself even more risk.
Routing the risk in certain directions made them even sexier, and instead of just being really cool they became useful. You could use a small amount of them to hedge other risks relating to interest rates, and thus make yourself and the world more predictable and efficient by channeling the volatility through specific instruments.
An analogy might be that we were distilling risk, they way people distilled booze. We were just rarifying it more.
The party really took off when people started writing options and futures on these things. This led to our good friends Long Term Capital who had won the Nobel Prize for defining risk in terms of option valuation in certain credit instruments. As it turns out they were wrong and they killed things for a while in 1998. Lehman almost got destroyed then and never really recovered as they were a prime manufacturer of these types of instruments.
The damage was done though. There was a huge appetite for these things and huge incentives to create them. It fueled liquidity which fueled the housing and real estate booms through ready access to capitol, and provided folks and institutions with superior returns with high credit quality. When the tech bubble burst in 2000 the triple A quality of these types of instruments made them even more attractive.
By now, CMOs no longer existed as such (or what did were considered quaint). You didn’t have to use just mortgages. You could hybridize CMOs by incestuously combining them back with these orphaned Z tranches and related derivatives, and a few other unholy ingredients and make the whole damn thing a VADiM except even better. You could truly securitize them through trust type instruments and manufactured holding companies and issue honest to God bonds and other things.
Collectively, these are known as CDOs or Collaterallized Debt Obligations. These thing were so complex and hybridized with so many other complex derivatives that really nobody actually understood them. Each one of them’s components of these instruments had its own huge prospectus. Each one of those was made up of tons of other pieces each with its own prospectus and so on and so on. To understand one, you’d need to read and understand millions of pages of legalese and math.
So, the rating companies called them all triple AAA and accepted their fees for doing so.
As soon as they started not to work, the defficiencies and problems with these things becaome immediately apparent to all concerned, and the whole thing blew up, killing the housing market. Everybody that was in the process of making and trading these things got stuck with billions of dollars of unsalable inventory, and has been taking losses ever since.
(part 3) coming up
People lost money, the stock market took a hit. The monoline insurers who insured these things based on their ratings almost got killed (and still may die,) But it was not an especially terrible correction. A bad year, a bunch of losses, but not a total global disaster.
By now you may be wondering about these rating companies and how stupid they were, just accepting fees and slapping triple A ratings on everything. They caught a lot of shit for this.
The ratings companies basically admitted they were incompetent. They decided that their own incompetance was so bad that it was incurable. Instead of actually trying to understand these things and assign an appropriate rating, they gave up and chose a proxy. That proxy was market price.
This was up there as one of the worst ideas anybody ever had. Seriously.
Let’s say XYZ company has a market cap of 50 billion and a AA rating. If there market drops to 25 billion the rating companies decide that that means there’s something wrong with the company and lower the rating. The partial logic of this is that this means that there is less of a market cap for that company to tap versus liquidity needs.
Hedge funds were already having a bad year and looking to recap losses. Short sellers were in a feeding frenzy. This was like ringing the dinner bell.
If you shorted a stock and drove its price down, it’s rating would drop. Most credit covenants require additional collateral when a rating drops which means the company has to put up more money. Of course they can’t get it easily because their rating just dropped. This makes the stock go down. The short sellers go nuts, and maybe the rating gets cut again. They need more liquidity, can’t get it, and the whole thing becomes a self-fulfilling prophecy. The act of shorting the company kills it. It becomes almost a true one way bet.
Thus dies Bear Stearns and Lehman Bros. They got sick on CDOs but the cause of death was liquidity suffocation at the hands of panicking investors and manipulative predatory short-selling.
Merrill, having gotten very sick off of CDOs very fast finally did something smart. They saw this coming, and raised tons of capitol any way they could. Last week they had over 100 billion in cash on hand. This was more than enough according to most anyone to see them through.
It didn’t matter though. The short selling was on. The cash on hand didn’t matter if the drop in market cap meant unending credit downgrades. They had lots and lots of existing obligations that would be affected and which they would have to prop up. Almost no amount of cash could protect you if your existing debt became worthless. Nobody would give you even overnight credit terms. Without that you can’t trade or conduct business, and you die.
So, Merrill blinked it’s big blue eyes, and Bank of America, the largest bank in the country took notice. It showed a little leg, and suddenly Bank of America forgot about bailing out frumpy old Lehman, and took them Merrill over.
Lehman declared chapter 11.
Now the short sellers have set their baleful gaze on AIG.
My guess, and it’s only a guess is that AIG already has its white knight lined up. I guess this because if it doesn’t and they go under we have really huge problems. Problems that are difficult to even imagine in terms of the consequences.
If AIG goes under, I’m thinking our new economic system is going to be indistinguishable from that in the Road Warrior. Basically we’ll just spend the rest of our lives being chased around a post apocalyptic wasteland by a dude in a hockey mask riding a dune buggy.
“Just walk away.”
That felt like giving birth.
So anyway, it’s not so much the stock market that’s over, but the mortgage backed market, monoline insurers and rating agencies. Assuming we avoid the apocalypse and the rapture, the market will recover, probably better than ever because money will preferentially run there as dividend based returns seemingly provide less risk and higher returns than either the bond market or the smouldering radioactive corpse of the mortgage market.
Heh.
And while I was writing that, the Gov bailed out AIG with a huge loan:
http://news.yahoo.com/s/ap/20080917/ap_on_bi_ge/aig
See, I told you so.
Yeah, that’s my understanding too.
So. Has it stopped doing that? When you say it’s over, that it’s served its purpose, you seem to imply that the need to raise capital beyond the means of the original owner of the business and the utility of spreading the risk (for loss and gain alike) no longer exist. Do you really believe that to be the case? Or perhaps you believe that some other superior means of meeting that need now exists?
Nah. The same need still exists. The market still serves its purpose. Its purpose was never to make me money or to fund my retirement. I, as an informed investor, took on risk. When Lehman had dropped more than 50% from its usual baseline I made the choice to risk a few thousand believing that the potential gain outweighed the potential risk. I lost that bet and I have no sour grapes. A swing and a miss. Other bets have paid off enough to offset that miss but even if my overall return was behind the indices and I was over the years losing, well, the market is still serving its purpose and I see no other mechanism that meets that need as well.
Now mind you today the markets serve other purposes as well. They provide a means for entities (companies, funds, individuals) across the world to invest in economies elsewhere in the world and thus to help form new economic equilibria. This purpose also is still being met.
Oversight? Better regulation? Yes. But companies folding, indices falling, funds collapsing, none of these are signs that the market isn’t serving its purpose. The market is doing what it should do - spreading the risk and reassessing the value in real time as information becomes available and based on individuals making reasoned assessments of how much risk they want to take for how much potential return and what they believe those odds actually are.
Thanks Scylla, very easy to read and understand post (and simplified for my benefit) I’ll sound like Cliff Clavin tomorrow at work when I try to regurgitate it 
Twenty-five. I started my IRA with $500 of AIG. 
Got out at $32 after losing 40% though. My $500 would be worth $20 right now had I not made the move. Now I’m just in an index fund. No muss, no fuss.
That’s bad, but not a huge loss. Good choice on the index fund. Besides, we’re both young (26 here.) My IRA right now is an asset allocation fund run by USAA that has a nice mix of stocks, bonds, and commodities, so I don’t think I’ve been hurt too bad in the short term. Of course, I’m down 12% and a couple hundred dollars YTD, but I’m still not too worried. I’m hoping, if I can actually get out of school and into a real job soon, that I’ll manage to get in close to the bottom of the housing market and start pumping up my IRA and (theoretical) 401k with more aggressive investing, though I think I will keep my asset allocation fund as a fairly large percentage.
Which is great, that is where you should be. One thing we do know is that recent poor returns will tend to make the future long term returns better. We also know that if an investor could choose when to have the bad years he would choose them all in the beginning.
Index funds suck. WIG is a component of both the Dow and S&P.
Financials and energy are going I be about 40% of your portfolio. By definition you will have the highest weightingss in the most overbought sectors.
So is down 17.35% ytd. Hardly admirable. Again, by definition index funds do poorly in bear markets.
The stock market may be “over” for the moment in terms of selling shares for more than the purchase price, which I would argue is the way most people view equity investment. However, the current rout is throwing up some great opportunities for people who buy shares for income (dividends) rather than capital gains, because stock prices and dividend yields move inversely. And a lower share price doesn’t automatically imply a dividend cut.
Indeed, just today during my lunch break I used some cash in my brokerage account to buy stock in oil company BP Plc, whose shares touched 650 pence in May and now are below 480 pence. The decline has driven the dividend yield up to almost 5.5%, which is terrific for that stock. BP’s share price may rise from here, or it may fall further - I don’t particularly care either way, as there’s almost no chance that the company would be unable to pay its dividend, and that’s cold hard cash going into my account four times a year.
Of course, one has to be careful, as companies in the worst-hit industries (banking and retailing, for example) have been cutting or eliminating dividends left and right. However, there’s a good reason for that - many of them are screwed. There are lots of companies out there, though, and the ones in my portfolio are still raising their dividends, some by quite a bit more than the rate of inflation, even though their share prices are lower.
By definition, index funds do whatever the market is doing.
and there’s no car better suited to ruling a gasoline scarce wasteland than a supercharged V-8 '73 Ford Falcon.
Everything I’ve ever read says that for 95%+ of investors, buying and holding index funds for the long haul is the best investment strategy. What’s your take?
shrug I’m having a hard time feeling sorry for those who are losing shirts right now in stocks. The phrase “buy low, sell high” is so shopworn as to be an outright cliche that can be quoted by even the most benighted investing troglodyte.
Yet when it’s time to put your money where your mouth is, what do you try to do? Follow the herd, buy high, sell higher, which often doesn’t work out as you expected.
I’m not going to pretend I’ve always been some sort of investing genius. I lost a lot in the dot-com boom. What I learned from that was to be extremely cautious during the boom times, and buy when everyone else is scared. I mostly sat out the last boom, keeping my powder dry, and I’m now just waiting until it seems like the herd can’t get any scared-er. I’m not going to tell you I know when the choice moment will be, but I don’t think it will be before spring of 2009.
So Scylla, the stock market is not a casino because the casino is regulated? What is your take on Cox’s approach here? Don’t you think his hands off approach is what doomed these institutions?
They suck.
They’re based on market cap, which means you tend to be buying the companies that have gone up the most and are most expensive and selling the ones that have gone down the most and are the cheapest.
Works fine in a bull market, not so much in a bear.
You want to buy low/sell high. You don’t do that in an index.
The stock market is not a casino because it isn’t a casino, period. Casinos employ machines that ensure that each round of betting is entirely probabilistic to ensure nobody has any advantage other than knowing the odds on a particular game or machine. Stocks are much more deterministic; investors have real information that can help them forecast a company’s performance. That doesn’t mean it’s risk-free… sometimes the information is not perfect and it is not timely, but it’s not based on probability the way a casino is.
That doesn’t mean that ignorant people don’t see it as a casino or try to play it that way. There are some bookmakers who take odds that Vladimir Putin is the Antichrist. If something has an uncertain outcome, people can and do bet on it. But that doesn’t bear whether the event is deterministic or probabilistic, just people’s capacity and desire to bet on it.
In short, if you think the stock market is a casino, you probably shouldn’t be participating in it or talking about it.