The Panic of 2007: No Buyers at Any Price (April 9, 2007)
This week's theme is Denial with a capital D: all the stories which the corporate media either under-reports, dismisses or doesn't report. Let's face it: when you want an analysis of Friday's job report, you don't go to corporate news sites where you'll get mushy homogenized pap--you go to Mish.
In the spirit of skeptical analysis--and I think that's why 60 of you have surprised me with donations, because you're supporting skeptical analysis--let's tackle The Big One: sudden global financial meltdown.
At frequent contributor Harun I.'s recommendation, I've been reading Reminiscences of a Stock Operator, a 1923 classic with extreme relevance to today's market. The book is the thinly veiled biography of legendary trader Jesse Livermore, who made, lost and re-made enormous fortunes in the stock market. In the Panic of 1907, he made millions shorting the market.
The Panic of 1907 was a credit crunch which resulted in a 50% drop in the stock market--in today's parlance, a "liquidity squeeze." As the market fell, margin debt was called, and as people tried to borrow more money to cover their losses, they found the banks unable to lend. Their only choice was to sell stock, which naturally exacerbated the steep decline. There were simply no buyers at any price. The day was saved by banker J.P. Morgan, who organized a cash infusion of $20 million into the market by drawing down the New York banks' reserves.
Virtually no one today foresees even the slightest chance that such a panic could occur today. A Google search turned up this one story:
The Panic of 2007? by Robert J. Samuelson
The subprime mortgage mess hasn't yet depressed overall lending. But a larger horror story may be unfolding
What I will suggest here is that such a panic is not only not impossible but increasingly likely. And I will sketch out one scenario for its unfolding, not as a prediction so much as a possibility.
As background for the plausibility of such a fianncial panic, please read the book The Misbehavior of Markets and these two articles: Financial Disasters Will Keep Coming and The Sordid Business of Predicting A Crash which were kindly submitted by frequent contributor U. Doran. If you read these works, you will be persuaded that financial panics are indeed possibilities and perhaps even likelihoods.
I have long recommended The Misbehavior of Markets for just this reason: the brilliant mathematician Benoit Mandelbrot utterly demolishes the theory of Modern Portfolio Theory that risk has been diminished to near-zero by derivatives, which is the current (quasi-religious) belief on Wall Street and global bourses.
Let's start with a chart of the U.S. Dollar.
This isn't exactly the picture of robust health, is it? The "line in the sand" is 80; if the dollar breaks below 80, there are no historical antecedents for a bottom. Some target 65, others even lower.
As additional background, let's look at who's stockpiled vast quantities of dollars: Japan's foreign reserves hit record high:
Japan's foreign exchange reserves rose to an all-time high of US$908.96 billion at the end of March from the previous record of US$905.05 billion in February, the finance ministry said Friday.One last bit of background: the global currency markets trade $3 trillion a day:
The figure is now roughly double the $1.5 trillion a day traded in 1996, the year before the Asian financial crisis. Some perspective: the $3 trillion figure is ten times the value of daily stock and bond turnover, and a hundred times the value of daily goods and services trade.So how could a global financial panic erase 50% of global stock markets? Here's one scenario (of many):
1. Step one: the dollar slips from 82 to 75. Of course there will be a desperate defense at the "line in the sand" of 80, but can any institution counter the trend in a $3 trillion-a-day market? No. The Bank of Japan or the U.S. Federal Reserve or the Central Bank of China could each buy billions of dollars a day, but if the trend is down then their purchases would be mere drops in the bucket. The entire dollar reserves of Japan and China combined equal a mere 2/3 of one day's currency trading.
2. Who's dumb enough to buy into a losing proposition? When it become obvious that holding dollars or bonds and equities priced in dollars, not to mention buying more, is a losing proposition, then who will be dumb enough to "put good money after bad"? In other words, if the Saudis, Chinese, Japanese et. al. realize that throwing another $20 billion or even $100 billion isn't going to turn the tide, then at what point does a Central Bank manager decide to start unloading dollars before it drops even further?
3. The Fed raises interest rates in a last-ditch effort to support the dollar. Recall that a 10% rise in interest rates--from 4.5% to 5%--erases 10% of the value of existing bonds. The entire global bond market measures nearly $60 trillion, of which 41% is denominated in dollars. Thus a 10% haircut of bond valuations would instantly knock $2.4 trillion off the value of bonds denominated in dollars.
The natural, and indeed the rational, capital-preservation reaction of global fund managers would be to sell U.S. debt instruments before they lose even more value.
4. As interest rates rise, the market for U.S. mortgage-backed securities tumbles as investors domestic and international grasp that higher interest rates will throttle both home sales and increase the risk of defaults in adjustable-rate and subprime mortgages which have been securitized in residential mortgage-backed-securities (RMBS), CDOs (collaterialized debt obligations) and various other debt-based derivatives.
5. The U.S. stock markets drop as the bond market gets hit and as general financial uncertainty increases. Margin debt (at a record high) is called, i.e. those investors whose portfolios fall below 50% of cash value must either raise cash or sell stocks.
6. Lenders get squeezed on multiple levels. Buyers of rapidly sinking RMBS and CDOs demand lenders take back the risky loans, the cost of overnight money rises, and the risk premiums for all debt shoots up. Historically low reserves are suddenly increased by nervous regulators, and banks are suddenly unable to lend, regardless of massive injections of liquidity by the Fed.
7. You can't force people to borrow and sink "good money after bad." If you're under water on stocks, then who would be dumb enough to borrow more money to cover your margin call when you suspect that tommorrow your portfolio will be worth even less? Holding onto stocks will just guarantee that you'll get another margin call tomorrow. The only rational action is sell now before the losses get worse.
8. As the market drops, a self-reinforcing feedback loop develops: losses trigger more selling, which begets even more selling. Who will be dumb enough to buy when the chances of losing another 20% appear extremely high?
The standard answer is "The Plunge Protection Team," but even their buying won't stop the avalanche of selling generated by margins being called, stop-losses being blown and a general panic to get out before losses increase. The PPT could staunch the death-spiral for a few hours, but no amount of intervention will change the trend.
This is how you get a massive global financial panic in which there are no buyers at any price, and a liquidity squeeze in which bankers and clients alike are suddenly reluctant to "put good money after bad" as real estate, bond and stock markets all plummet.
Recall that a 10% drop in global bonds is a $4 trillion loss, as is a 10% decline in global stock markets. (Global GDP is estimated at $44 trillion.) Thus a "modest" 10% decline in global stock and bond markets would mean a sudden loss of $8 trillion. If any of that is borrowed--and undoubtedly a significant part of it is borrowed-- then other assets will have to be liquidated to cover the losses.
That's how you get a self-reinforcing global financial meltdown. . . which of course "can't happen" due to the "distribution of risk" via derivatives. Believe that if you wish, but by all means read The Misbehavior of Markets before concluding such a meltdown is "impossible."
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