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01 October 2008

Can someone explain to me why the current stock market "crash" is so bad? Pictures inside.
≡ Click to see image ≡

OK - So I understand that there's been a bit of a dip, but if you look at that dip over the course of the last 80 years, it appears to be more of an adjustment than an actual dip. It seems nowhere near as extreme as the Wall Street crash. (far left) I fact the only thing worrying about the right hand side of this picture is the big steep rise in the last few years.

So why the big worries and the doom and gloom? What am I missing?
posted by seanyboy 01 October | 04:49
As for that chart, notice that the y-axis is a logarithmic scale, not linear.

As for the doomsday worries, I can understand it in those who own stock in banks that fail because their shares pretty much become worthless. As for everyone else, the reasons become more vague the further any particular group lies in relation to those banks.
posted by Ardiril 01 October | 04:58
I think the stock market fall and the credit crunch are two different things.

I think they're both overstated though.

The theory behind the credit crunch being an apocalypse is that the banks aren't able to borrow money from each other except at extortionate rates, since the lender is scared that they'll go bust.

Banks work by borrowing money and then re-lending it at higher rate of interest. So in turn, when the banks lend money to normal people and real get-stuff-done businesses, they'll also have to charge extortionate rates, or not lend at all.

So, the average guy trying to get a mortgage for a house suffers. The average businessman trying to borrow money to set up a second barber shop or whatever, also suffers.

So in theory, the banks' problems could hurt the rest of us too.
posted by TheophileEscargot 01 October | 05:11
The market regained two-thirds of its losses Tuesday, on the hopes that Congress will roll over now that Wall Street has given them a good scare.

As TE said, the credit crunch is actually probably going to be the bigger problem for most folks.
posted by BoringPostcards 01 October | 06:20
It dropped over 100 so far today, though.
I think the stock crash is a worry because:
1. many, many people work for publically traded companies, and stock prices crashing could mean layoffs. I know that's my concern, my company's stock dropped by a third in the last two weeks and has yet to recover. Our annual raises were already cut by a percent because of the economy, I suspect if we don't see some upwards movement on the stock some people won't be here in a month.

2. most US retirement plans are invested in the stock market, so when it loses we see very tangible results in dropping savings. This could be very bad if you're nearing the age to retire (or have immediate plans for the money, as I do), or just worrying. In any case, it's pretty nasty to check your 401K and see it's down 20% from the week before- even with the most recent deposit.
posted by kellydamnit 01 October | 08:43
It's dropped 100 this morning, but if previous days are anything to go by, it'll rise slowly over the rest of the day.

I'm guessing that the early-birds on the stock exchange sell a bunch of stock first thing in the morning, (causing the price to plummet), buy it back 2 hours later when the computers have stopped panicking, and then go to bed ready to do the same thing first thing tomorrow morning.
posted by seanyboy 01 October | 08:51
Investment banks in the US have, basically, made up money over the last several years to loan out. If they panic, or their bankrupcy-buyers panic, because the institutions need access to the money they claim they have (but don't), and they decide to start calling in those debts (which include things like small-business loans, mortgages, student loans, credit card debt, etc.), then pretty much everyone is screwed, because there are not actually enough US dollars in the world to cover what the banks have decided are their assets.

It's worse now than it has been in the past because the deregulation of banks has meant shitty, shady business practices (which means more bad loans and made-up money than in the past) and more interconnectedness of the banks (more loaning of shitty debt to each other), so that when one topples, they all start to teeter.

I liked this explanation on Bitch, Ph.D.
posted by occhiblu 01 October | 09:38
Ikkyu also pointed me to this Berkshire Hathaway shareholder letter written by Warren Buffet in 2002, that gets at the foundation of the whole mess:

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives. Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
posted by occhiblu 01 October | 09:46
More on credit derivatives, from a 2005 article:

According to Ramaswamy, it is unlikely that trouble related to a single company like Delphi will spill over to the broad markets, but he said it would be worrisome if a large number of companies ran into serious difficulties. And Rosen noted there is a lot of dry tinder on the forest floor -- a mushrooming issuance of low-rated, high-risk debt. "I will be shocked if we don't see a significant rise in default rates over the next 18 months," he said.

posted by occhiblu 01 October | 10:02
From my view, the credit market conditions have much more of an effect on the average person than the stock market does. It's just that the stock market is easier to measure and report on.

But here's a good real-life example of the problems created in the credit markets:

Finance Company A (FCA) is a private non-bank lender that finances small- and medium-sized businesses. Most of the loans that FCA makes are secured by working capital--mostly accounts receivable and inventory. FCA's borrowers aren't sterling credit-quality, but fast moving A/R and inventory generally is very safe. FCA generally lends between $2 and $20 million via revolving lines of credit.

Craft Materials Co (CMC) is a typical borrower. Revenues less than $100 million and coming off of two unprofitable years and a restructuring. CMC sells various crafts and art materials--it's three biggest customers are Michael's, Wal Mart and Jo-Ann's. It's too risky to lend to CMC directly (unsecured), so FCA arranges to advance funds against 80% of A/R (which is technically a liability of Wal Mart, for example) and 50% of inventory. Because companies like Michael's and Wal Mart generally take their sweet time paying bills, CMC needs FCA's money to make payroll and keep the lights on.

Because CMC is borrowing less than $20 million, it's inefficient for most large banks to take on this business. It requires a lot of people power to monitor all that collateral on a monthly or weekly basis. So the Bank of Americas and Citigroups of the world aren't interested even in normal economic conditions (though they do the same type of lending for larger companies). Smaller regional banks will do this sort of business, but those banks are now conserving capital due to losses taken from mortgages and construction loans, which have been their bread and butter.

FCA itself is financed by two large German banks, which together lend the company about $600 million. But now those German banks are getting beat up by the credit crunch--they've taken huge sub prime losses in the US and now European mortgages are taking a beating too. Banks don't trust one another right now, so the cost of securing overnight interbank loans has sky-rocketed or disappeared altogether. These overnight loans are necessary to keep up with regulatory deposit reserves. So the German banks are conserving their capital (or getting bailed out by various governments). It hasn't happened yet, but it's possible that the German banks pull their lines of credit from FCA.

FCA is scared that the German banks will pull out. So it has stopped making new loans. If the German banks do pull out, it will have to liquidate its current portfolio. So how will CMC and other small- and medium-businesses that rely on short-term working capital loans finance themselves? It's a mystery!
posted by mullacc 01 October | 10:20
stock prices crashing could mean layoffs

That doesn't follow. Even if all of the shareholders in a company decided to sell and the stock price dropped to zero, it'd have no immediate effect on the company's finances or its operations, because the company has long since sold those shares and their current market value is irrelevant, at least until the company wants to issue new shares.

(which of course it might, if it can't raise capital by borrowing from banks, so there is a longer term effect on the company's cashflow)
posted by cillit bang 01 October | 13:37
If there's insufficient liquidity in the commercial paper market, then that's like the gears not being oiled, right? Stuff starts locking up. But how is that not an opportunity for another financier to come along and assume that risk in hopes of a better return via a loan with a higher interest rate? Or do I misunderstand the whole thing?

I want to know why, if banks are hurting for money, they are paying such terrible rates for CDs. I mean, a CD is essentially me lending the bank money, right? They need money, I want to earn interest, but the return on CDs is less than the rate of inflation!

I just don't get it.

I'm gonna invest in sandwiches. Everyone likes delicious sandwiches.
posted by BitterOldPunk 01 October | 15:42
But how is that not an opportunity for another financier to come along and assume that risk in hopes of a better return via a loan with a higher interest rate?

If most banks are scared to loan money, then one bank loaning money (unless it's a looooooooooooot of money) doesn't change anything. If you make one small business (for instance) solvent, it doesn't *stay* solvent unless its customers and vendors also stay solvent.
posted by occhiblu 01 October | 16:44
This American Life's episode "The Big Pool of Money" really helped explain things for me. I'm pretty sure it's still available as a podcast/mp3 thing.

The short answer is that the economy -- meaning, jobs and decent standards of living for us working slobs -- only thrives when the wealthiest people and institutions on the face of the planet let other people play with their money, on the hopes that said playing will, in the long run, make them even more money.

When it turns out the people playing with their money (investment bankers, mortgage lenders, etc., in this case) are irresponsible and lose all of it, they teach the rest of the world (poor working slobs, and their middle managers) a lesson by refusing to let them play for a painfully long time. Mild versions of such reprimands are called recessions, and severe versions are called depressions. It seems like the rich people/institutions are currently undecided as to whether they're going to give us a mild or severe reprimand, but it's likely to be somewhere in the middle of the two.

If congress gives them a bailout, then us working slobs are basically apologizing for the mismanagement of the investment bankers/etc by paying for their collective stupidity with our hard-earned tax dollars. If congress doesn't bail them out, then the wealthiest people/institutions are much more likely to punish the whole lot of us by not letting anyone at all play with their money for quite a long time.

The performance of the stock market is really just a vague indication of how angry/happy the ultra-rich are, but it's the best one we've got -- so we watch it, and worry, and duck for cover when ever there's a sign that we're about to beaten senseless and sent to bed without supper, for god knows how long.
posted by treepour 02 October | 00:47
I'm gonna invest in sandwiches. Everyone likes delicious sandwiches.
Invest in tobacco and alcohol shares - no matter how bad the economy is, people will still find the money to drink and smoke.
posted by dg 03 October | 03:48
Subprime problems explained (SLYT) || Tivo surgery?