Paul Krugman: The Big Meltdown

Paul Krugman, looking back to today from March 2, 2008,  analyzes the recent drop in U.S. stock prices and what it might mean for our economic future:

The Big Meltdown, by Paul Krugman, Commentary, NY Times: The great market meltdown of 2007 began exactly a year ago, with a 9 percent fall in the Shanghai market, followed by a 416-point slide in the Dow. But as in the previous global financial crisis, which began with the devaluation of Thailand’s currency in the summer of 1997, it took many months before people realized how far the damage would spread.

At the start, all sorts of implausible explanations were offered for the drop in U.S. stock prices. It was, some said, the fault of Alan Greenspan, ... as if his statement ... that the housing slump could possibly cause a recession ... had been news to anyone. One Republican congressman blamed Representative John Murtha...

Even blaming events in Shanghai ... was foolish on its face, except to the extent that the slump in China — whose stock markets had a combined valuation of only about 5 percent of the U.S. markets’... — served as a wake-up call for investors.

The truth is that efforts to pin the stock decline on any particular piece of news are a waste of time. ... In 2007, as in 1987, investors rushed for the exits not because of external events, but because they saw other investors doing the same.

What made the market so vulnerable to panic? It wasn’t so much a matter of irrational exuberance ... as it was a matter of irrational complacency.

After the bursting of the technology bubble of the 1990s failed to produce a global disaster, investors began to act as if nothing bad would ever happen again. Risk premiums ... dwindled away. ...

For a while, growing complacency became a self-fulfilling prophecy. As the what-me-worry attitude spread, it became easier for questionable borrowers to roll over their debts, so default rates went down. Also, falling interest rates on risky bonds meant higher prices..., so those who owned such bonds experienced big capital gains, leading even more investors to conclude that risk was a thing of the past.

Sooner or later, however, reality was bound to intrude. By early 2007, ... collapse of the ... housing boom had brought ... widespread defaults on subprime mortgages... Lenders insisted that this was an isolated problem, which wouldn’t spread... But it did.

For a couple of months after the shock of Feb. 27, markets oscillated wildly, soaring on bits of apparent good news, then plunging again. But by late spring, it was clear that the self-reinforcing cycle of complacency had given way to a self-reinforcing cycle of anxiety.

There was still one big unknown: had large market players, hedge funds in particular, taken on so much leverage — borrowing to buy risky assets — that the falling prices of those assets would set off a chain reaction of defaults and bankruptcies? Now, as we survey the financial wreckage of a global recession, we know the answer.

In retrospect, the complacency of investors on the eve of the crisis seems puzzling. Why didn’t they see the risks?

Well, things always seem clearer with the benefit of hindsight. At the time, even pessimists were unsure of their ground. For example, Paul Krugman concluded a column published on March 2, 2007, which described how a financial meltdown might happen, by hedging his bets, declaring that: “I’m not saying that things will actually play out this way. But if we’re going to have a crisis, here’s how.”

_________________________
Previous (2/26) column: Paul Krugman: Substance Over Image
Next (3/5) column: Paul Krugman: Valor and Squalor

Comments

[billy]

Let me count the ways

- "Theres no bubble"
-"Is all due to improved productivity"
- "Savings glut"
-"Housing prices are justified by income"

The establishment has always found reasons to keep the speculation going. All those Wall Street bonuses and Private equity buyout jackpots - all private profits.

When it all starts to crash, it needs to be propped back up. Who will foot the bill? "Too big to fail" will be trotted out again? After all of Wall Street got their cut?

Who exactly was responsible for this complacency? Who actively encouraged, or dissuaded any regulation of these risky bets?

Hello? Is this so hard to understand? Moral Hazard?

[Bob Dobalina]

Krugman writes bearish column. Yawn.

[Peter Schaeffer]

I give Krugman credit for being willing to stick his neck out. A year from now, he could be looking rather foolish.

However, net I don't see it happening. Maybe the U.S. (as in U.S. investors) deserves it. But baring some debacle at home or abroad, where is the trigger?

Yes, sufficiently inflated markets can simply fall of their own weight. However, P/Es aren’t that high compared to interest rates.

[calmo]

Isn't this view from the future by PK a rerun of another column where he looked back from the future? (Let's try a variation on this time-travelling: we go back to that former article and compare the pieces to see if as a writer he is making progress or beating a dead horse.)
[Why don't I like most science fiction? I need some humor in this piece from PK --maybe something to do with Bernanke or Greenspan--not the self reference at the end.]
How daring an explanation is it to claim that people were too complacent? Isn't it a bit like Madame Torzo letting you know that unless you shape up, there are clouds in your future?
In my crystal balled head, I expected PK to pin-point recent acquiescence on the part of the Fed to examen HF regs, to identify the underfunded SEC's efforts to control back-dating on option grants to executives and a host of other violations that are occurring because Wall St is allowed to regulate itself.
So it wasn't that all the marbles are in a few hands and the few marbles that are not, are about to be grabbed by these same few, but that the general marble-less population has become too complacent, too disconnected from their political representatives to initiate change.
Almost Chomsky.

[Movie Guy]

Paul Krugman's November 2008 column:

"Democratic Presidential candidate wins in a landslide. Polls indicate that market meltdown contributed heavily to voter decisions."

[Lafayette]

PS: "But baring some debacle at home or abroad, where is the trigger?"

Why is this not the "perfect storm"? Because for the first time in (recorded) history, world economic growth is NOT dependent upon either the US or Europe or both.

World economic growth is chugging along under its own steam.

People think (wrongly), "But, if the US slows down, Chinese output goes down the tubes". No, it hiccups. Don't think the Chinese are fixated on the US as a principal market and, if they aren't, hope strongly that they keep buying T-bills to finance America's spending obesity.

Krugman is right about the mortgage defaults in the US. But, for the perfect storm to occur, then those defaults should be replicated in Europe or Australia. And, they wont be. It is so difficult to qualify for a mortgage, that the default rate is spectacularly lower than in the US. (No one can put you out of house and home, or confiscate your property, in most European countries without a court order to do so. The concept of mortgage and property rights sit on different legal fundamentals.)

So, yes, there is a minor correction in market expectations. But, global economics, though not captivatingly brilliant over the next months, neither are they all converging on a black hole.

Not for the moment, anyway. If anyone knew the future, they wouldn't be writing about it. They'd be hedging it.

And, let's be grateful that multi-polarity in economic fortunes are no longer dependent on just two poles, the US and Europe. That game was getting very boring, indeed.

[Elvis]

So he's saying "SELL", right? In so many words.

[Lafayette]

calmo: "but that the general marble-less population has become too complacent, too disconnected from their political representatives to initiate change"

Good stuff and to the point.

Mr. & Mrs. America take hubris for granted. The political process is not only complex, it is manipulated by select groups who, through the media, manipulate the larger population.

A democracy is more than a word. It is participative. If people dont participate, then they simply spectate - thinking that their interest in the game is no consequence to the outcome.

But democracy is atomized and we are all participants in deciding our destinies. If we don't, we sacrifice that right to some one else who will only too willingly exercise that right on our behalf.

Politics IS boring. As our economies become more complex, the ways and means of running it, and particularly legislating it, are exponentially complex. That challenge does not excuse us from the duty of personal oversight of the process.

Where is THE process that makes democracy participative. It is in the town hall where all assembled vote on issues that affect their communal lives. That town hall concept can be expanded not only to the state but to a national level by means of selected referendums that consult the will of the citizenry. Better yet, why not referendums that can recall any legislation that was passed by Congress?

Representative government has reached its limits, that of the weakness of ordinary men/women who represent us. It is time to take that privilege back and exercise it ourselves. Why can't parties decide on legislation, debate it Congress, pass legislation and then seek approval of the population as a whole?

For instance, on a four year budget that an administration MUST ADHERE TO or go back to Congress for ex-budget spending? Or, on health insurance? Or any other matter deemed of sufficient importance.

Why is it that giving representatives the privilege of deciding in our place is no longer adequate? Just look at the mess we are in, not only internationally but domestically.

It is TOO EASY to blame the politicians. We elected them.

[Winslow R.]

I see Krugman predicting a sell off in the bond market resulting in interest rates rising. This is something Krugman has been predicting for years ever since he refinanced his house to a fixed rate mortgage. Perhaps he is right this time, though I doubt it.

With a former Goldman Sachs guy as Treasury Secretary I doubt the stock market will be sacrificed and could even become the next asset bubble through which the economy is stimulated. Sorry MG I can't imagine the other 'Paul' letting it happen.

Calmo is on target and I'd like to see those past Krugman stats.

[Lafayette]

WR: "With a former Goldman Sachs guy as Treasury Secretary I doubt the stock market will be sacrificed"

And, what, pray tell, will the Treasury Secretary do about it?

The Fed would have to lower interest rates to help the stock market, which is entirely plausible. The rise in stocks enhances the FGF (feel good factor) of American consumers since it increases disposable income, so they purchase. The virtuous circle starts again.

But, the above scenario is not the resort of the Secretary of the Treasury. Unless I'm missing something?

[Lafayette]

Roubini: "The US is likely to enter into a recession in 2007; and even a likely and early easing of monetary policy by the Fed will not prevent such a recession as there are too many weaknesses in the US economy: a housing recession, an auto recession, a manufacturing recession, a real investment recession (as corporations are reducing real capital investment and inventories are falling), a US consumer that is on the ropes and at its tipping point; a meltdown in sub-prime mortgages that is leading to a generalized credit crunch in the economy. It is already ugly and it will get uglier in the real economy and in the financial markets. We are likely to observe a vicious cycle where a credit crunch and a persistent sell-off in equities leads to a worsening of the real economy with a hard landing (recession) that then weakens further the financial system. One cannot rule out a broader banking crisis if a deep recession occurs."

No comment.

[Lafayette]

PS: If Roubini is correct, this looks like the making of a solid presidential victory for the Dems, rather like that of Bill Clinton in 2000.

Or, it is curious wishful thinking on the behalf of an economist who would like to be nominated Secretary of the Treasury under a Democratic administration.

[maria]

Morgan Stanley "almost junk"---should we be worried???

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a0j4oiYE3Bfw

[marcel]

Lafayette: Bill Clinton in 2000? I thought Gore won that (popular) vote?

[anne]

Yes; the completely unknown difficult is the extent to which derivative use has created international market connections that are exceedingly difficult to untangle. There has been Warren Buffett's worry and the reason Berkshire Hathaway has gradually sold away all derivative positions. I do not understand the possible extent of this potential problem.

[anne]

Darn; what we do not understand, and what I worry about, are connections that derivative use have created among investment markets that are not easily untangled. Berkshire Hathaway spent several years to shed a derivative portfolio, and this was a difficult expensive process through an excellent market. Suppose this has been primarily an Asian market derivative problem, is there insultation enough beyond?

[Real Person from the Real World]

Anybody read the NYTimes article today, about 13 being arrested for INSIDER TRADING? Bubble or just collapse, them that gots gets more.

[Bupa]

"Anybody read the NYTimes article today, about 13 being arrested for INSIDER TRADING?"

I prefer to start my day with the Financial Times. The 13 are on the first page. Also on the first page, Buffet warning about hedgefunds and an article on global market volatility. Nice way to start the day.

Lafayette thinks the world only hiccups if the US slows down. Well, world markets have never been more interconnected. If the largest economy in the world slows down it might just be a hiccup. If the largest economy in the world has a rougher ride only a fool could think the world will not notice.

Lafayette and MG jump to the conclusion that if the US economy slumps the Democrats will win in 2008. I certainly hope they are right but after witnessing the idiocy of the American electorate and media during the last decade I would hedge my bets.

[Winslow R.]

L wrote: "But, the above scenario is not the resort of the Secretary of the Treasury. Unless I'm missing something?"

google "plunge protection team"

[ltlee]

Hi everyone,

Liquidity drives stock price. And with a relatively flat yield curve indicating no inflation threat in the near future. The market will go up again.

BTW, the flat yield curve is the result of complacent. Rather one should thank the Fed bankers for this engineering marvel. The flip side: When the change comes, it will be quick and utterly unpleasant.

[bullbust]

google "plunge protection team"
Please. Not that. And not gold & ammo. A more sane take is here.

http://bigpicture.typepad.com/comments/2007/03/the_soothing_fe.html

Despite this -- and all the bullish protestations of a strong economy, a soft landing, a goldilocks scenario -- Tuesday's selloff wasn't even in the books before the pleading for Fed cuts had begun. This morn's WSJ notes that "Federal-funds futures contracts on the Chicago Board of Trade -- bets about the future course of rates -- reflect a near-100% chance the Fed will cut the federal-funds-rate target by a quarter-point in August from its current level of 5.25%. Late Monday, expectations for an August easing were about 40%."

Indeed, the nature of this economy and the market's cyclical rally since 2003 reflect a system overly reliant on the Government largesse. Not organic growth, but ultra-low interest rates, ginormous tax cuts, and huge money supply increases are the basis of our post-crash economy. Its no wonder the Bulls are always begging for more; They are all-too-aware of what will happen when Daddy Warbucks proclaims No Mas!

[ken melvin]

The stock market is the big vacuum cleaner in the sky. The higher stock prices, the more sucked up from the economy.

[cm]

bullbust: PPT is little more than a metaphor for propping up "the markets" and "investor confidence" by providing liquidity, which is pretty much what your quoted article states. It appears you are not doubting that general phenomenon. It should be of little consequence that some make grand conspiracies with funky offshore finance operations and whatever else out of it.

[Lafayette]

WR: "google "plunge protection team""

Thank you. Interesting. But, it seems that the real influence of the PPT is controversial.

[Lafayette]

bupa: "If the largest economy in the world has a rougher ride only a fool could think the world will not notice."

The second largest economy in the world is the EU. It is not about to enter a black hole.

[Bupa]

Lafayette, I agree that the EU is the second largest economy and certainly the most stable (if least dynamic) of the big economies. So I don't expect the global trouble to start there.

But if the US economy has an old fashion recession, China will certainly be hit. China doesn't need a period of negative growth to trigger a financial crisis. Slowing to European levels of growth would probably do the trick. Chinese banks have been plagued for years with high levels of non-performing loans. Their balance sheet challenges will be more difficult to deal with in a slower growing economy. Banks are financing all kinds of crazy investments which are more likley to sour if growth slows.

While the EU can hope to weather the storm if the US and China go down, there certainly will be some collateral damage. They won't get out unscathed. The ECB has interest rates at 3.5 percent and is marching fairly decidedly towards 4.0. Euro appreciation should be a worry.

[calmo]

Bupa, we often see this "Chinese banks have been plagued for years with high levels of non-performing loans." and I wonder how plagued this is compared to Japan's "non-performing" loans (or their capacity --given stunning 10% growth rates for the last decade to manage this "plague" as if it were more like a common cold that it has been in the past 9 years).
I find it a bit hard to swallow the line in any case with the deficits we have, you?

I'm not convinced that Europe is the most stable economy, partly because China trades increasingly with Europe, not the US but partly because a whack of that China trade is transnational (US).
Part of the reason that the clamps have not been put on China for that imbalance is because those Chinese imports have a large transnational component, yes?
So there is this interdependence in my view.

Maybe one could venture further: the same money/players that exited the Chinese stock exchange might be the same money that is exiting other EMs and making a dent in the US markets. It might be a distraction to pick the geography/nationality of the 'collateral damage' rather than the occupations/classes within those somewhat old-fashioned national boundaries.

[Lafayette]

Bupa : « They won't get out unscathed. The ECB has interest rates at 3.5 percent and is marching fairly decidedly towards 4.0. Euro appreciation should be a worry. »

No doubt. I can only agree.

But, we are/were talking about the magnitude of the "meltdown", as inspired by both the Krugman article and the Roubini comment (that I posted).

Like many people, I invest in the stock market. Like many people I don’t want a melt down. But, unlike many people, I should like to avoid wishful thinking.

So, like some people, I think of the fundamentals. And, unless there is a nuclear war somewhere, I don’t see a structurally serious depreciation in stock market values if they are sufficiently well diversified. Meaning, if one is not wholly invested in the Shang Hai listed stocks.

I, for one, am greatly pleased that this world is going multi-polar economically. I am tired of the expression, “When America sneezes, Europe catches a cold”. I am thrilled at the idea that the rest of the world can still carry on even if the US AND Europe are not pulling their weight.

Furthermore, if the US is in for a general correction, then maybe it is about time. By exaggerated liquidity availability, it has built itself one mighty real estate headache. But, “dull Europe” (with the exception of the UK) has had no such exaggerated appreciation of realty prices. Not only, industrial capacity is still low enough not to provoke inflationary factor re-pricing. Nor is consumer demand all that glowing, as Europe crawls out of one the most serious long-term post-war recessions. (Notwithstanding the next i-rate move upward that you mention, which is a fairly good certainty, though I put it a quarter point.)

China is sufficiently well-enough diversified in its market outlets (Europe, Africa, Eastern Europe and the Middle East) that, yes, it will weather diminished American demand. But increase in total production will suffer by only a few percentage points, since China is developing apace a sustainable internal demand for goods and services.

All of this leads me to believe that this one is not the “perfect storm”.

[Bupa]

Calmo, since 1999 China has repeatedly recapitalized banks suffering from large nonperforming loans. The sector has been fraught with policy-induced nonperforming loan. They have been making attempts to clean up their act by carving out bad assets and shipping them to asset management corporations. This has led to a reduction in the official ratio of NPLs to total loans from about 22 percent in 1998 to about 8 percent in 2005 and the official capital adequacy ratio of the sector has improved. However, there has been a tremendous lending boom. If the economy were to slow the number of NPL would soar.

You are right that Europe trades with China and the US and would be caught up in any global downturn that might take place. My point is that the EU doesn't suffer from as many imbalances as the US and China and so might not suffer as much in a crisis. On the other hand, there are a number of very vulnerable countries in the EU (especially, Hungary and Poland) that might not ride the waves as well as the EU as a whole.

Lafayette, I can only say, don't take investment advice from me. I do well with exchange rates but the opportunity cost of my pessimism in terms of foregone profits is remarkable. I thought Greenspan was a bit late with his irrational exuberance speech in December 1996.

A big old fashion recession would impact all of those places where China has diversified it export to. The finanicial markets are the kicker.

[Lafayette]

bupa: "A big old fashion recession would impact all of those places where China has diversified it export to."

That would be remarkable. Absolutely remarkable.

[DAN RATHER]

Columns like this have been written since the begining of the markets. Krugman is a bear. Yes the market did react big time to Greenspan, the man needs to stay off of the topic. Even the "meltdown" of the bubble in 2000 was only a 20% drop after a huge attack. Downturn, yes, slower year, yes, maybe evne a few down years but it always comes back. Check th edow since 1933.

says...

From Kudlow's blog - hilarious!

Three Cheers for Krugman!
Congratulations to Paul Krugman for his ninth bear market recession forecast in the last four years.

My only criticism of his column in The New York Times today is his boring lack of creativity. He cites the housing slump. He cites China, and junk bonds, and hedge funds, etc.

Really boring...

It’s almost as boring as Alan Greenspan’s forecast that the economy is going into recession because it's going into recession, meaning that after five years we’re due for a recession.

But back to Mr. Krugman.

He dated today’s recession forecast and stock market meltdown February 27th, 2008. Get it? It’s really a year ahead! So that would make this his tenth recession forecast.

But the really neat thing going on here is that he could’ve dated today’s meltdown forecast Feb 27, 2003…or 2004…or 2005…or 2006. (In fact, I should probably Google it and see if he’s already done just that.)

At any rate, many congratulations to Mr. Krugman.

Congratulations are also in order to The New York Times. Thank you for running his column. Very helpful stuff. Don’t know what I’d do without them.

[john 28.01]

Kudlow has been old dead balls on accurate while Reich and Roubini come on his show calling, screaming for recession. Hasn't happened, ain't gonna happen and those who listen to common sense rather than liberal mental disorder ramblings will cash in on this irrational sell off.

[billy]

Kudlow is going to get his ass handed back to him on Monday.

Fremont General, 78th largest bank in US, about $9 billion depositor funds, is on its way to failure. Reason? Subprime lending. FDIC is already looking into it. See latest business news.

It's going to be "interesting", as the Chinese saying goes.

[maria]

Worst scenario worry: Brokerage accounts are government insured only to a half million dollars. Insurance above that is private. If Morgan Stanley's credit rating is now only a hair above junk, is it too big to fail and take street name accounts with it? LOL?

[maria]

Fremont Investment and Loan, main subsidiary of Fremont General, has a 4 or two star rating, one step above the bottom:

http://www.bankrate.com/brm/safesound/
commfin.asp?fedid=762661

[maria]

More re Fremont:

http://www.fremontgeneral.com/
phoenix.zhtml?c=106265&p=irol-fremonthome

[James Killus]

For what it's worth, the inflation adjusted Dow still hasn't recovered to its 2000 high, nor has the S&P 500.

Stock yields are still positive over the last 7 years, owing to dividends, but just barely.

[anne]

No; there is no danger of Morgan Stanley failing or taking customers along. Securities we own, even through finds, whether through Morgan or Merrill are ours. There is no more danger than a loss in market price of our securities.

Also, recording markets from highs makes no sense if the purpose is to make money investing. The need is to look for value, and I could care less where the market was 7 years ago. Even 7 years ago, all I cared about was where is the value.

[anne]

Ah, always pay attention to Paul Krugman on investing, for Krugman has been repeatedly right in all sorts of subtle ways. When I most disagree with Krugman, I listen most carefully. What is worrying now is not knowing how much leverage there might be in derivatives with limited liquidity. I worry when I have no understanding of such a problem, and I hear the same worry from some awfully smart people. The problem that developed at Long Term Credit in 1998, took a fine bull market down 20% in a month and needed 3 fast rate cuts to settle.

[maria]

Anne: The SIPC (federal agency) insures brokerage account stocks up to half a million in value, with the obligation merely to replace them if the broker goes bust. (Brokers can go bust and have, but it is quite rare). Cash in a brokerage account is government insured up to $100,000 same as in a bank. Most brokers carry private insurance over and above the half million level. But that is not quite the same as government insurance. I have a friend, retired VP of a Federal Reserve Bank, who had a brokerage account with a small firm that went bust. He got nothing for his stocks over half a million. You might Google for SIPC to get the facts. Regards, maria

[maria]

For Anne:

http://www.sipc.org/media/release28Dec06.cfm

[Lafayette]

ane: "Even 7 years ago, all I cared about was where is the value."

All boats rise with the tide, which is general revaluation of markets.

Specific value is difficult to find. By the time it comes up as a stock, it's specific value has been IPO'd by those who created it. So, one must be in on the ground floor.

Ride with the tide. Be patient and not a glutton - be content with three times the Fed rate.

Life is more than being shackled to a terminal looking hourly at an index valuation.

NB: 114 words and still working at it. When I get it into a haiku, I’ll publish it. ;^)

[Theodore R.]

I prefer to start my day with the Financial Times.

Bully for you.

[Movie Guy]

Theodore R. => bigstick@whitehouse.gov

aka Karl Rove?

I kind of doubt it...

[anne]

Maria, if you have a sense of how your friend lost the value of the brokerage account, please do explain a little more. I suspect your friend did not have control of the securities in the account. All securities we own however are directly held and controlled by us. I will ask my sister for a quick safety evaluation, but I have not the slightest concern about an account loss extending beyond market price change.

[anne]

Suppose we think of funds; how could an investor in a bond index in which there are no derivatives positions lose more than a day to day loss in index price? The value of the fund is in the bonds held which each investor owns. Heck, in the case of a treasury bond fund the actual insurance is completely unlimited. What happens to the parent company will and should make no difference to the fund owners. The only possible loss I could imagine would be through derivative positions that were taken using fund securities.

[anne]

Simply make sure that your individual securities or fund securities cannot be used by the parent company to take derivative positions. Beyond that concern which is easily dismissed with a company policy check, the concern is simply with what you actually own. No matter the amount held in the Vanguard inflation protected securities fund, for instance, the amount is completely insured because all the securities are Treasury bonds. There is simply no limit to the insurance.

says...

“It is impossible to get a number” on big investment bank’s exposure to subprime loans, said Richard X. Bove, an analyst with Punk Ziegel & Company. “And I don’t think they even know.”

The cost of insurance against potential bond default on Bear Stearns’s debt, for example, increased 40 percent recently, from about 22 basis points in mid-January to more than 31 on Tuesday, according to Lehman Brothers data.

Insurance costs for major firms with exposure to the subprime market, like Lehman Brothers, Morgan Stanley, Goldman Sachs and Merrill Lynch increased similarly. Brad Hintz, an analyst with Sanford Bernstein, said investors are increasingly concerned about Wall Street’s exposure to that market.

[maria]

When one has a brokerage account, one's stocks are registered in the name of the broker. That is "street name." It is, or was, possible to retain ownership of the stocks (keep them registered in your name) but that is virtually unheard of by most investors and many firms will not accept such accounts because of the complications involved. With most brokerage accounts it is like having your money in a bank. The bank has your money and you have simply a claim on the bank for it. If the bank goes bust, you lose your money to the extent that it is not insured. One can hold stocks outside a brokerage account, but then one doesn't get the convenience of automatic collection of dividends, etc. I suspect most people with brokerage accounts don't realize that they do not directly own the stock. The broker is the intermediary between them and the company.

[maria]

That is the reason for the SIPC---to protect clients with brokerage accounts from loss if the broker goes belly up. It is like FDIC insurance on bank accounts. SIPC protection is capped at half a million and this has not changed for ages. Since numerous brokerage accounts have millions of dollars worth of stock in them, this government insurance presently covers only a portion of the amount in these accounts. Hence most big brokers like Morgan Stanley carry private insurance to cover amounts over half a million. If MS were to go belly up, one hopes that the insurance company would cover one's losses, and it would if the insurer remains solvent. But in a big big meltdown that most Americans cannot even imagine, well....? The reason for this insurance is that most investors do NOT directly own the stock they have in brokerage accounts. If they did, the insurance would not be necessary.

[maria]

In the case of a mutual fund, the fund owns the stocks and you have a claim on a portion of the fund. You have to trust the integrity of the company that runs the fund. If, perchance, the people who run the fund decided to sell the stock in the fund and pocket the proceeds, you would have a claim on a fund with no or diminished assets. I am not aware of any government insurance vs. that kind of fraud. Again, the fund is the intermediary between you and the stocks. I am not aware of any recent of significant case of fund fraud and it seems very rare. But did Bernie Cornfield (name?) not loot funds run by companies he controlled. I will Google to investigate.

[maria]

Robert Vesco was perhaps the prime example of a fund looter. Bad old days, never to be seen again????????? Hmmm.....

http://en.wikipedia.org/wiki/Robert_Vesco

[maria]

In the case of the Vanguard Fund invested in treasury securities. Yes the securities themselves are guaranteed by the US government. But you have no guarantee that I know of aside from Vanguard's reputation for honesty that the treasuries might not "disappear" from the fund leaving you and other fund owners with a hollowed out fund. (Please note I do not predict such an eventuality; I merely point out that it is conceivable and there is no government insurance to protect you against it).

[anne]

No; we directly own all of our individual securities and dividends and the like are directly credited to us. Accounts are completely unified, even for tax purposes. There is not the slightest difficulty or concern with account safety. As for our fund securities, they are directly owned by the fund and we have never used a fund that uses derivatives. I am more cautious than you might suppose, but I am not in the least concerned with more than investment understanding.

Different investment companies have different policies, and Morgan Stanley or Merrill Lynch have investment policies of which I am not aware because I do not invest there, but I know where I do invest.

[anne]

Again I will think through the matter and ask my sister who thinks in terms of account safety, and I know people can be quite foolish, but I am not concerned with account safety.

[anne]

Robert Rubin was once asked about the possibility of a prime Japanese bank becoming bankrupt, for Japanese banking is especially concentrated. The answer was, there was no possibility of such a bankruptcy. The financial structure is and will be properly protected against systemic failure in Japan or China or here.

Also, our investment accounts are better protected than insured bank accounts unless I really fail to understand the nature of protection.

[Michael]

permabulls are funny hahaha!
China can crash the US economy any time they want too.
Oh, no! they would never do that, it would hurt them too! hahaha! The Chinese leadership controls everything here in China. If they ask the citizens to give all their dollars to the government because they need to crash the US economy to defend China, the people would line up to do so and would sacrifice everything to assure it was effective.
As long as the US has so many dollars and treasuries in foreign hands, nothing is secure and safe. The ponzi can be broken at any time.

[anne]

Come kiddies, give us your dollars all your dollars so we can crash America. "Crash, smash, splash." Imagine, all those dollars marching marching marching but where are they marching?

[maria]

Don't want to nag, Anne, but in a street name account which is what most investors have with, say, Morgan Stanley or Schwab, or whatever, one does not directly own the securities. They are registered in the name of the broker. One has a CLAIM for them on the broker. Just as in your bank account. The bank has your money as a part of its assets and you have a claim on the bank for the money. But if the bank goes bust and there is nothing left with which to pay you what the bank owes you, the government insurance agency FDIC will reimburse you up to $100,000. If your bank account exceeded that amount, you would simply lose the excess. Same with a brokerage account. Your shares are comingled with all the other shares registered in the name of the broker. If you ask for a certificate for your shares, then the broker has to register the shares due you and issue out to you a certificate that puts the shares in YOUR name. If the broker goes bust for whatever reason, you get your shares replaced by a government agency (SIPC) up to a total value of $500,000. Above that, you either lose your investment or if the broker has other insurance, the insurance company would probably pay you again up to whatever limit is in its agreement with the broker. Go to the SIPC site and read it. If people directly owned the securities in their street name accounts, the SIPC would not be needed. They do not and that is why it exists.

[anne]

Please do argue away, because the issue is important. We do not ever use "street name" for individual securities. Individual securities are held in our names by the investment company, we have notarized duplicates, and we seldom trade but can with a fax.

Also, I have not checked though I will but I believe Vanguard's private-insurance for individual accounts, and an individual can have several accounts, is in the millions of dollars.

This discussion is helpful in any event, simply for us not to worry.

[Lafayette]

maria: "But you have no guarantee that I know of aside from Vanguard's reputation for honesty that the treasuries might not "disappear" from the fund leaving you and other fund owners with a hollowed out fund."

That's called fraud.

And, in a civil suit, the mutual fund would have to pay restitution. Which is why some think that large mutual funds are "safer", which may be true.

[Lafayette]

DR: "Downturn, yes, slower year, yes, maybe evne a few down years but it always comes back. Check th edow since 1933."

What nonchalance.

The calculation is simple: If one does bail out immediately of a downturn, to put their money into alternative investments that gain positively, then an investor must endure "gains forgone", meaning the gains that would have been obtained if they had bailed out and reinvested.

This happens because a stock market takes time to come back to original levels. If that period of time is, say, 2 years, then the gains foregone are 5 years of money-market interest on your funds’ value.

People are not fools and they bail out typically immediately upon the first shock, which only creates the second shock, which creates the third and so forth.

People who remain in the market are those who think, like you, that "oh well, the market always bounces back". True enough, but keeping your money in it means to forego gains that you would have had otherwise elsewhere.

Consider those who bought at the end of the dot.com bubble and stayed the course throughout have still not recuperated their original investment and have foregone money-market gains over the mast 6 years.

That is not what the "smart money" is doing, since bailing out is cheap. Waiting to recuperate losses is expensive.

It is wise to employ the rule of thirds: One third in illiquid investments, one third in highly liquid investments and the last third in between. Stocks are highly liquid investments, which is why they are so volatile. They are best kept to a minimum of one third of one's total net worth.

[maria]

Anne: well if you hold your securities in your own name then there is no intermediary and you have direct ownership. The failure of the agency or broker holding the securities will not damage you. But most people have "street name" accounts and thus only a claim on the brokerage firm who has their accounts. If you ask a broker to register the shares held for you in your name it is complicated, costs more as far as I know, and probably most brokers would not accept doing so.

Laf: yes absconding with the investments of a fund would be fraud. But if it happened you'd be in a mess for years as the matter was sorted out and if the mutual fund company did not have the means to make restitution, you'd get nothing. (I admit this is very low probability). But during the time things were being resolved you'd not have access to your money; for practical purposes it would be gone.

[maria]

Laf: but unless your stock is in a 401 or charitable trust or some vehicle to avoid capital gains, you have to pay the tax on gains (if you have them) when you bail out. The tax is less now than it used to be. Still losing 15% of your gains to taxes means you have that much to get back later. And when the market declines no one knows how far down it will go. If it does not go down much and the drop is relatively minor selling out can be costly.

[anne]

Agreed on generic financial risk; and another reason I was not and am not pleased in allowing banking to be joined to investment banking.

[dd]

Derivatives can be structured to hollow out asset valuation even of assets not owned. They are effectively a naked bet; so even though the institutions I deal with may not be making these bets, the bets as a whole impact the marketplace, my investments and pose a danger of seizing up markets. The Delphi & GM bond squeeze taught investors that much. Publicly traded corporations also use financial derivatives that are presumably structured by investment banking; so again we're all investing in derivatives and our investment banks (on the other side of the bet). Then again, what do I know other than the few crumbs the Fed and the Treasury hand out after the fact and from the generous web contributions of more knowledgeable players.
IMHO for all intents and purposes the Fed & the Treasury now oversee the entire system with the SEC and CFTC there to salve investor concerns.

[Lafayette]

Maria: "And when the market declines no one knows how far down it will go. If it does not go down much and the drop is relatively minor selling out can be costly."

Agreed. One does not know how far the decline will be, but in serious declines as 2000 or this last one, it is fairly obvious.

The tax certainly can be a hindrance, and each case is specific if it can be offset by other losses.

[Elvis]

Just wanted to thank everyone for their posts here. A real education.

[lonesome moderate]

Even the "meltdown" of the bubble in 2000 was only a 20% drop after a huge attack.

That was the Dow Jones, which is not a good equivalent of the broader market. The NASDAQ lost 75% from its peak, and is still down 50%. The S&P 500 lost 50% and is not quite back to even.

[anne]

http://select.nytimes.com/2007/03/04/business/yourmoney/04gret.html

March 4, 2007

Mortgages May Be Messier Than You Think
By Gretchen Morgenson

WHAT investors don't know about why the home mortgage securities market is in distress could fill volumes. As is often the case, only after fiery markets burn out do we see the risks that buyers ignore and sellers play down.

Because so many players in this world have an interest in keeping risks under wraps, a complete understanding of the mortgage market's ills may take time. Unlike recent corporate disasters that have occurred at hyperspeed — think Enron and WorldCom — the mortgage securities boom seems to be unwinding in slow motion.

But trains wrecks are train wrecks, even when they occur at a crawl.

Wall Street, of course, prefers a more upbeat approach. And by the end of last week, many there were celebrating the fact that the indexes on mortgage securities, which had been in free fall, had stabilized. Big brokerage firms have also tried to persuade investors that mortgage woes would be limited to subprime loans — those given to people with weak credit histories.

But last Thursday, the annual report from Countrywide Financial, a major lender, told a different story. While it confirmed fears about subprime loans — 19 percent of those in its portfolio were more than 30 days delinquent at the end of last year, up from 15 percent in 2005 — Countrywide also indicated that the percentage of prime borrowers encountering difficulties is rising. Delinquencies in the company's prime home equity loan portfolio totaled 2.93 percent, almost double last year's 1.57 percent....

[Ah, I was much suprised how much investing was suddenly the topic this weekend.]

[Lafayette]

And apanicking we go, apanicking we go ....

Before embarking, a word from a cooler head, market historian, David Schwartz: “In the last quarter-century, there were 64 short-term declines of at least 5 per cent. It is not common knowledge, but the average length of these declines was 32 days.”

Take a month-long vacation in some warm southern clime. Don't watch the boob tube ... it would do most of us a world of good.

[Lafayette]

I love journalists. They are real marketeers.

The market is going up?, give people fifty reason why the direction is entirely predictable and therefore they should buy.

The market is going down?, give people fifty reasons why the direction is entirely justified and therefore they should sell.

Giving people what they want - that's successful Marketing. (Which is both predictable and justified.)

[S]

Some people knew this was coming in 2008. How and Why? Why now? Read it at:

http://managementchitchat.blogspot.com/2008/09/wall-street-meltdown-2003-taxcuts-are.html