|
Written by David Blitzer
|
|
Thursday, 01 January 2009 00:00 |
|
Page 1 of 2
Writing about markets that move at the speed of light in a bimonthly publication risks being out of date before the ink is dry. But then, the markets are overflowing with risk, and everyone seems to want to read about little but those markets.
The last year or more, since two Bear Stearns hedge funds stumbled in August 2007, has been a roller coaster driven by periodic panics and few—very few—moments of relief. We have witnessed a boom in home sales in the U.S. morph into a financial crisis, the likes of which most of us have never before experienced firsthand. In September and especially October of 2008, the crisis hit the stock markets. October saw the worst monthly performance in the U.S. markets and the S&P 500 since October 1987. In many ways, the damage is much worse than it was 21 years ago when the market dropped sharply in the week of Oct. 12, and then lost more than 20 percent in a single day. That year, stocks closed roughly even for the calendar year. As of Oct. 31 this year, the market is down 34 percent year-to-date, making full-year gains unlikely.
Along with falling prices has come sharply higher volatility. The CBOE Volatility Index, better known as VIX, measures the option-implied volatility of S&P 500 options and is considered by the press and much of the public as the market's "fear gauge." In the last five years, the VIX measured at an average of 16; in the 12 months through October, it averaged 27; in October alone, it averaged slightly over 60.
Why all this happened will be debated for quite some time—probably until the next crisis. However, we can begin to unravel some of what happened, including what the linkages were from one bump to the next.
While the current financial turmoil is global in scope and there are some parallels among countries, the story starts in the U.S. with a surge in home prices. In the wake of the 2000–2002 bear market, the Federal Reserve brought the Fed funds rate down to 1 percent, and mortgage rates dropped to under 6 percent for traditional 30-year fixed-rate mortgages (with a 20 percent down payment). After the bear market, people were worried about their retirement savings and scared of the stock market, and what better way to save and invest than to own your own home? Real estate looked like a good idea: No one was making any more land. However, many people were building houses, convinced that prices would never fall, and creating apparently attractive ways to buy a house with little or no money down. A house boom replaced the dot-com boom and everything took off. Public policies to encourage home ownership only spurred more people to buy a house, or even several houses.
The housing boom was national in scope. Cities, states and regions across the country have seen housing booms and busts as long as they have been inhabited, but there were no truly national events until this one.
The next link was in the mortgages that financed the home price surge—they were sliced, diced and securitized into all kinds of securities and spread around. The idea was that if enough good mortgages were mixed in with the inevitable, but rare, bad mortgages, any risks would be minor and manageable. One is reminded of a rhyme from the early days of environmental controls: "Dilution is no solution to pollution." Better not to have dirty water than to try and hide it among the clean stuff. From the beginning of the home price surge during the 2000–2002 bear market to sometime after the price peak in 2006, the stock market seemed to take little notice of what was happening until early August 2007, when two hedge funds ran into difficulties stemming from mortgage-backed securities. Then the financial markets woke up to the housing bust.
|
