Sub-Prime Crisis

I was in New York when the bad news really hit the headlines and CNBC. And I saw major panic in my beloved Nintendo (down 10% one night in Tokyo). Jim Cramer had a much-publicized meltdown on CNBC one Friday afternoon:

I’ve started reading some really good economics blogs now that I took those two econ classes over the summer and can understand what the economists are saying a lot better. The whole sub-prime issue is a hot topic for them of course as they try to quantify the damage that the GDP will incur and also how all these complicated derivative trades on bad loans will unwind.

It cracks me up that virtually every reference to what people believe is the cause of the stock market volatility as it relates to the sub-prime crisis, is termed “black boxes designed by PhDs”. It’s like people really have a hard-on for pointing out the failure of these PhDs. It’s the same to me as the media consistently referring to “the radical cleric Muqtada Al-Sadr”, blatant yellow journalism.

I’m thinking that the sub-prime crisis is largely contained at this point. I was reading that banks would have had to report major problems in the most recent SEC filings. So while there will certainly be bad conference calls in the next few quarters as the damage is converted into balance sheets, I think that the traders and loaners and hedge funds adjusted pretty quickly to the new environment so that they wouldn’t get scalped even further.

The major banks turned into the Plunge Protection Team (PPT) of perma-bear lore and came out to defend the equity markets. They financed their worst-hit funds with extra capital so that investors in those funds would have tangible assets. The Fed cut the discount rate 50 basis points and got the major banks to use the discount window as a sign of solidarity. Tons of money was injected into the market both in Europe and in the US to provide liquidity.

There is a lot of debate about whether this is a sustainable long-term strategy for monetary policy but I think most economists agree (whether correctly or not) that active monetary policy has avoided another stock crash of 1929, where the big players just let it all collapse without doing anything.

I believe there’s still significant risk as it’s only August — September and October are historically horrible times for the stock market (most crashes happen in Aug-Oct) and if more uncertainty comes out of all this then a failure of the Fed’s and banks’ moves could be seen as failed last-ditch efforts. Furthermore foreclosures affect real people and I’m disappointed that there’s not more reporting in THAT area. It’s similar to what happened in Katrina, that vulturous insurance and credit companies swooped in and flayed the poorest, least financially educated people in the country along the southern Gulf coast, while journalists concentrated on more visible controversies like FEMA and Bush.

What just happened was a credit freeze. Banks did not know how much their assets were worth and so they put a halt on most capital investment until they could figure out how much damage was done. Risk management. Capital investment is the lifeblood of our economy — it makes up by far the most important component of GDP calculations. If people aren’t lending money out, then business expansion cannot happen. We’ve benefited from really easy money — so easy that it caused a tech bubble and allowed for people to buy homes with almost nothing down.

This all works when everything goes up, but things can cascade quickly once problems emerge, because everyone is operating at full margin and there’s little underlying value to back it up. In other words, people are buying $250,000 homes even though they might not make a quarter of that much a year. Brokers have been circumventing downpayment regulations by footing the initial bills. It’s hot money.

I have another concern about all of this: I don’t see how this could not affect GDP growth. Not only was the credit market locked for at least a couple weeks (and it could readily happen again), but loans are going to be a bit more strict in the future so you’ll need better credit to obtain them. Won’t that slow things down a bit? (although it would be a good thing in the long-run)

One thing that I don’t know too much about but see possible manipulation in is the currency rate. In order to off-set other issues in our economy, it seems like the dollar is being dropped so that our exports can compensate for slowness in other GDP components. Here is how the dollar is doing against the Pound, Euro, and Yen. Surprisingly the Yen is like the only major currency the dollar has bottomed against, I assume as Japan re-emerges from its slump.

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I am closely watching the dollar because it has made recent attempts to break downtrends. I think it may be close to a bottom although nothing has confirmed that yet.

I have been all cash for a while now but I saw a bullish recovery candlestick setup on the major indices (see below). There was a morning doji star bottom with strong bullish candles and I bought as soon as the turn-around was confirmed. This happened the day of the Fed cutting the discount rate. A morning star bottom is a downtrend followed by a gap down on the open and a sell-off that ends in a rally at the end of the day (creating a candle with a long wick below the body), followed by a gap up and a rally on the following day. I put 25% into the international fund in my govt. retirement account and it’s up $1 already to $23.77. I didn’t put more in because I consider it too early to buy in full, particularly with unanswered questions still out there.

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The runner tech stocks (Apple, Research in Motion, Google) also sprung back quickly from the panic. These ones aren’t done running yet, I think.

As a final note, I attended orientation for Georgetown MSFS the last two (long) days. The former students and faculty really stressed the importance of taking extra finance classes for quantitative skills. Furthermore I’m enrolled in int’l trade and int’l finance classes in my first semester. It will be painful but considering how much I learned in my econ classes, I’m hoping that I’ll become even more of a ninja after this semester. I’ll also probably re-orient my future classes towards finance for that hard background!