Wednesday, August 08, 2007

Notes on a "Free Market" and The Great Bail-Out

Longtime readers know that one of my pastimes is losing money in the stock market.
Oh, sure, I try to do what I think will make money, but this typically generates the opposite effect, i.e. a losing trade. It's tempting to do the opposite of what one's analysis suggests, i.e. bet on a rising market, but I can't quite bring myself to jump off this cliff.

Astute reader Zeus Y. succinctly summarizes what many of us are sensing:

"I have a strong intuition that October will be the gold-to-lead month as it was in the Great Depression and in the 1987 crash. People sleep through the summer, re-enter in September and will be hit by some cold realities. It just makes sense historically. But on a national and local level too, many people are putting up September as “decision” time (i.e. Whether the surge is working in Iraq or my own disassociation from some institutions I’ve been spending way too much of my time trying to help carry in financial and non-financial ways), which means that October is likely to be “consequence” time. All Hallow’s Eve indeed. It’s going to be interesting."

Frequent contributor Fastwater had these thoughts on the extraordinary precariousness of the U.S. economy:

"It's worth reading this blog entry. The author is writing *specifically* about CDPO's. But I think that the general idea applies as well to the entire range of credit derivatives: Sigma Happens.

This is what I've been thinking, but not able to articulate. We are in the middle of a 3-sigma event, but nobody seems to notice that we are in the middle of an unusual event. No, instead this 3-sigma environment has been wrongly perceived as 'it's different this time'. It looks like that misperception is being 'repriced'.

Or, by analogy, rating models -- by assuming there will *never* be higher default rates -- are wayyyyy off, because they did not take the 3-sigma environment into account. I'm wondering how long it will take for this realization to dispel the current Euphorestra induced fog? Maybe a few handfuls of people already understand the reality rather than the illusion. But most are probably not saying anything right now, because they have been told not to.

The larger factor, that leaves me with a queasy feeling, is that the macroeconomic backdrop has changed from a manufacturing base to a service base and that means that capital investment is in furniture. It costs less for a 'service' provider to just close the doors, than to ride out a downturn. Forget about employer loyalty, there's no such thing anymore. So, tell everyone to go home and last one out remember to turn the lights off.

To summarize, high employment could happen almost overnight. Doesn't it strike anyone else as a little odd that, as the subprime and other brokers go out of business there is not even an effort to survive. No progressive downsizing, no visible attempt at all to keep the doors open. They just fall like a row of dominoes. This 'service economy' could turn into something really unpleasant."

In other "free market" news, the regulatory agency which oversees the government-backed mortgage outfits Fannie Mae and Freddie Mac are considering allowing these monstrosities to add even more subprime high-risk mortgages to their bloated portfolios of bad debt. For a full account, please read Karl Denninger's account at Market Ticker.

The idea here is to saddle the U.S. taxpayer with the burdens of all these mortgages blowing up in the face of irresponsible lenders and borrowers. As Karl points out: offering this sort of "guarantee" is what triggered the financial problems which nearly sank Fannie Mae just a few years ago. The solution to the weakness caused by blood loss, we're being told, is to bleed the patient further.

The whining and gnashing of teeth has yet to truly begin in Default-Land. So let's look at the borrowers. Yes, no doubt a few people "did the right thing" and saved up money for a down payment and got a 30-year fixed mortgage, and they are now in financial trouble due to illness or job loss. But let's face it: the vast majority of people now at risk of default/foreclosure were basically gambling that the housing market's ascent would never end.

Have we become a nation of aggressively blind-to-risk gamblers? Apparently so. How many stories do we have to read about folks with net income of $2,600/month taking on a mortgage of $2,600/month--on a no-down loan, of course. How many stories do we need to read about people with equity in their homes extracting every last penny via HELOC (home equity lines of credit) or new adjustable-rate mortgages?

And how many young people (i.e. under 35) expect to own a new car, travel to Europe and own their own condo or house--without having to save a dime? I know this may amaze and amuse younger readers, but a mere 20 years ago it was standard practice to scrimp and save for years to come up with a down payment for a house--ditto for the overseas vacation and the new car.

As for my friends who didn't come from/marry into a wealthy family--nobody took overseas trips or bought new cars until they already had a house, which meant they were in their early 30s. And the house was purchased with 20% down, except for veterans who could get a VA loan with 3% down--a huge benefit at the time.

Now we already hear calls for a $200 billion "bail-out" of reckless borrowers and lenders. If we're going to support reckless gambling, why didn't we bail out everyone who lost money gambling in the dot-com stock market meltdown? A financial gamble is a financial gamble, and just because someone gambled with borrowed money doesn't let them off the hook for the losses.

Yes, I gamble in the stock market. There is risk, and anyone who buys and sells securities is (vaguely) aware that they can lose the bet just made. (Or experience has shown them that this is a possibility.) Now that the nation has gambled recklessly with real estate and mortgages, having thrown common-sense to the winds, now "we" (i.e. those not yet bankrupt) are supposed to pay hundreds of billions in taxes (or interest on new Federal debt) to "save" reckless borrowers and their "poor" lenders?

The cheerleaders of our system always refer to the glories of capitalism. Let's recall that the foundation of capitalism is "creative destruction." The market rewardeth and it taketh away. Those who prospered in the feeding-frenzy of loose lending and rising housing demand a socialist "guarantee" now that they've begun to suffer the slings and arrows of outrageous capitalist fortune; This is indeed the epitome of hypocrisy.

You can go to Las Vegas and enjoy various distractions without gambling away your entire life savings/net worth. Or you can go there and gamble away your net worth. To say you didn't know you could lose--our sympathy never hits water, no matter how deep we dig.

Speaking of gambling: it's interesting to look back at the Dow Jones Industrial Average circa 1937, 7.5 years after the Great Crash of 1929:

Please see the main site www.oftwominds.com/blog.html for the charts.

I have printed this chart before to suggest we are poised on the cusp of the "echo bust" of the 2000 stock market meltdown. What is interesting in the context of the past few weeks is the high volatility experienced in periods just before sharp declines in 1929 and 1937.


Here we have a 2-year chart of the VIX or volatility index. Note that despite high volatility, the Dow Jones Industrial Average sits a mere 3.6% below its all-time high of 14,000. Is this modest decline all that such volatility begets?

Or do periods of low volatility beget periods of high volatility which beget sharp declines? The next 10 weeks will either support or disprove this assertion.

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