The New York Stock Exchange has been down a lot over the past couple of months. It’s down about fifteen percent from its high of just over 14,000. Many people are wondering why and how far it is going to fall. This is my attempt to explain why it has been falling.
Our story actually begins in the housing and sub-prime loan markets. As many of you know, mortgage companies don’t actually have the millions and millions of dollars they loan to homebuyers. What they do instead is make a loan, say for $250,000, and try to find some investor (generally a bank or some other financial entity) to buy the mortgage. The company serves as a middle man between the homebuyer and large financial institutions.
What has begun happening recently is firms have been buying large numbers of mortgages of all different sizes and interest rates and rolling them into one package, kind of like a mutual fund. They then began to sell shares of this “fund” to investors and investment banks. This has never been done before. People on Wall Street have never been able to buy shares in a mortgage security because mortgage securities didn’t exist.
Now investments are rated based upon their safety as an investment. For example, a triple AAA rating means that the stock or mutual fund you are buying is pretty safe and unlikely to fall far in value – wiping out your investment. It also means the return will probably not be as high as other investments. A single A rating means that the stock isn’t as safe as the triple AAA, but could potentially have a higher return.
Well the various companies that have created the rating system needed to rate these mortgage securities. In some cases they gave triple A ratings, in others double and single A ratings. Then the mortgage securities were marketed based on these ratings.
So like any bubble, there was far too much exuberance in the market for these funds and they were overpriced and overrated. That was one problem. The deeper problem, however, is that mortgage companies began making lots of bad loans (e.g. requiring no down payments from the people they were lending to, not checking credit history, proof of income, etc.) This was not a big problem until the housing market started to slump.
When the values of houses started falling, those people who had taken a $400,000 mortgage out on a $400,000 house found themselves with a $400,000 mortgage on a house that was now worth $350,000. Not a good place to be. So they just walked away (that means the bank foreclosed on their house.) But no one is in a good situation here. The bank is left with a house worth less than the loan it made and these people are down a home. There were a couple of other issues about variable interest rates that I won’t go into here. The point is that there was a huge increase in the number of people defaulting on their mortgage loans.
So big picture, these mortgage based securities that were being doled out like mutual funds, started collapsing. All of a sudden people began to realize that these securities were not as valuable as they had initially thought. So the price began to plummet. And to make things worse, no one really knows how to evaluate the worth of these securities. The fact that they are so new and the rates of defaults on loans are variable makes people afraid to purchase the securities; even after they have fallen substantially in price.
Here’s where it affects the credit market. Some of the chief buyers of these securities were giant investment banks, Merrill Lynch, Bear Stearns, Morgan Stanley, etc. The investment bankers at these firms made varying degrees of stupid decisions. At Bear Stearns, for example, the investment bankers bought the securities on margin, which means they were borrowing money against their current assets to buy more shares of the securities. Though always a risky idea, if your investments are good it’s not a problem. Once these securities started crashing though, the market froze. No one was willing to buy but everyone wanted to sell. So Bear Sterns went from having 800 billion dollars worth of securities in its investment branch to 300 billion dollars worth in a week or two (Note, these are not the literal numbers but they are characteristic of the idea). And, because they had bought on margin, they still owed the hundreds of billions of dollars they had borrowed.
This is why the market is unhappy. Hundreds of billions of dollars have just disappeared. These are not literal paper dollars, but electronic dollars in the credit market. This is one of the reasons why it is difficult to take out new loans. The Federal Reserve has stepped in to try and fix the problem, but that is a completely different story.
What does this mean? Well, credit markets are in turmoil. No one knows how to value these securities. A number of lending companies have gone bankrupt. These financial problems affect the economy by limiting business’s and individual’s ability to borrow money for various projects. Don’t panic, it’s not the end of the world. Give the market time to sort itself out. We tend to overly concerned about the immediate present rather than the future. So what if one quarter has slow growth, or even negative growth? There will be hardship for some people, but the market will come back if left unhindered by government intervention. Also, it will come back quicker if consumer’s had more confidence. Consumer confidence tends to be a self-fulfilling prophecy as to the performance of the market, at least in the short run. So be patient, things will get better.