Well, folks, we did it. On October 9, 2007, the Dow Jones Industrial Average hit 14,198 points. Today, on October 8, 2008, 365 days later, the DJIA hit 9,194 points. 5,000 points, or a 35.2% loss, over 365 days. On average, it only lost 13.6986 points per day for 365 days.
However, just since May 19, 2008, the DJIA has dropped from 13170.97 to its present position. And on September 19, 2008, the DJIA hit 11628.63. So the DJIA dropped almost 2500 points in 13 trading days, or an average of almost 200 points per day.
More telling than the decline of the DJIA, however, is the decline of the S&P 500. While the DJIA is the sexy, most known index, the S&P 500 is a broader index that more accurately tracks trends and the economy. The S&P closed today at 984.94. If the S&P hits 967, which at this rate it will by Friday, the S&P will have lost 50% of its inflation adjusted value since 2000, when the S&P hit its high.
One of the troublesome ideas behind these numbers is that they are occurring while the "fundamentals of the economy are still strong." True, there is a lot of fear, both justified and unjustified, in the marketplace. One of the huge problems with the market, however, is the complete overvaluation of stocks for many years. That, however, is just one of the many problems.
The fun word a few weeks and months ago was "speculation." Some in power believed that if we stopped the short term speculation, both the short and long term outcome of the markets would be viewed in a completely different light. So we, along with other countries, banned short selling of some stocks and instituted other control measures that would theoretically help liquidity in some companies and industries. Very few people wanted to admit, however, that we were, and still are, in financial trouble.
What are some other factors that have contributed to the decline of the markets? The obvious ones are the bursting of the housing bubble, which helped precipitate the sub-prime mortgage crisis as well as the personal and corporate credit crunches. Housing and building were propping this economy up for a few years, similar to the tech bubble of the late 1990s. But you can only build so many houses and have people with good credit occupy those houses. In order to truly fill all the houses being built, everybody had to be able to purchase a house. That is where the sub-prime loans came into play.
And theoretically, it was a good gamble. See, if we loaned money to people at a sub-prime rate for a few years and then had them facing a balloon payment, the natural result is that people will move every few years to avoid the balloon payment. In other words, I buy a house in 2002 for $175,000 with a sub-prime loan. The reason the bank lends me money is their belief that the resale value of the home will greatly appreciate over time. I make low payments on my home until 2006, when the balloon payment is due. Now, I only make $40,000 per year, so I cannot afford the $25,000 balloon payment the bank seeks. So I put my home on the market. By this point, since I bought a home in a new suburb, the resale value of my home has increased to $250,000. I sell my home, make the payment, buy a new home with a new sub-prime loan, and expect to be able to sell my home in 2009 or so at a premium.
However, there are limits to both the amount of people who will move into an area and buy homes, and the amount of jobs available in any given area at any given time. When other parts of the economy begin to slow down, people start getting laid off. Their income decreases to unacceptable levels and they are no longer able to make payments on items like their house, car, furniture, etc. So they put their homes up for sale. Except when these homes sell, the sellers take the money and do not move into a new home. Now there are excess homes in the market. Supply now exceeds demand, which starts driving prices down. As prices keep declining and more people are removed from the workplace or are underemployed, the number of uninhabited dwellings increases exponentially, while the sellers cannot sell their investment homes for even a fraction of their initial outlay of money. The banks start foreclosing on people's homes and driving them out. Now the banks own homes that cannot be sold: they are receiving absolutely zero Return on Investment. The loans they made are now worthless.
This is where it gets tricky, and part that I do not understand all that well. An underground trading market developed for these mortgages and other loans. The riskier a loan, the cheaper a company could purchase the loan. If you purchase a loan on the cheap, you do not need to collect as much on it to break even or make a profit. So financial institutions would purchase these junk loans for pennies on the dollar. When collection time came, they only needed a couple of borrowers to actually repay the full amount in order to make a profit. Put that together with the money the lenders made by selling some of their own loans and they could show a large gain in Accounts Receivable for only a nominal outlay of cash. This helped inflate the value of the companies by making it appear that the companies would have a steady flow of income for the next few years simply by collecting these junk loan payments. Again, this worked fine in theory as long as people kept buying and trading houses. If the economy did not sour, people could keep making payments by trading houses. As we already discussed, however, you can only build so many houses before a glut of houses causes the market to deteriorate.
So where are we at this point in the discussion? The collapse of Bear Stearns and the investment banking structure of the United States. Bear Stearns heavily invested in these junk loans in addition to making some other poor decisions. I am not familiar enough with all the details of Bear Stearns finances to delve deeper in depth here. However, because the economy took a downturn, people stopped paying their loans since they didn't have either jobs or money. B.S. and the other banks, investment banks, and financial institutions had a choice: they could either write down the value of their investments or wait for the money to simply dry up. The majority of companies opted to write down their investments in order to show a more accurate picture of the amount of money they actually possessed and the amount they actually expected to receive on the loan repayments.
One problem with this, however, is that it wiped billions of dollars of capital from the companies. When a company is worth $15 billion one day and the next day it is not worth even half as much, it spooks ordinary people, not just investors. So people start pulling their money out. B.S. and the other investment banks ended up facing atypical bank runs. People started pulling their money out of the banks while nobody put money back in. All of a sudden the companies had no capital and no cash reserves. The only options were liquidation or government intervention.
Investors, politicians, and the general public fear large scale liquidations. When a stalwart of industry is about to collapse, it initiates economic panic. Moreover, liquidation hurts more than the individual company that is on the verge of collapse. For instance, where did the company receive their financing? Who backs up the company's loans? Who backs up those guarantees? Who will end up paying for the mess?
Had B.S. been allowed to collapse, the fear was that it would cause a global financial meltdown. Here is why: B.S. collapses. B.S.'s investors, the largest of which are institutional investors, now lose billions of dollars of investments. But that is not all. Insurance carriers backed the loans B.S. took on from individuals. Those loans are now worthless and the insurance company is out billions of dollars. The reinsurance industry, the people who insure the insurance agencies (or where the real money is), now faces a liquidity crunch. They are forced to start calling in capital in the form of loans or debt. The pressure on these companies could cause one of them to collapse. If a major insurance or reinsurance carrier collapses, millions of people worldwide are affected, but so are the majority of major corporations. Now they have no insurance coverage for their loans and other assets. Nor can they receive any new financing. That was the feared domino effect.
However, even government intervention may not be enough to stave off a panic when the perfect storm hits. That is what we have occurring right now. People have little money so they cannot buy consumer goods, much less homes (reports are that the economy and jobs actually shrunk by as much as 3.5% in September, while initial projections called for up to 2.5% growth). That is why you are seeing stocks of grocery stores and supermarkets do well while stocks of restaurants and retail stores are taking a nose dive. People are buying the basics only.
Moreover, there is widespread belief that the government does not know how to bring the economy out of this mess. This fear started with the panic bailout of B.S. orchestrated by the New York Fed. Strangely, that has led to something rarely seen in the West recently: governments investing in corporations to keep their liquidity. In other words, some financial institutions are becoming partially nationalized (re: Britain's move to purchase large amounts of bank shares on the heels of the failure of the Royal Bank of Scotland; or, it can even be argued that the government loan to AIG smells a bit like nationalization).
What it boils down to for now, though, is the days of freewheeling spending, for both individuals and corporations, are dwindling. No longer will people or companies be able to borrow large sums of money, because that money no longer exists in the market.
So what caused this mess? All kinds of things. Hell, you can probably trace the roots of it back to the 1980s and the Savings and Loan scandal. I for one cannot tell you how this mess started. To move forward, though, that is what we need. We need to look back and see where this all went wrong. Was it lack of government regulation? Is it simply a normal business cycle? Perhaps the theory of free market economics has some gross flaws in it, as President Bush suggested in a speech (he said something to the effect of "For years the free market has allowed the economy to run smoothly, but now we are seeing that might not be the case."). Whatever the causes, we must find them before we can move forward. Blaming other people is great fun, but it does not get you anywhere. This Administration certainly could have handled the economic situation better, but same goes for Clinton. And Bush Sr. And Reagan. And definitely Carter and Ford. So don't worry, there will be plenty of blame to spread around.
What we need now are solutions, though. We need to find people to pull their heads out of their butts long enough to research this information and report back on individual causes. Once we have the causes, it is a whole lot easier to come up with a comprehensive solution. The nearly $1 trillion dollars of bailout money the government has approved is simply a Band-Aid. It means nothing if we do not learn from this process and figure out how to stop this kind of thing from happening again in the future. But good luck finding that kind of forethought in Washington these days.
Two other concerns: while employment numbers technically rose in the past, those numbers were all menial jobs at low base salaries. Moreover, the percentage of people receiving under the table income has increased to around 10% recently. Which brings us to taxes and spending. Whichever idiots think we can reduce taxes enough that we can spend our way out of this crisis have not been paying attention. Excessive spending is one of the main catalysts behind this mess! Plus, if we give people more money now, they are not going to invest it. If they invest it, it will simply lose value. They will save it and remove the currency from the economy, furthering the decline.
On the other hand, the government sure as hell cannot spend its way out of this mess either. Again, what got us in trouble in the first place? Excessive spending by individuals, corporations, and government. What we need is a much better balance. Cut spending and increase taxes. To paraphrase Tom Friedman, it sure isn't patriotic to pay less taxes. Especially considering the cost of defense, education, and health. It is patriotic to pay taxes and help move the country forward. This isn't calling for radical increases, but slight increases in some areas. It also means that if you can't afford something, don't spend your damn money on it! Again, the Republicans and Democrats (from now on both parties combined shall be called the Kleptocrats) are both to blame.
Anyway, really this is about me ranting. I think it is a pretty good rant at that. It has length, details, ideas, and a general plan about finding a solution. Sorry for taking up so much time and space, but hope you enjoyed the read.
And the DJIA should theoretically settle in the 9,200-9,500 point range eventually.
One last interesting point. Even though the DJIA and S&P 500 are tanking, people are still investing in American currency. The dollar is still seen as the pillar of stability and has been steadily gaining ground against the Euro and most other key currencies other than the Yen. I find that interesting, anyway.
"I have always imagined that Paradise will be a kind of library."