ok, here is what we know:
change from July 17-August 17, 2007
US Markets
DJIA: down 6%
S&P 500: down 6.5%
Energy sector: down 12%
Basic Materials sector: down 16%
Services sector: down 3%
Financial sector: down 9%
Technology sector: down 15%
UK
FTSE100: down 9%
Europe
DAX: down 7%
CAC40: down 11%
Asia:
Hang Seng: down 13%
Nikkei 225: down 15%
Well, that is a correction allrite. No arguments there. I will not give you more numbers about the layoffs announced this past week at mortgage arms of financial firms. You can read them everywhere. So amidst all this we kept hearing the following words over and over again:
-Liquidity
-Sub-prime
-Structured/Packaged products
-Fed discount rate
What do these things mean and how have they affected the recent market crash? Well, I have been reading up this past 2 weeks and based on that have tried to come up with a simplistic explanation for this mess. Let me give it a shot here.
I wish I could draw charts to explain this but darn it I do not have access to a Word-to-pdf converter software. So this has to do for now.
You and Bank A
-You (w/bad credit) buy a home you can't afford
-Bank A gladly gives you a loan, even maybe a low interest ARM to begin with
-Both you and Bank A are giddy
-You make your first few mortgage payments on time
Bank A --> IBanks -->Hedge Funds/Private Equity
-Bank A combines your loan with thousands of similar ones
-Bank A sells these loans as packages to IBanks (you dont need to know what package means)
-IBanks re-packages loans, say as a bond, and sells to investors (Hedge Funds, State Retirement funds, countries, whoever wants to take it on)
-You make mortgage payment--->Hedge funds etc get a coupon payment for the bond.
-Everybody giddy
Hedge Funds/Private Equity-->Bank B
-Hedge funds etc borrow money from Bank B to invest in these packages
-Since borrowing rates are so low, Hedge Funds/Private Equity also borrow money to buy companies. Think the sale of Chrysler.
-Bank B happy to let them borrow money as they know track record is good
-Remember, the most important that is still keeping everyone giddy is your mortgage payment
Following this so far? Ok, let's keep at it
Packages
-Remember those packages that were sold to the Hedge Funds and other investors
-Now, these packages have been arrived at via complex financial models using math
-Regardless, unlike your stock or a bond these packages are not traded on the market
-So? Well, if anything is not traded on the market, no one knows what the actual worth of it is.
-Unless someone tries to sell it.
-When you are making your mortgage payment and everything is rosy, these packages can be sold in the market and people will buy since they are getting a good return for this investment. So all is good as along as that mortgage check is being mailed.
Now, let's try to combine all this.
You-->Bank A-->IBanks-->Hedge Funds-->Bank B
-Well, you woke up and realized you dont have enough to pay the monthly mortgage payment
-uh oh! The shit hath hiteth the rofeth!
-Bank A now can't pay a return on investment to the IBanks and the IBanks to the Hedge Funds
-Hedge funds realize they can't show any return on investment to their rich clients
-Panic sets in! Angry clients want their money out of these investments.
-Hedge funds can't let them do it since the value of those packages will plummet.
-yeah, remember them packages? Once you can't sell them you do not know how much they are worth.
-Now, Bank B also realizes that these Hedge Funds/Private equity types are not in good shape, hence stops issuing any further loans.
-No loans for not only this but also for other private equity buyouts. uh oh!
well, that is how a liquidity crunch comes about (a simplified explanation). No more money can be borrowed to be invested. This is where the ECB in Europe and the Fed in the US stepped in to pump some liquidity into the market.
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2 comments:
The subprime market is not the only problem, not only people could not afford the house, but added to that, the price of the house was not based on true value but in speculation. Therefore, once the loans start defaulting the banks or whoever holds the bond is not even able to obtain the full value of the property that was lended to the original borrower. Nice huh? IN other words, the bonds are somewhat worthless or only worth perhaps 70% of their original issue price. ( here comes the smart investor who would buy these bonds in the under the table market for $0.20 of the dollar and sit on them for 20 years or until things have calmed down and he can get let's say... $0.50 of the dollar) Basically, the private investor who has cash wins. Example George Soros.
The other assumptions are somewhat correct, however Bank A has saved himself from any defaults on the mortgages by selling them in packages. However they are at the mercy of Wall st to obtain money for new loans. So if Wall st does not get investors, new loans are scarcer. Every time Bank A sells his loans in packages is recovering his original investment and thus lending it again to other folks.
Now, loans I believe are traded in other markets as bonds, not precisely as stock, however it does affect the market indirectly through the companies who hold them, wachovia, Hartford, etc, etc. And the best part! We invest our retirement money on these games! Lovely.
The problem comes when investors try to get liquidity from their bonds whose loans are defaulting, the houses can not be instantly sold and even if they were, their price is not enought to even cover the original issue price, let alone produce some return.
Thus, this demonstrates inestability, investors pull out as much as they can, and consumer confidence plumets to the floor. Now, many American companies borrow most of the money they use for daily expenses, such as new hires, new equipment, etc, etc. Counting on the strenght of the economy, but when consumer confidence has plumeted people wait and spending gets tight.
Tight spending reflects on poor sales, poor sales affect the ability of companies to borrow more money to grow the economy and produce.
No production, less jobs. Bad quarterly reports mean even more loss of investor confidence.
And all of this brought to you by courtesy of Wall st. who coincidently are the only ones making lots of money out of all of this and not matter what :)
I once heard that to understand the stock market you had to understand and learn to play monopoly very well. I thought it was ridiculous at the time but it was very true. If you can understand the concept of "Imaginary money" you can imagine ways to make money in Wall st that other wise would not exist :) Money is imaginary in Wall st.
Crazy huh?
Oh! and I forgot to mention the wonders banks, investors and Financial companies can do with a magic word called "leverage".
Thanks to today technology that makes funds and money transfers available almost immediately. Today we can also purchase things with money we do not even have, all we need it is a minimal amount perhaps 1% of the purchase price.
Thus, many bonds or stock was purchased with money that did not even exist.
One clear example " Forex" markets.
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