The Story of 2008: What Went Wrong?

The past year has been financially chaotic on a level almost no one alive has ever seen. The devastation has hit almost everywhere, world wide, including finance, manufacturing, oil, consumer companies, technology, real estate and commodities.

2008 was the worst year for the S&P 500 since 1937, and the third worst year ever for the Dow (behind only 1907 and 1932). The NASDAQ had a worse year than in 2000, when the great tech bubble broke. 95% of S&P 500 stocks were down for the year. Only six funds out of 1,591 US mutual funds larger than $250mm were up, leaving 99.6% of the funds down for the year.

Since the Great Depression, only two recessions have run longer than this one, the first ending in 1975 and the other in 1982. Each lasted 16 months, according to the National Bureau of Economic Research.

The current recession, beginning in December 2007, has run 13 months and could easily surpass those two. If it goes past March, as many economists expect, it will become the longest-running since the 43-month Great One that ended in 1933.

So what brought all this about? I will try to describe in a nutshell what transpired this past year:

Suppose a bank has $1 billion of capital. They buy $30 billion worth of triple-A mortgage-related debt using $29 billion in loans from their gracious neighborhood banker. This sounds like very high leverage (and it is), but many financial institutions did just that, because their models told them they can't lose more than 1%. However, suddenly home prices decline nationwide, and 20% of the mortgages default. The recovery on them turns out to be only two-thirds, thus the bank loses $2 billion, or twice its capital, which makes it insolvent. The marketplace quickly grasps that there'll be nothing left for the people who are last in line to withdraw their money, and there's a run on the bank.

Sounds bad, but that's just the beginning. Many related scenarios also took place simultaneously. Suppose now that another bank sold some hedge fund $5 billion of credit default swaps on the bonds of a certain company, and to insure itself bought $5 billion of credit protection on it. The company went bankrupt, and the bank paid the hedge fund $5 billion. But the firm that sold our bank the insurance also went bankrupt, and the bank can't collect the $5 billion of insurance due to it. The bank's capital is gone and now it is also bankrupt.

Now assume another bank lent $5 billion to an investment firm with equity of $1 billion. That investment firm in turn bought $6 billion of securities, a conventional leverage ratio on Wall Street until this year. The value of the firm's portfolio fell 17% (not uncommon in 2008 markets), wiping out their entire equity. The bank demands more collateral but there is none. So the bank forecloses the portfolio and tries to sell it in an illiquid down market. It can only get $4 billion for it and so they lose $1 billion, their capital is gone and the investment firm is out of business.

Consider all the funds that borrowed to buy securities and had many of the same positions. When the firm in the example above got its margin call, its liquidation forced securities prices lower. This exacerbated the downward spiral and created mark-to-market losses for many more institutions.

All of the above scenarios and many more are exactly what happened to banks and financial institutions across the globe, and that's why so many of them either disappeared or needed a bail out from their respective governments. The common denominator was the combination of leverage and a false sense of security borne by flawed assumptions. Because extreme volatility is rare, they assumed unusually large losses did not exist, so banks all over the world were engaged in a high-risk game, misunderstanding it as low-risk.

How can scores of sophisticated, experienced people make such flawed assumptions, and be inveigled into making such horrible investments? They did so because they placed ambiguous values on homes, the underlying collateral of all those mortgages. Some people may think a house is worth its cost to build, others prefer replacement cost, yet others place a certain multiple of rental income as the value, or what it last sold for, or what the one next door sold for. Some people even gullibly believed a house is worth what the bank is willing to lend against it. But the truth is houses are worth what someone will pay for them at any given point in time.

So now we are witnessing the greatest deleveraging in history, leading to forced selling in security markets around the world. The panic is extreme and the indiscriminate selling urgent.

This is the third bear market I personally endure since starting in this business, and the second since launching my investment firm, Wellcap Partners. Bear markets are difficult experiences, but they provide unique prospects. I believe we will look at the present U.S. stock market valuations as perhaps the best investment opportunity of a generation.

For the market to go up from here, the news doesn't have to be good. It just has to be not quite as bad as what has already been discounted. The world is not ending; indeed there are many mitigating factors. Interest rates are low, inflation is low and unemployment is still within reasonable levels. The US and EU took initiatives to bolster banks and guarantee their debt. Consumers now benefit from drastically lower energy prices.

There are also many indicators showing the US stock market in general is cheap. For example, equities as a percentage of GDP are now at 59% vs. long term average of 79%.

Or ponder this: at the November market low, the S&P 500 annualized ten year real return (inflation adjusted) was a negative 3.8%, an all time low. At the 1974 low, the trailing ten year annual real return was negative 2.7%. Moreover, the annual 10 year return for large company stocks has turned negative only two other times since tracking began in 1926, and that was in 1938 and 1939.

The S&P 500 index was at 1,200 on January 1999, ten years ago, and it is at 900 now. Do you really think the largest US companies are worth 25% less than they were ten years ago, with all the economic growth, technological breakthroughs and productivity advances, not to mention plain old inflation, of the last decade? I don't think so. Eventually value will trump fear, as it always does.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at [e-mail].

Comments

[wiseapple]

I guess now that most everyone is living paycheck to paycheck, the only ones who will be able to take advantage of the current market are the extremely well-off. Funny how that seems to work all the time.

[PhilipTaylor]

Alan, Certainly Leveraging as you describe was a major factor, but there is much more to the STORY:

Wall Street Generated this Housing Crisis in Derivatives and Bush pushed Fannie/Freddie into buying their FAKE paper! See videos below:

This was stage 1 in the Bush/Wall Street PONZI plan and involved much larger FEES than "Safe" mortgages:
_______________
2002 Video of Bush encouraging Banks/Brokers to offer minorities non-qualifying home loans and requiring Fannie/Freddie to buy sub-prime mortgages:

http://www.youtube.com/watch?v=kNqQx7sjoS8&feature=related

English with German sub-titles and a different twist:

http://www.youtube.com/watch?v=GkAtUq0OJ68&feature=related
__________________

Stage 2 Investment Banks "Slice and Dice" these high risk mortgages into Derivatives!
Banks add Massive Fees to Derivative Paper eating up 15 to 30 years of Appreciation!

Stage 3 Bribe Ratings Agencies to rate HIGH RISK Derivatives as "AAA" paper like T-BILLS

Stage 4 Easy to sell "AAA" paper all over world to innocent victims. Sold paper on a $200,000 at a cost to victim of $400,000 due to imbedded FEES.

It worked like any PONZI Scheme but failed like any PONZI Scheme when the housing stopped appreciating and the Victims refused to buy.

When original $200,000 home dropped in value 40% to $120,000 then the $400,000 paper was worth only 30% of what Victim paid!

Trading in Derivatives and Credit Instruments using leveraging was a MAJOR Factor!

Naked & Leveraged Shorting of Company after Company into or near Bankruptcy requiring Taxpayer Bailouts!

[rockyersocksoff]

WHAT went wrong in 2008?


The year 2000.

[JBS]

"Do you really think the largest US companies are worth 25% less than they were ten years ago,"?

Yes, I do. They've been hollowed out, assets stripped and turned into shells.

[research]

Good description of the Credit Default Swaps and insurance scam that really is the heart of the whole crash.

As a result of allowing mortgage banks to become investment bankers we got this Crash and the great depression.

The two final straws were killing Glass Steagall and dropping the top marginal income tax to 25%.
http://en.wikipedia.org/wiki/Glass-Steagall_Act

CDS credit default Swaps and CDO the insurance scam is till going on. Still completely undermining the Real economy.

CDS is folks betting on stock they DON"T OWN!

Pure off track gambling with OUR fortunes

[cylindar]

You are right, but the fact is that liquid cash is hard to find nowadays and thus investment for the future is only a game the very stable wealthy can afford to play at this stage of the game. Very few ivestors will be able to reap the benefits of this market and that is the way it has always been. This is not a market for the average investor.

[FreelanceMinion]

Yes, this is a great time to invest... IF the company you buy stock in doesn't go bankrupt. Even reorganization could mean YOUR stock is worthless. Want me to show you my old Fruit of the Loom shares?

But Index funds might be a good investment--a single stock which owns everything comprising the Dow Jones, Nadaq or something.

IF, you have any cash.

[Peter007]

Good post.
Imagine this, Suppose the banks that bought AAA Mortgage backed securities were really buying AAA stuff. . Would that have made any difference?
Suppose that the rule of " Mark to Market. had not been enacted? Would that have made any difference?
Finally, suppose that the measure of the money supply, as measured by M1 or M2 took into consideration, the liquidity that was created by using the new instruments, CDO's , and other fancy securities.
Sometimes there is a flood because the dam was designed poorly. Other times there was a flood because someone forgot to turn off a faucet.

[nezumi]

Yes, indeed. To all three of these.

[DuganS1]

"suppose that the measure of the money supply, as measured by M1 or M2 took into consideration, the liquidity that was created by using the new instruments, CDO's , and other fancy securities."

I believe M3 took those things into account. And the tremendous inflation of M3, because of the things you mentioned, was the big reason the Fed decided to stop publicly keeping track of it.