Dow Drops 504 points

[echoes]

For some Americans, today has not been a good one due to this drop. It reminds me of the Friday after 9-11, when the Market re-opened.
Can remember holding my breath that day...it was a very long day... Have just read that todays drop is the worst since that day.

http://www.marketwatch.com/

September 15, 2008 4:44 P.M.ET

BULLETIN

Blue chips drop 500

It's the worst day for the Dow industrials in seven years, and Wall Street is in full tilt after Lehman Brothers fails to find a buyer but Merrill Lynch does. Stocks slump and bonds jump.

[Jack Moroney (RIP)]

While I am sure that this too will pass with a long and painful recovery, what bothers me most about this is not the dent in my investments as much as the total lack of accountability for those that were instrumental in precipitating the events that led to this day of reckoning. While this is not the end of life as we know it, it certainly is another indication that those in positions of power, as well as those of us that put them and keep them in power, need to pluck their heads out of their collective fourth points of contact and get this right. We are truly at a breaking point the in US's ability to secure its national interests at home and abroad-and for that you can thank our self-serving politicians.

[kgoerz]

Originally Posted by Jack Moroney

While I am sure that this too will pass with a long and painful recovery, what bothers me most about this is not the dent in my investments as much as the total lack of accountability for those that were instrumental in precipitating the events that led to this day of reckoning. While this is not the end of life as we know it, it certainly is another indication that those in positions of power, as well as those of us that put them and keep them in power, need to pluck their heads out of their collective fourth points of contact and get this right. We are truly at a breaking point the in US's ability to secure its national interests at home and abroad-and for that you can thank our self-serving politicians.

But the Dims say we are on the Highway of Hope, if we get off on the Exit Ramp of prosperity that leads to the side road to change. Whatever that means

[nmap]

The underlying problem is the derivatives market. As Lehman is liquidated, its securities must be sold to someone at some price. When that happens, we have a new, recent price for those securities.

However, a number of banks have their capital invested in such things. When the trade occurs, the banks must adjust their capital numbers - perhaps below minimum levels. Thus, there is a cascading effect.

The real excitement now is in AIG. They're looking for $75 billion after a credit downgrade. Will they survive? I certainly wouldn't buy their bonds, much less their stock.

This feeds back into the housing market. We had a robust housing market, partly due to freely available mortgage money. It is unlikely that anyone will touch new "creative" mortgage securities for quite awhile. Hence, perhaps less money for new mortgages - thus putting downward pressure on house prices. Will people keep paying the mortgage on a house that isn't worth nearly what they paid for it? Hmm.

By the way - the credit default swap (CDS) market is around $60 trillion dollars. (Yes, trillion with a "T"). It is unregulated, uncontrolled, and unreported. In essence, someone, somewhere guarantees that a debt instrument will be repaid. The lack of transparency in such a large market is problematic.

[Penn]

nmap, Thanks for the PM. Can you elaborate on the CDS market?

[nmap]

Originally Posted by Penn

Can you elaborate on the CDS market?

I'm glad to, Chef Penn.

Let's suppose someone wishes to purchase some bonds - say, $10 million dollars worth - but they want a guarantee that the bonds will fulfill their payments. They could pay a premium - usually, a small premium - and someone, somewhere guarantees that the bond will meet its terms. It is also possible to trade the CDS, so the person making the guarantee can sell it to someone else. One problem is that no one knows who is actually obligated.

As an example, someone might have guaranteed that an XYZ bond would not default. They then found someone to trade this with, perhaps making a profit. That person (or company, more likely) did the same. This may have happened many times - say, five times. Now, if XYZ does default, a bond holder would go to the original person making the guarantee. This person would point to the next person down the line, and so forth. This works just fine if the person at the end can perform - but - what if they cannot? They refuse to pay or default. You can see the end result. It all goes to court. And if the failure is large, their may be bankruptcies all around.

Add in another problem. The CDS market was highly leveraged - as I understand it, 20 to 1. A small series of defaults results in a large, bad outcome.

Here's an example of the price action, from todays WSJ:

On Monday, many of AIG's bonds traded at levels more reflective of junk bonds that are on the verge of default. Some of the bonds traded at less than 50 cents on the dollar, having fallen from more than 80 cents last week. In the market for derivatives contracts that provide protection against debt defaults, investors were agreeing to pay $2.5 million upfront plus $500,000 annually to hedge against a default of $10 million in AIG's debt over five years, according to data provider CMA DataVision. The cost is so high because sellers of the protection want to be adequately compensated for taking on the risk.

Key point: If a bank owns an AIG bond, and wants to buy insurance, it will cost $2.5 million dollars, plus $500,000 per year to guarantee $10,000,000 in debt over 5 years.

To put this in perspective, to guarantee U.S. Treasury bonds would cost about $25,000 for $10,000,000. By the way, that's up from $21,500 on Friday. So if you had made the guarantee on Friday, you would lose $3,500 if you liquidated it today. That's volatility. Now - if you had only put up about $1,500, you would have lost all your money plus another $2,000. LINK (Saying this another way - in this example, you would promise to pay $10,000,000 to a person buying insurance if the treasury bond defaulted. They would pay you $25,000 for doing this. If you suppose the default wouldn't happen, it's like free money. If the default does happen, there is a problem.)

AIG made a lot of these guarantees - but as overall fear in the credit markets increase, the cost to offset a guarantee goes up. Here is a link to some AIG-specific details: LINK

This goes to the bailout or not question. Bailouts are a problem. But not bailing them out can create lots of other problems.

Another link might be of interest... LINK

[Red Flag 1]

nmap.

PM inbound.

RF 1

[The Reaper]

So why bail out Bear Stearns, but not Lehman Bros.?

Is the decision itself by the government not potentially litigious?

TR

[Sweetbriar]

Reading this at Patterico, including some of the comments, and along with the WSJ article helped me understand a little better.

[CoLawman]

Nmap,

For those of us with mutual funds, what action does a fund manager take to mitigate losses when the fund has substantial holdings in, say a Lehman? I assume (the alternative is too frightening) they are doing something!

[Team Sergeant]

I believe we have built an economy based on a financial "house of cards"; that house of cards being promises to pay (credit) and the greed of large financial companies (predatory lending). Because so many promised to pay, those financial companies built a house of cards to the moon and beyond. Now that house of cards is collapsing causing a cascading effect and it ain't over. Those cards at the top are huge and they are falling and they in turn are going to take out every card below.

I do not believe the US Government has the money to plug the holes in this dike. Fannie Mae, Freddie, AIG, Lehman, Merrill Lynch, et al they do not deal in billions but trillions of dollars and we cannot cover them all.

I also believe we have arrived at the financial & economic "event horizon" and are now witnessing a slow motion train wreck that cannot be stopped.

Unless you are one of the Ivy League geniuses that run those failed companies (that make hundreds of millions in salaries), I’d prepare for hard times ahead.

This will not be a national problem; this financial crisis will effect the entire globe.

Just my .02

TS

[Penn]

I’ve sent an email to my economic professor at Penn. He is on the board of the Federal Reserve here in NYC, asking for his advice on modeling my business and current position with regards to the market in the near term. He responded that he just completed two straight weeks (7days) of 18-20 hour days and would get back to me tomorrow.

I have already witnessed the impact on the service industry. We are responding by lying off 1/3 of the staff, changing the menu from a la carte to a Prix Fixe. Right now the model shows $ 27 at break even with the menu change. It will be interesting to see how he evaluates my consideration and if we will survive this downturn.

[echoes]

Originally Posted by Jack Moroney

While I am sure that this too will pass with a long and painful recovery, what bothers me most about this is not the dent in my investments as much as the total lack of accountability for those that were instrumental in precipitating the events that led to this day of reckoning. While this is not the end of life as we know it, it certainly is another indication that those in positions of power, as well as those of us that put them and keep them in power, need to pluck their heads out of their collective fourth points of contact and get this right. We are truly at a breaking point the in US's ability to secure its national interests at home and abroad-and for that you can thank our self-serving politicians.

Col. Sir,

You have very eloquently put so many Americans thoughts into words, indeed.

The only thing I enjoy reading as much as your posts, are posts about guns. Go figure?

Holly

[nmap]

Most funds - except a few sector funds that focus on a small area - avoid heavy exposure in a single stock. Even those that do have such big positions will generally liquidate early in the process - it is a rare money manager who hangs on like grim death as a stock declines into oblivion.

However - you asked about mitigation. One easy approach would be the purchase of put options. I don't know how familiar you are with options, so I'll take the liberty of talking about them.

An option is a contract that can be traded in the open market. A put option permits the owner of the put to force the seller of the put to purchase 100 shares (usually) of a stock, any time before a specified expiration date, at a specified price - which is called the "strike price". So, if the stock goes down, the option owner can "put the stock to" the option seller.

Suppose a hypothetical stock is selling for $20 per share, and we were concerned it might go down. We could purchase an April 2009 put with a strike price of 15. We might pay as little as $25 to purchase it. So if our stock went to $10 per share, we could force the other person to pay $15 per share any time before the expiration date in April. Cheap insurance, right?

We could also sell a call. The call permits the buyer to take the stock away from us at a given price. Suppose we sell an April 2009 call at a strike of $20. And suppose we get $150 for it. If the stock sinks to $19 per share, we have a loss on the stock of $100, but a profit on the calls we sold of $50 (the $150 we got for selling it, minus the $100 loss on the stock).

All the numbers are hypothetical, of course, and purely for illustration.

You can see an example of calls on LEH HERE. Calls are at the top, puts at the bottom.

Individuals can do this too, but it generally works best for a large portfolio - such as a mutual fund.

Hope that helps...

Originally Posted by CoLawman

Nmap,

For those of us with mutual funds, what action does a fund manager take to mitigate losses when the fund has substantial holdings in, say a Lehman? I assume (the alternative is too frightening) they are doing something!

[nmap]

AIG - looks like the Fed is coming to the rescue. LINK

Wise? I think so. The economy is already seeing some decline, and further disruption of the credit markets doesn't help anyone. The action may be inflationary, and may put an additional burden on taxpayers - but the present market volatility could be disruptive.

A bit more obscure:

Lowry's reports that yesterday was a "very decisive 90% down-day", the third one in September and the sixth one since April.


This comes from a subscription newsletter, so I cannot provide a link. Usually, the market goes up for from 2 to 7 days after a hard down day. A 90% down day means that 90% of the New York Exchange's volume came from declining stocks.

For a turn, we need several of these, followed by a 90% up day. The present situation is part of getting to a bottom in the market, so in a way, this is good news.