Stock Market = PWND

Although this is usually a poker brog, it's really often a running summary of conversations between myserf and Brackchips. Rike everybody erse, we have been marveling at the spectacular decrine of stock prices in the last few weeks. There's no particular reason why readers should give two shits about what I have to say about this whole mess, but here it is anyway!! Feel free to read, comment, or ignore to your heart's content.


First of all I think that individual CEOs and financial deregulation have gotten a little too much blame for all this. There's no doubt they contributed, but the role that Fannie and Freddie, and the general policy of the federal government to promote home ownership, has really been swept under the rug. I assume this is because the creators of this policy can credibly claim to have had only the best of intentions, desiring to help lower income brackets build some wealth by buying into "the American dream" of owning a house. Meanwhile the CEOs and deregulators were presumably driven by desire for personal gain. Be that as it may, what started this entire debacle was large bets placed on the housing market, made by the financial sector as well as individuals purchasing homes with little or no money down. These bets were in large part possible because Fannie and Freddie, at the prodding of Congress, bought up huge amounts of these types of mortgages.

For a long time it has been the case that banks making loans do not actually assume the risk of the loan defaulting. They turn around and sell this mortgage to someone else. Sometimes that someone else then bundles together those mortgages and sells slices of them to investors. The result is that mortgage originators will make any loan they can later sell. If there were no market for sub-prime loans, there would have been no sub-prime loans made. And again, Fannie and Freddie's demand for these loans brought this market to the size that it ended up obtaining. So that's kind of part one of the story.

The second part is when real estate prices finally started coming down. The value of those mortgages came down, and foreclosure rates went up. This is still ongoing. The severity of this problem is in part due to U.S. mortgage default laws, which basically say that debtors can't go after an individual's other assets if they default on a home loan. This means that if you owe more money your house than it's worth, you might as well just turn in the keys and walk away. If your down payment was zero, this happens as soon as your home decreases from your purchase price.

The third part is that all the banks holding mortgages and mortgage-backed-securites (the "slices" I referred to earlier) lost a lot of money on these things. At least on paper. It's hard to put a value on what these assets are actually worth now, but everyone realizes that it's a lot less than what they're supposed to be worth. This has lead to some bank closures and sales, as well as a general distrust between the banks about each other's credit-worthiness. As a result banks don't want to lend to each other, and instead want to hoard cash to make sure they can cover whatever their eventual losses on mortgages turns out to be. This hoarding of cash means not only less lending between banks, but also less lending by banks to businesses and consumers, which threatens to bring the non-financial economy to a halt.

Next, some individual investors saw all the chaos and decided they'd just freak out and convert all their assets into cash-in-hand or gold. Some of this made a little bit of sense, as one money market fund actually did break the buck (i.e., accounts lost value) based on the Lehman failure, and mutual funds and hedge funds saw huge redemptions. Some of it, like taking cash out of FDIC-insured deposits, made zero sense. People, if you have a savings account worth under $250k, every bit is safe. You don't need to take any of it out. In classic liquidity-crisis fashion, these panics exacerbated the problem, as banks became even more cash-hungry as depositors withdrew funds, and equity prices fell, reducing the attractiveness of selling equity in exchange for capital.

The final part is the last week, in which the stock market went completely bananas. The valuations of many stocks right now, as measured by the price to earnings ratio, are just absurdly low because the prices have fallen so far. There is no doubt that those valuations are unsustainable and will correct over the coming months. The question is whether they'll correct by prices (the numerator) going up or earnings (the denominator) going down. For some stocks the ratios are just so low that prices must go up at least somewhat for the valuations to make any sense at all.

There's still some chance that credit markets will not recover for a long time and a very long, deep recession will result. The stock market has already priced in at least a pretty bad recession if not more. Personally I remain somewhat confident that the actions of the U.S. and other governments will get credit markets moving again. If that happens, stocks will respond positively. I don't know if we'll be back up to Dow 11,000 or 12,000 any time soon, but I do think the doomsday scenario of Dow 5,000 and a decade of slow to no growth can be averted.

I hope that whatever the government ends up doing will co-opt the private sector as much as possible. While it's better than nothing, I don't know if I like the government could do a good job picking winners and losers (e.g., who gets capital and who doesn't) all on its own. Some kind of scheme matching private investments would be better. Here is one such idea.

Anyway, I hope you guys haven't lost too much!!

-BRUECHIPS