A decade of Dow

 

Call it curiosity or joblessness, today I decided to spend few hours looking at the Dow Jones Index data for the last decade. I have no stake in any US stock, but my objective here is to understand the magnitude of impact of any event on the stock market. Though doing this exercise on the Sensex would have made more sense to me, I figured that finding data and information on something that is US based is probably faster than its Indian counterpart. 🙂 

Thanks to MSN, I got the Dow Jones Industrial average data for the period Oct 1998 to Oct 2008 within seconds. I marked all the major high and low points in the graph (in blue). And a mouse over feature on MSN helped me find out the dates and correspoding closing values of the index. That data, in turn was used to create the left side of the table below the graph. 

The right side of the table shows information collected on the events that coincide with the corresponding high-low points. These events have been gathered from google searches which resulted in articles and news reports relevant to the months/indices in question.

 

 

 

The first row of the table shows an important event that is not marked in the chart. 1997 saw turbulence in the Asian market that affected the world markets. The major event was the fall of LTCM hedge fund and default by Russia which led to a major financial crisis. Prior to that the US economy, since 1992 was on a Clinton Bull Run. The Dow was at around 4000 when Clinton took office and went on to hit 12000 by 1999.

Bush took office in 2000 and for the next 3 years a series of major events of all kinds – social, economic and financial, resulted in a very erratic market behavior. During that period, Federal interest rates were cut multiple times resulting in very cheap credit. Slowly, the housing mortgage market began growing. Internet and technology companies continued seeing good boosts and grew at phenomenal rates.

The Bush Bull Run from mid 2003 to 2007 was initially marked by the capture of Saddam Hussein. The same period saw tax cuts and rise of internet giants like Microsoft and Amazon. General confidence in US market started growing and companies across industries did well. The Industrial average index saw new Tech companies being a part of it. The year 2005-2006 saw setbacks that had impact on oil (in the form of hurricanes Katrina and Rita) and uncertainty (due to change in Fed Chairman). However those were minor and the general trend was bullish.

The subprime mortgage credit crunch that we talked about in previous posts, characterizes the major dip since end of 2007. As you can see, the fall till date is a very steep one. And every other day marks a new record of historic importance. The past year has seen a tumble of about 7000 points which is more than the points gained in the Bush Bull Run.

While there is no particular conclusion I can or like to draw from this post, I am wondering if I can do something with this and my earlier post about technical analysis and make some predictions. Well then, I guess the agenda for the next post is set and if it doesnt work, I’ll go on and do the Sensex version of this one! 🙂

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What just happened??

[A layman’s view to understanding the present US Financial Crisis]

 

Before we get into the events, it is important to understand certain basic terminology and mechanisms.

Mortgage backed securities – Banks have two primary functions. Accept deposit and lend loans. When a borrower approaches a bank for a loan, the bank (after due diligence of the creditworthiness of the borrower) lends him money from the funds it has accepted as deposits. The bank charges a rate of interest for the time the borrower takes to repay the loan.

Given this simple mechanism, the bank may face a problem when the market rate of interest fluctuates or when it may run out of funds for further lending at a certain point. 

In order to solve these problems the concept of mortgage backed securities was introduced. In this system, the bank issues bonds against the loan and sells it to investors at a rate of interest that is equal to the interest payable by the borrower on the loans.

For e.g, say X borrows $1,000 for a home loan at 8% interest p.a from Bank of America. The bank may sell 100 bonds worth $10 each to an investor promising an interest of 8% on the amount. This way the interest payable and receivable are cancelled out by the borrower and the investor. So basically whatever the borrower pays as interest goes to the investor as his return on investment. The problem arises when X defaults his interest payment.

Subprime lending crisis – Check out my earlier post, Crash, boom, bang!

Credit crunch – A situation in which there is a sudden reduction in the availability of loans or increase in the cost of lending by banks and financial institutions. This is usually caused when banks and institutions have suffered losses in lending and have bad debts.

Bankruptcy – A legally declared inability or impairment of ability of an individual or organization to pay their creditors. This is also known as Chapter 13 in financial circles.

Bailout – A situation where a bankrupt or nearly bankrupt entity, such as a corporation or a bank, is given a fresh injection of liquidity, in order to meet its short term obligations. Often bailouts are by governments, or by consortia of investors who demand control over the entity as the price for injecting funds. 

Housing Bubble – Is a type of economic bubble that occurs periodically in local or global real estate markets. It is characterized by rapid increases in valuations of real property until they reach unsustainable levels relative to incomes and other economic elements.

Foreclosure – Is the legal proceeding in which a mortgagee, or other lienholder, usually a lender, obtains a court ordered termination of a mortgagor’s equitable right of redemption.

 

So… what just happened?

7th September 2008 – Fannie Mae and Freddie Mac takeover

Fannie and Freddie are two very large mortgage companies that are sponsored (but not run) by the Federal Government. Their primary business is to guarantee the mortgage bonds to the investor in case payments are missed by borrowers. They also create a fund(as in insurance) to make up for losses in cases of default. This fund is created by taking a certain percentage of the payments or from sale of the house.

Since Fannie and Freddie, the Government backed institutions provided guarantee, the mortgage securities industry flourished.

When the subprime crisis started in 2007, all the defaults, bad credits and foreclosures largely affected Fannie/Freddie’s business. The two have more than $5 trillion in outstanding mortgage backed securities. The share prices hit rock bottom.

The Government had no option left but to take over the two companies and infuse money from the treasury to clean up the mess.

14th September 2008 – Bank of America acquired Merrill Lynch

ML is a large investment banking and financial firm that incurred billions (app. $51billion) in losses due to investing in mortgage backed securities that went bad during the subprime crisis. The company was recently acquired by its rival, Bank of America.

15th September 2008 – Lehman Brothers bankruptcy

Lehman Brothers is a 158 year old global financial services and investment banking company. It had ventured into mortgage backed securities and during the subprime crisis, one of its firms was closed. The company lost huge sums in the form of goodwill and its share prices tumbled. Neither Bank of America nor Barclays who were called for deals to buy the Lehman, made a bid. The Government also refused to bailout the company from bankruptcy.

16th September 2008 – AIG bailed out

AIG, the largest insurance company in the world is being bailed out by the Government. The problem is the same; loss due to subprime crisis resulting in bankruptcy. AIG’s main line of business is insurance services but the company had diversified and entered other areas including mortgage backed securities.

The Government decided to bailout AIG due to its enormous funds (trillions), public stake, global ties across industries.

 17th September 2008 – WaMu Auction

Washington Mutual or WaMu is a former mutual fund company which later became the third largest mortgage lender. In 2007, the company suffered huge losses in its home loan divisions due to the subprime crisis which resulted in layoffs and affected stock prices. Now the company has hired Goldman Sachs to take care of its auction.

 

Why this happened?

As you would have noticed by now, the answer to the ‘why’ is quite clearly the subprime crisis. Let us drill down further.

In the early years of this decade, in order to remove the sluggish nature of the economy, the Federal Reserve lowered the mortgage interest rates. This resulted in a trend of rising housing prices. Unlike traditional loan diligence, the borrowers were given loans without looking at their creditworthiness. Instead, people who were lower on their creditworthiness rating were charged a higher rate of mortgage interest. Because of the housing bubble and the high demand for loans, banks and financial companies didn’t waste their chance to make a quick profit out of the situation. Loans were endlessly given out. Very high rates were charged. These loans were in turn sold as mortgage backed securities to investors. This business picked up across companies in the financial industry and everything seemed to go well until the bubble burst.

When the interest rates reached a level where it was too high to afford by many borrowers, lot of the loans went bad. This in turn had an impact on the investments in mortgage backed securities. The demand for Fannie and Freddie guaranteed securities decreased. Foreclosures increased, house prices plummeted, and lenders incurred huge losses unable to value assets resulting in liquidation.

A major argument and an increasing realization is that there was very less regulation imposed on the financial instruments by the Federal Reserve/ Government.

 

Who gets affected?  

The real estate crisis infected the financial markets. This led to enormous job losses and money losses. The financial institutions were unable to lend money to business that really needed it to grow. This is leading to a snowball effect and is slowly hitting every industry one by one. This, coupled with the rising and highly fluctuating gas prices is resulting in a huge economic recession instead of what was hoped to be only a slowdown in the US.

Thats not all. Most of the afore-mentioned companies operate globally. They have presence in all continents. And in this global economy, a financial meltdown in the US market is bound to have far reaching impact on world markets.

 

Solutions?

The current Wall Street crisis is touted to be the biggest since the Great Depression that hit the US economy in the 1930s. It has been a chain reaction with people across industries suffering. Though the Government has been working on immediate short term relief like the economic stimulus package, it is very obvious that the economy needs a long term sustainable solution to get out of this mess.

The 2008 Presidential Elections will certainly be one of the most important of its kind in a very long time. And the policies, ideas, determination and resolve of the next President will be the crucial factors determining this election.

references

www.wikipedia.org ; www.nytimes.com ; www.spiked-online.com