Similarities Between the 2010 and 1997 Market Crashes

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


My blog post on May 4th mentioned the stock market was rolling over and on May 5th, I made the comparison between the problems in Europe today with those of Asia in 1997. I specifically pointed out that the Dow Jones Industrial Average had a one-day 7% drop because of the Asian crisis. The next day, the Dow was down 9.9% intraday on the current European crisis.

The Asian crisis in 1997, frequently referred to as the Asian contagion because it eventually spread from country to country, started with a currency crisis in Thailand. It soon engulfed most of East and South Asia. While Thailand's economy was small, it had been vibrant for many years. Its currency was overvalued though and this is where the problem began. Few people would characterize Greece as having a vibrant economy at the moment, though it is certainly represents a very minor part of overall eurozone economic activity. As the Asian situation in 1997 demonstrated, problems that show up in small countries can easily spread throughout an entire region and have global consequences.

So what did the EU leadership do? Despite this recent historical lesson, they decided to continually postpone dealing with the situation in Greece. Not surprisingly, contagion began to spread to the other PIIGS countries (Portugal, Ireland, Italy, and Spain), the euro tanked and this in now endangering the export based economies of currency union, and finally, world markets have sold off. Fortunately, EU authorities weren't faced with an outbreak of bubonic plague - otherwise we'd all be dead.

The U.S. stock market drop in 1997 mostly took place on October 27th.  The Dow Jones Industrial Average closed at 7715 on Friday the 24th. It then dropped 554 points on Monday, closing just off its low for the day. The loss was 7.2%. The bottom wasn't hit until intraday on the 28th however. At the low, the Dow had lost another 225 points and was trading at 6936. From top to bottom, the index was down 10.1% in a little over a day. On Thursday, May 6, 2010, the Dow at its intraday low was down 9.9% from the previous day's close. So far at least, the percent of the two drops is almost identical.

The 200-day moving average was an important barrier in 1997 and probably will be so in 2010 (at least for now).  The markets were trading way above the 200-day before the drop in 1997, as they have been recently. There was some piercing of the 200-day both times. It could happen again in the next few days, but the 200-day should be considered an important support level that the market will try to hold or return to quickly on a break.

The VIX, the volatility indicator, spiked into the high 40's in 1997. In 2010, it rose to 42.14. While the highs are somewhat different, the rallies of the VIX in both cases are very similar. In October 1997, the VIX had been slowly rising for almost two years from a low of around 10 and was trading around the 20 level. The low of 15.23 in 2010 was hit in early April. The VIX rose approximately 47 points from its value a few weeks earlier during both crashes.

The important question now of course is what is going to happen. The markets recovered rapidly in 1997, but this was during a long-term secular bull market. We are now in a low-term secular bear market and such buoyancy can't be assumed. The 1997 crash was not the end of the market's problems either. Regional financial crisis after all can easily cause problems for a couple of years. A deep, but short, bear market followed in August 1998 caused by the collapse of Long-Term Capital. Central banks reacted by pumping liquidity into the financial system and the tech stock blow-off followed. If they do that this time, and they most certainly will, expect a commodities blow-off instead.

Disclosure: None relevant.

Daryl Montgomery
Organizer, New York Investing meetup
 http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

New Homes Reveal Old Problems With Government Statistics

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

The U.S. New Home Sales report released on December 23rd indicated a drop of 11.3% in November. Analysts had expected a gain. According to the previous Commerce Department reports, new homes sales had risen every month since April. They were expected to rise again in November because a government tax credit for new home buyers was originally scheduled to end in the beginning of the month (it was extended to June 2010), so analysts had assumed that there would be a rush of last minute buyers. There may have been and without them the drop might have been much greater than 11%.

New Home Sales is almost certainly the most inaccurate of the economic reports issued by the U.S. government. I can say this with some certainty because it would be almost impossible to produce something more error ridden. One of the major news services stated in their coverage of the November report, "Government statisticians have low confidence in the monthly report, which is subject to large revisions and large sampling and other statistical errors. In most months the government isn't sure whether sales rose or fell." Read that last sentence again and then consider that if the U.S. government is willing to issue an official report on housing that is about as accurate as picking numbers randomly out of a hat, how much can you trust the GDP, CPI, PPI (the two major inflation reports) and Non-Farms Payroll reports. Also note that the mainstream financial media seems to be well aware of the lack of reliability, but doesn't mention it except on very rare occasions when the news is particularly bad.

If the New Homes Sales report is so prone to inaccuracy why not just fix the problem? This is indeed a good question. The statistical tools to make this report better have been known for decades and yet the U.S. Commerce department doesn't seem to be able to apply them. It can be assumed that this isn't done because they don't want to do it. Statistically sloppy work is extremely prone to manipulation after all, solidly done work is not.

When confronted with this problem, you will get a more accurate picture of what is taking place by looking at many months of data in aggregate and comparing it to the previous year (the errors will cancel out at least to some extent). In the first 11 months of 2009, new home sales are down 24% from the first 11 months in 2008. Inventories have been falling throughout 2009 and are now at 38 year lows. The number of homes under construction or planned for construction have fallen to a record low. If new home sales were rising between April to October as the Commerce Department reported, why are home builders building fewer and fewer homes? That doesn't look like an industry in recovery as the public has been repeatedly told. For some reason, we seem to have gotten a glimpse of the true state of the housing market in the November New Home Sales report. Perhaps the guy in charge of producing cheerful statistics was on vacation? Somehow, I'm sure he'll be back soon.

Disclosure: Not relevant.

NEXT: Investing Themes for the Next Decade

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Exposing Fannie Mae and Freddie Mac - The Government Takeover

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video for this posting can be found at: TBA

It took only about six weeks after congress passed a bailout package before the U.S. government had to take direct control of Fannie Mae and Freddie Mac. The terms of the bailout package were open ended and extremely generous at Treasury Secretary Paulson's insistence. He claimed that if it was made obvious that the full financial power of the United States government was behind Fannie and Freddie, the need to take any action would be minimized (despite the fact that is was universally agreed that Freddie was insolvent and would therefore need continual cash infusions to keep operating). The Congressional Budget Office backed up Paulson by estimating that there was a greater than a 50% chance that the bailout would cost nothing.

On September 7th, the U.S. government seized Fannie Mae and Freddie Mac, firing their top management and taking direct control of their operations. The Treasury department announced almost immediately that it would initially be pumping $200 billion into the two companies (so much for the bailout costing taxpayers nothing). Auditors who had been examining Freddie and Fannie's books found that Freddie had made accounting decisions that pushed losses into the future and postponed a capital shortfall until the fourth quarter of 2008, which it wouldn't have had to disclose until early 2009. Fannie Mae had used similar methods, but to a lesser degree. Both companies needed capital and a lot of it to keep operating. One wondered how many U.S. banks and brokers were doing similar things with their books, but the public didn't know about it because there were no outside auditors to tell them.

With the government takeover, Fannie and Freddie's over $5 trillion in debt would now reasonably have to be added to the official U.S. national debt figures. Adding Fannie and Freddie's total debt to the national debt would increase it to between $14 or $15 trillion or roughly the size of the official GDP figures (the actual GDP figures were much lower than those claimed by the government and the actual national debt, including social security, medicare and medicaid entitlements was somewhere around 50 to 60 trillion dollars). Ironically, the idea of privatizing Fannie Mae was conceived of in the 1960s during the Johnson administration to get its debt off the government's books.

The government bailout was intended to support Fannie and Freddie's bonds, many of which were held by foreign governments including China and Russia. U.S. banks and thrifts also held an estimated $1 trillion of this debt. If Fannie and Freddie defaulted on their bonds, the U.S. would have had great difficulty ever borrowing again from foreign sources and both our government and economy would wind up seizing up almost immediately. A number of U.S. banks would likely have gone under soon thereafter as well in the event of a bond default. While bonds holders got bailed out, the stockholders were wiped out. This included U.S. pension funds, most of whom were major holders of Fannie Mae and Freddie Mac stock.

Fannie and Freddie were by far the largest bailout in U.S. financial history. Where would the already debt ridden U.S. government get the money to pay for it? If it couldn't borrow the money, which was indeed likely, it would have to print it. Only time would tell how much inflation this would cause and how much value the U.S dollar would lose as a result .

NEXT: Probable Future Outlook for the United States

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Exposing Fannie Mae and Freddie Mac - The Bailout

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video for this posting can be found at: http://www.youtube.com/watch?v=Q8XU5XhwdyY..

In mid-July 2008, Fannie and Freddie's stock prices were plummeting, with Freddies stock getting into the low single digits. Knowing that they had to do something right away, the Federal Reserve and Treasury department announced emergency measures to rescue the two companies. First, the Fed opened its discount window to Fannie and Freddie, something that had only been available to commercial banks for more than seven decades until broker-dealers also got access to the Fed in March 2008 (it was clear that the expansion of this privilege to more and more industries was a trend in the making). Secondly, the Treasury department went to Congress with a bailout plan. Secretary Paulson asked for a blank check from the U.S. government on behalf of Fannie and Freddie on the grounds that just having such strong financial backing would prevent their problems from getting worse. In less than two months the U.S. government would be forced to take direct control of both institutions, indicating that this was either one of biggest lies or most imbecilic statements in U.S. financial history.

The U.S. congress passed the 'Federal Housing and Economic Recovery Act of 2008' in late July. In the bill, Paulson got the blank check he requested, at least until the end of 2009. Provisions were also made to give up to 400,000 homeowners lower fixed-rate interest rates loans and an additional $3.9 billion was allocated for neighborhood grants (which seemed to be some pork barrel provision). The bill also established a new regulator for Fannie and Freddie to replace OFHEO. There was nothing wrong per se with OFHEO's regulation, other than every time it tried to control Fannie or Freddie, powerful politicians stepped in to prevent it. Of course, the politicians responsible for creating the Fannie and Freddie mess were not going to put the blame on themselves, but tried to make OFHEO the fall guy instead.

Without question, the most outrageous part of the bailout bill was its cost estimate. The Congressional Budget Office (CBO) predicted it would cost only $25 billion (the same as the cost they predicted for the Iraq War, now estimated by a recent outside study to be over 100 times higher at $3.2 trillion). The CBO even made the preposterous statement that there was a greater than 50% chance the bailout would cost U.S. taxpayers nothing. What thinking, or lack thereof, led to this conclusion is not clear. Since everyone agreed that Freddie Mac was insolvent, by definition it would have to have money pumped into it to keep it operating. So from the beginning there was a zero percent chance that the bailout would cost nothing.

There is certainly evidence that Congress itself had a more realistic assessment of the potential bailout costs. As part of the rescue package, they raised the national debt ceiling $800 billion (the sixth time the national debt ceiling was raised during the Bush administration) to $10.6 trillion. If the bailout was going to cost only $25 billion, there was no need for a higher debt ceiling. Clearly the cost estimates were meant for a gullible public, not Washington insiders who knew the truth. It was the New York Investing meetup's opinion that the Fannie Mae and Freddie Mac bailout would cost U.S. taxpayers at least a trillion dollars - and even that might be an optimistic projection.

NEXT: Exposing Fannie Mae and Freddie Mac - Future Risks

Daryl Montgomery.
Organizer, New York Investing meetup.
http://investing.meetup.com/21.

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Exposing Fannie Mae and Freddie Mac - Subprime Crisis

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video for this posting can be found at: http://www.youtube.com/watch?v=pQjgEAMa5SA.

By August 2007, it became clear that the U.S. housing market was in trouble. Banks and brokers were starting to face massive write downs for all the irresponsible home loans they had been granting for the previous several years and this was causing available mortgage money to dry up. Federal government officials, including President Bush, the Treasury Secretary Henry Paulson, the Fed chair Ben Bernanke, the head of the Senate Finance committee Chris Dodd and his counterpart in the House Barney Frank, unanimously supported using government backed Fannie Mae and Freddie Mac to help prop up the faltering mortgage market. While this was done purportedly to help struggling home buyers, it was in reality an attempt to help the U.S. banking system. The likelihood that the U.S. taxpayer would be stuck with one huge bill because of these actions didn't seem to have been considered - and if it was, no federal official or representative seems to have been bothered by it.

Fannie and Freddie were encouraged to buy dicier loans, particularly Alt-A. Even some subprime loans started showing up on their books. Together these loans accounted for as much as 20% of the total debt they backed by the first half of 2008. A similar percentage of loans on their books were for over 80% of the original home price and since housing prices were falling, this percentage for actual home value was not only much higher, but growing rapidly. Caps on the size of a mortgage that Fannie could handle were raised substantially at that time to over $700,000. These actions along with the diminished role of banks in mortgage lending wound up creating a de facto nationalization (the de jure nationalization would come later) of the American mortgage market. In the last half of 2007, Fannie and Freddie backed 90% of mortgages in the United States and 81% in first half of 2008.

As a consequence of government policies, the condition of these already financially weakened and corruption plagued companies deteriorated even further. The leverage, calculated as liabilities divided by shareholder equity, that Fannie Mae was utilizing rose to an eye popping 78 to 1, more than double the 33 to 1 leverage that caused Bear Stearns to implode overnight. This huge leverage was made possible with the complicity of Fannie and Freddie's regulator (OFHEO) who kept lowering the capital surplus requirements the companies needed to maintain, first from 30% to 20% and then to 15%. This allowed Fannie and Freddie to continually state to the press that they had much more capital on hand than the minimum amount set by their regulator and thereby imply that they were in a sound financial state, even though they were not.

In fact, by the first quarter of 2008, Freddie's liabilities exceeded it assets by $5.2 billion. Based on the basic principles of accounting, it was an insolvent company. While this information was public, other than the New York Investing meetup, few seemed to notice this obvious fact. Only when a former Fed official made a public statement pointing out that the emperor had no clothes in July 2008, did the problems with Fannie Mae and Freddie Mac suddenly receive major press and government attention.

NEXT: Exposing Fannie Mae and Freddie Mac - The Bailout

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

Exposing Fannie Mae and Freddie Mac - Origins

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.


Our video for this posting can be found at: http://www.youtube.com/watch?v=Ennn4Qq8MUY.

After the market close on September 4th, 2008, it was announced that the U.S. government would likely be taking over mortage giants Fannie Mae and Freddie Mac in what would be the biggest financial bailout in U.S. history. Congress had already passed a bailout bill a month earlier making this action possible. The New York Investing meetup had already predicted that the need for the bailout the previous fall. This topic was raised in the December 2007 meeting and in the April 2008 meeting, Fannie Mae and Freddie Mac were on our list of the dirtiest dozen financial companies.

The origins of Fannie and Freddie were innocent enough and didn't presage their ultimate blowup many years later. New Deal mortage progams actually started with the FHA, which was created in 1934 to insure mortgages that had less than a 20% down payment (most mortgages in the 1920s had much higher down payments). Fannie Mae was then established in 1938 to buy FHA mortgages, creating a secondary mortgage market. For the first 30 years of its existence Fannie Mae had limited impact on the U.S. housing market because it had acess to little credit and significant restrictions on the size and type of mortage it could back. All of that changed around 1970 however.

That year, the U.S. government ranamed the existing Fannie Mae, Ginnie Mae, and then created a new Fannie Mae that would be a quasi-govenment backed company that could purchase riskier mortgages (Fannie's charter allowed it buy even 100% mortages as long as the amount over 80% was insured). The reason for making Fannie Mae a publicly traded company was the government wanted to provide expanded mortgage services, but didn't want the debt on its own books. In tandem with Fannie Mae's creation, Freddie Mac was also created as a GSE (government supported enterprise). Its purpose was to package mortgages into bonds, known as mortgage backed securities (MBSs) and sell them to investors thereby recycling the capital available for mortages. Freddie didn't become a fully traded public company until 1989.

The scope and extent of Fannie's operations expanded greatly in the 1980s and 90s. In 1978, Fannie was allowed to back mortgages for multifamily dwellings. In 1981, it added adjustable rate mortgages to its operations and in 1983, even riskier second mortgages. At the same time, the maximum amount of a mortgage that Fannie could back was also rising going from
$108,300 in 1980 t0 $252,700 in 2000. After 2000, this amount increased at a much faster clip, reaching $417,000 in 2006 and $730,000 for awhile in 2008. By raising the mortgage caps repeatedly, the U.S government created a bubble feedback loop that made the U.S. housing bubble possible - housing prices went up; the amount of a mortgages that could be gotten by a homebuyer went up; housing prices went up again; and the amount of a available mortgage went up again and so on and so on.

Between 2001 and 2007 alone, the amount of mortgages backed by Fannie Mae went from 2.5 trillion to $5.0 trillion. U.S. housing prices approximately doubled as well during this same period. Most amazingly, all of this took place even though one of Fannie and Freddie's major purposes was to increase home ownership for the poor. Acting to constantly support higher and higher U.S. housing prices didn't seem to be a particularly efficacious approach to accomplishing this goal.

NEXT: Exposing Fannie Mae and Freddie Mac - Corruption

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21