Market Crashes and Recession of 2008 Explained

Market Crashes and Recession of 2008

Written by Tumelo Molwantwa

Monday morning 23rd may 2008 downtown Manhattan the chairman and longtime CEO of Lehman brothers investment bank Sir Richard Fauld calls his chief operating officer Joe Gregory to tell him that they are down 21% and he’s just lost 9 million dollars personally the events that followed thereafter have the makings of a Greek tragedy. After big mortgage holding banks like Bear sterns were bankrupted and sold to J.P Morgan chase for $2 a share with $30 billion dollars worth of toxic assets on their balance sheet and most of the big five investment banks on wall street having more or less the same on their balance sheet the monster has shown its head and its name is credit!

Bank after bank kept recording losses after investors lost confidence in American investment banks it triggered a sudden dramatic decline of stock prices across a significant cross section of the stock market. By definition a stock market crash. These events all seem so foreign so awkward and unbelievable in every way shape and form. But stock market crashes are more common than what you might think the only difference is the volume and the velocity to which it happens.

Stock market crashes are normally driven by panic as much as by underlying economic factors where a combination of crowd behavior and external economic events where selling by some market participants drives more market participants to sell. Generally stock market crashes happen under prolonged periods of rising stock prices and extensive economic optimism crashes are normally distinguished by double digit percentage loss in the stock market index over a period of several days.

The underlying mechanics of stock market crashes have their deep roots in statistical stochastic processes and mathematic chaos theory, chaos theory is a field of mathematics with applications in different disciplines including physics, economics and biology. Chaos theory tries to explain sudden movements or unexplainable movements within bounds. In statistics early assumptions about the stock markets were that stock market crashes follow a random log-normal distribution, Benoit Mandelbrot (mathematician) later proved this was wrong he suggested that crashes could be much better explained by non-linear analysis namely a levy flight RANDOM WALK. That is “random walk “in the sense that knowing the price of a stock today will not enable us to predict its price tomorrow, that is price behavior of stocks is essentially random, today’s price is equal to yesterday’s price plus a random shock. An example of a simple random walk model,

Where is the error term and the model is from time t=0 to t=1.

One of the most famous financial market crashes is wall street crash of 1929 the economy had been growing fluidly for most of the twenties during which innovations like the telephone, aviation, and power grids were developed and companies that specialized in making them profit soared, companies like general motors. The Dow Jones industrial average stood at a value of 63.9 by September 3, 1929 it had raised more than six fold to 381.2 it would not regain this level for another twenty-five years. On October 28 /29 the Dow Jones fell an average of 38 points to 260. Money managers had to keep in contact with their investors and Telephone lines and telegraphs were clogged and were unable to cope this lead to fear and panic and a huge sell off followed. By the end of November 11 1929 the index stood at 228 a cumulative drop of 40% from September in the coming months the market rallied but this was a false recovery as the crash was followed by the great depression.

So what could have lead to this horrific event, well one reason is what is known as circuit breakers or more commonly Trading curbs in the cash market these are un-correlated large trade strategies by brokers and traders that result in a halt in the derivatives market due to sell orders they dry up liquidity and make it difficult or even impossible to speculate on future prices and movements therefore making uncertainty the name of the game which drives away risk adverse investors which are typically the people with access to a large variety of investment capital.

Enough of the history lesson back to reality the 21st century more specifically 2008 did we not learn from the past, and from catastrophic events like the LTCM (Long-Term Capital Management) 1999 disaster where the inventors of the black-scholes options pricing formula PhD and Nobel laureates Myron s. scholes And Robert c. Merton lost nearly $4 billion in less than four months an dropped a record of half a billion dollars in a single day of trading because of there over leverage in the derivatives markets and because of their exposure to the Russian market made by complex mathematical models, there model black-scholes options pricing formula quickly became the norm and was used every day and continues to be used till this day this coupled with them starting their own hedge fund made them awfully wealthy billion dollar billionaires and rock stars in their own right this was the start of what I like to call the start of the party the 90’s

Soaring bonuses for traders, on Wall Street hot shot traders and brokers took home bonuses of $500 000 to $1 000000 a year everything was looking up this continued for a decade long the peak of this insanity was probably the summer of 2006 where hedge fund managers were calming enormous bonuses amounts like never before Louis Bacon taking home $400 million dollars that year, Bruce Kovner $800 million dollars, Steven Cohen who took an estimated $1 billion dollars home that year alone! But the guy who takes the cake is Edward Lambert who took home an estimated $ 1.5 billion dollars in summer of 2006 alone clearly this is an alarming statistic on the soul basis of this it’s clear that no one wanted it to end and everyone wanted to be a hedge fund manager and take home in one year what others can only dream of.

Needless to say this didn’t sit well with investment bank CEOs while they were taking home $3-10million dollars a year their counterparts were taking $30-50 million dollars home, this instilled a need within investment bank managers to take on enormous types of risks and entering into markets that were predominately labeled as risky before with not as much as a second thought and the vehicle of choice mortgage backed securities these provided the necessary financing to make unbelievable profits I mean who didn’t want a house?

I mean even if you were a caveman you wanted shelter and these banks were happy to do it! All they had to do is to get you to sing a thirty year contract at a prime interest rate of 12% then they would spin it off to some other investment bank in some other country and use an insurance company to cover their risk as long as credit markets were flowing and the housing market kept going up derivatives were open to speculation and champagne fell from the heavens along with gold plated rolls Royce phantoms the party was on, and the party was happening like a disco at midnight but like every party there is a time when that guy shows up and ruins it for everybody.

Unfortunately mortgage owners started to default on payments one after the other like dominos this triggered speculation into the housing market in a certain month more than 70 mortgage companies failed in America this was a resounding light switch saying the party is over! And the biggest of the big mortgage biased banks went bankrupt the likes of Bear sterns and Freddie n Fenny Mac this was an ideal situation to start a circuit breaker and it did panicked investors called for large sell off and withdrawals from major American investment banks.

Lehman Brothers was the first major American bank with foreign exposure to be hit severely it stock kept dropping through several months, the result on September 15 2008 was that Lehman was instructed to file for bankruptcy and allowed to fail by the US federal reserve. An investment bank of such exposure had never been allowed to fail by the American government, A day after investors all over the world wanted out of American investment firms this was going to be a largest removal of money from American capital markets in 500 years, so naturally speculation led to more speculation which led the markets to take further dives as the Dow fell continuously eventually credit markets froze and deposits were shrinking by the day on large investment banks like Goldman Sachs and Morgan Stanley and so forth.

Unfortunately the story gets even worse some insurers were also entice by the returns that big banks were making and they insured the banks risky mortgages all just so that they could claim billions of dollars in fees. Now the situation was going to be a global disaster AIG took enormous risks on their books hoping that the banks would never claim because of the same assumptions made by the banks the housing market will never go down. AIG with 81 million life insurance policies with a face value of 1.9 trillion dollars were now at risk obviously this was a company that could not be allowed to fail It was going to be the end of the world! This is how it was going to happen the mortgage interest rate goes up for someone who is repaying it he defaults on payments now banks have insured against this by taking the risk to insurers like AIG, mortgage -back securities starts to tank all of them all over the world at the same time! And AIG and other insurers have to pay back the swaps all of them at the same time well AIG and others can’t pay every back the insurer books records massive losses on the same day and then they go under as well and the whole financial system crashes!

Eventually the Federal Reserve was forced to intervene they bailed out AIG and other insurance companies as well as all 5 major American investment banks but this was not enough to unfreeze the credit markets so the federal reserve merged some commercial in America banks with the 5 major investment banks but this made these banks’ exposure and Americas exposure in the world financial market of mammoth proportions JP Morgan,City Group, Goldman Sachs and seven other major banks hold 77 % of Americas banking assets and have been declared too big to fail all of this to bail out money managers who took unnecessary risk in the market.

But this can make one wonder if big brother (depression) is really gone or has been avoided or is he just waiting for the most opportune time to join the party one thing is certain the future has a lot on uncertainty and credit is going to be the determining factor for anyone who wants to make money or finance any activates through financial markets its very evident that we have to learn and train ourselves how to manage and understand credit markets for future generations I leave you with this last thought – “in order for us to conquer the world we must first conquer ourselves”-Robert brown.