The Coming Crash of 2008: A Result of Overleveraging

I think it is highly likely that the stock market will crash before the spring of 2009. I choose the spring of 2009 as my outside date because corporate earnings reports are only audited once a year, at the end of every year. These audited reports are a key reason why stocks did so poorly this January. When accountants only review (not audit) quarterly reports, there is a lot more discretion on how to value your derivative holdings or "mark them paper to market", as the accountants refer to it.

That being said, our critical problem with the stock market is overleveraging.

Recall that in the roaring 20s, during that fantastic stock market boom, people were allowed to purchase stock on just 5% margin. Fantastic sums of money were made on the way up, but this extreme overleveraging caused their magnified losses to become catastrophic when events turned unfavorably. Conceptually, it's similar to how you can quickly lose much more than your initial investment in the futures market, because only a very small margin deposit is required.

As a collateral point, I must mention that economists widely regard the Florida real estate crash of 1927 to be a material factor in triggering the 1929 crash. I assume the reader is familiar with the state of the Florida (and California) real estate market today.

That being said, after the 1929 crash, there was a very large outcry for something to be done to prevent future crashes. In 1932, Congress recognized the problems posed by excessive leverage and passed the Glass-Steagall Act which required all common stock purchases to be backed by at least 50% margin.

What has gone wrong in the current market environment, however, is that we are still excessively leveraged. The problem is that the bond and derivatives markets dwarf the stock market in size. The Financial Times has published estimates that the size of the derivatives markets is currently estimated to be 450 trillion dollars and the notional value of credit default swaps is 45 trillion. And these staggering sums do not even include the gargantuan government and corporate bond markets or the commercial paper markets.

And these enormous markets are unfortunately traded typically on 3-5% margin. Recall that Carlyle Capital only put up 3% margin and then folded when the market turned against them. Bear Stearns (BSC) leveraged its 11.8 billion of capital from its shareholders to control a balance sheet of 395 billion. There is simply not enough room for error when trading at such gearing ratios.

What is in fact occurring is conceptually similar to a massive margin call that would take place in the futures markets. The difference however is that it is occurring as you read this in the massive derivatives markets and this is now beginning to cause major players to be forced to dump stocks and banks to stop lending even to their most creditworthy clients.

There are other serious difficulties that are highly likely to lead to this crash. I will not explore them here. However, I am filming a documentary entitled "The Crash of 2008". Portions of what will be used in parts of the film are now available online.

I was a market maker in derivative securities and have read hundreds of research papers published by individual Federal Reserve branches. I found the most informative ones to be from Kansas City and Atlanta and the least helpful ones to be from St. Louis and San Francisco.

Additionally, I have reviewed scores of research papers by various Federal Reserve branches prior to publication.

Comments

[disbeliever]

Another in a world of doomsayers. It might be interesting if there was any empirical evidence, but there is not. A more plausible thesis would be built on either the Elliot Wave Theory or Kondratiev Waves with business and consumer wave cylces.

Sounds like this author is trying to sell a book or movie rather than be predictive.

[User 165139]

Greenspan and this guy seem to be on the same page.Oh Boy!

[Pragmatus]

I think Matt makes very good points. I don't think it is possible however to nail a disaster timeline successfully, any more than it is possible to successfully "time the market". But there are deep problems not only in the derivatives market but in nuts-and-bolts investing as well. The business world is so divorced from reality that when any company has a pot of cash to spend, do they distribute it in the form of dividends, or invest it in R&D? No, they announce stock buy-back plans, one of the worse uses of cash imaginable. (The theory is that with fewer shares outstanding the price per share will be driven up, but this never has any long term positive effect--it is exactly like inflating a bicycle tire that has a hole in it. It works only for a while.)

This is the sort of insanity (along with silly schemes that squeeze another cent onto the earnings report merely for the sake of "beating the estimates", the company be damned) that has to be shaken out of business thinking before the current whipsaw, panicky markets can return to some semblance of usefulness for investors.

[Georealist]

This what is known as simple minded linear projection. Do you have a real job or is this how you inflict yourself on people? I've been an investor for over 35 years and watch the investment markets very closely..and I have no clue about a yer from now..or even 6 mos. from now. One thing is certain..every wanna be financial futuist now has a band wagon to jump on...and very few of them were riding on it when it counted.

[Roseu]

Lots of misinformation; margin rates are set by the Federal Reserve, not the Glass-Steagall Act. Further, not all economists ascribe the Depression to the Florida bubble. I wonder what else is wrong here?

[Tom B]

I think we'll see significant turnaround 1) If Helicopter Ben gets axed and/or 2) with an Obama win in November. The latter, because one major drag on the economy is the money-hole known as Iraq.

[gatekeeper]

Mr. Dubuque, how do you think this 'problem' should be addressed?

[Things ComeUndone]

What other factors at play can cause a crash or stop one? Fear of losing money is now building up momentum which is never good for the market. To have a good market show me what can get people happy about profit again.

[poet1]

From Fast Food Nation 2002: (glass/s act)
The history of the 20th century was dominated by the struggle against totalitarian systems of state power. The 21st will no doubt be marked by a struggle to curtail excessive corporate power. The great challenge now facing countries throughout the world is how to find a proper balance between the efficiency and the amorality of the market. Over the past 20 years, the U.S. has swung too far in one direction... (p. 261)

I think Schlosser has it right. Enron is an inflection point for the forces of corporate power. Today's Times reports that the "bankruptcy reform bill" that passed both houses of Congress last March -- a bill practically written by credit card companies to make it harder for consumers to wipe debt of their records by filing for bankruptcy -- is now up for revision:

Some lawmakers are weighing whether to revise provisions that could appear anti-consumer and poltically unseemly after a corporate collapse that hurt thousands of workers and investors. "Even some of the lobbyists who supported the bill tell me that they are afraid to touch it now," Senator Leahy said.

I'm interested to watch the degree that consolodations will now break apart. Tyco spent the last five years acquiring at a massive rate; now it will split into a series of independent companies, sometimes even using corporate names left in the dust two or three years ago. The Glass-Segal act, a law passed in the 1930s that mandated a separation of lending and investment banking, was repealed in 1999. Now, Congress is discussing reinstating the act (though the Times calls the odds of reinstatement "very unlikely."). In politics, a swing to the left may be beginning. An abashed liberal president? Could happen in 2008. Maybe even 2004. Good news for John Kerry? Good news for Anti-Trust Attorneys?
· How Will Washington Read the Signs? [NY Times]

[Tom B]

"The history of the 20th century was dominated by the struggle against totalitarian systems of state power. The 21st will no doubt be marked by a struggle to curtail excessive corporate power."

And, so far, we are losing. In the US, corporations seem to have more "individual right" than Individuals. The EU has somewhat more common sense in these matters (e.g. much smarter antitrust regulators).

[jcrash]

Seems we are losing the state power battle as well. I'm pretty sure Mr. Bush hasn't extended me any NEW rights and I know for sure he has taken some away and feels that HE is "the decideder."

[Climateer]

How many facts can you get wrong in 600 words?
Wirehouse margins were 10% not 5.
Glass-Steagall was enacted in 1933.
The Florida land boom peaked in 1925, by the time the Great Miami Hurricane hit in 1926 it was all over.
You underestimate financial leverage. It runs 25-35 x for investment banks, up to 100 x for LTCM.
Other than that...

[clitosil]

The melding of state power and corporate power is called fascism. As a country we used to be opposed to it, now we are it.

[tradersystemguru]

Matt, looking forward to seeing your film. Two questions for you.

1) The CDS derivatives market is approximately $45 trillion at last estimate (and had been doubling every year). Do you have any idea how much of that is at risk if real estate prices continue to drop?

2) Have you done any research on the demographic challenges facing our economy in work done by Harry Dent and Daniel Arnold? In a nutshell, their premise is that in 2009-10, baby boomers who now represent 78 million Americans hit a median age of 49 after which they will begin to reduce spending in preparation for retirement. This will cause a dramatic drop in consumer spending which is 70% of the US economy. According to the data, each time this has happened in the past (1930 and 1966 in the US and 1990 in Japan), at a minimum a serious extended recession has resulted.

I'd be curious to communicate with you for a possible interview. I can be reached at matt at tradesystemguru.com......

Thanks

[drmalaka]

Judging from these comments I could not be happier being short. How come everyone is looking for a bottom six months after the top? The top was completely artificial, based on historically high PE ratios and net profit margins.

Stop looking for a bottom in these financials, these are criminal enterprises that stole billions of dollars from their shareholders and to think about investing in them is rediculous. The Fed told us yesterday that they will save the markets but they will not save equity investors in these crappy companies.

This is the same idiotic attitude everyone took with ABK, every other Friday there was a new rumor, first one sent the comapany to 12.5 the next one sent it up to 11.5 and now it below 6.

This economy is a mess. We Americans are a joke. We have spent so far above our means that we have no way to go but down. How many idiots took equity out of their house to buy a new Hummer with 22" wheels? Everyone in this country thinks they are entitled to live this incredible standard of living, flat screen tvs in every room, new lap tops, new cars every three years. Then we look to the government to bail us out. Where the hell do we think the money is coming from? Cool, we tried to help this recession with a stupid 150b stimilus package that we billed to our kids.

For all you bulls who have found a bottom, what makes you think consumers are going to be spending a lot in the comming months? With what money? With the money they have to spend on high priced gas and food because our Fed keeps inflating our every day expenses to save these criminal bankers who should probably be lined up against a wall and executed?

I have been praying for years to see $5 gas, I just can't believe it happened so quickly. There is nothing more satisfying to me than seeing the look on the faces of people spending $100 to fill up their SUV that they drive around in alone.

And for the economic illiterate that said if Obama gets elected then we will be in better shape. Please drop me a line, if he gets elected I would like to sell you all my stock. Yeah, a socialist is going to help markets. Taxing corporations and capital is the way to spur an economy on. Hmmm, who can do better with capital, smart people who made the money, or lazy, stupid, economically illiterate leaches that suck off of society?

[GKM]

drmlaka I think you've nailed. it.

This is what's going to happen today (in about 40 min). The Fed will cut 100 bps. The market will explode higher, especially crude and gold. The dollar will absolutely crater. This will look great. For a while. Then folks will wake up and see what they have done and the party will be all over but for the hangover. The Fed is going to throw the party for Wall Street and Joe Public will get to deal with the aftermath.

Bear markets do not finish like this and its been that way since the beginning of time. Bull markets in oil, gold, and Euro do finish like this as time will shortly show.

[poet1]

DrMalaka- well said! So, where do you put your money?

[Rep07]

Great article... right in the face of snotty happy-thinking moron longs like georealist and disbeliever. It scares them, you can tell by the tone of their juvenile replies. Though the ongoing crisis will do untold damage to the world economy, it will be a pleasure knowing that insolent fools like them are being re-educated the hard way.

[Tom B]

"I have been praying for years to see $5 gas, I just can't believe it happened so quickly. There is nothing more satisfying to me than seeing the look on the faces of people spending $100 to fill up their SUV that they drive around in alone."

The markets have done what decades of Congressional inertia have failed to do.

"And for the economic illiterate that said if Obama gets elected then we will be in better shape. Please drop me a line, if he gets elected I would like to sell you all my stock. Yeah, a socialist is going to help markets."

McCain or Clinton would keep Iraq going longer; this is a money-losing proposition, unless they get some brains and re-group the whole US army around the oil fields and forget about Baghdad and "nation-building&...

[iThinkBig]

Very bright replies, all of them. In June I forecasted recession Q1 & 2 and recession again in Q3 & Q4 of 2009. I believe we will have a depression if we do not immediately innovate alternative energy as a national priority while de-regulating tapping into our own oil source(s). We must give the global consumer what they want and if we continue down this path of bailing Wall St. and the Central Banks any further, it won't be only Joe six-pack screaming for blood, it will be the entire world. Military misadventures in the nuclear age means a global societal correction nobody wishes to see.

[H2O]

Darn - Now We Have to ed-uma-kating - The Idiots!!!!

Now Obama says we have to reason with - The Idiots - Example
- IRAN training ala-quda - Here another doosie.

Cheney still preaching - IRAQ attacked America on 9/11 ....

Wall-street - passing of housing loans - as a big investment -
start a loan off low - and price it out of reach - but hey - thats
a good investment - ohhh wait - then why all the empty house - no
jobs - low pay jobs - The wall-idiots - just didn't get - how can
the people pay that much more ????

Okay it's a big dirty job - BUt lets start ed-uma-kating - The
wall-idiots .....

OHHHHHHHHHHH sorry - to all the washington insiders - and the wall-co's
I didn't mean to be like Clinton and make-fun of you using the way
you talk ......

WEll lets get busy - THis is going to be a majore job ....

I still think - It would be much-easier - to tar and feather them - and
run them out of town ....

...

[H2O]

Darn - Now We Have to ed-uma-kating - The Idiots!!!!

Now Obama says we have to reason with - The Idiots - Example
- IRAN training ala-quda - Here another doosie.

Cheney still preaching - IRAQ attacked America on 9/11 ....

Wall-street - passing of housing loans - as a big investment -
start a loan off low - and price it out of reach - but hey - thats
a good investment - ohhh wait - then why all the empty house - no
jobs - low pay jobs - The wall-idiots - just didn't get - how can
the people pay that much more ????

Okay it's a big dirty job - BUt lets start ed-uma-kating - The
wall-idiots .....

OHHHHHHHHHHH sorry - to all the washington insiders - and the wall-co's
I didn't mean to be like Clinton and make-fun of you using the way
you talk ......

WEll lets get busy - THis is going to be a majore job ....

I still think - It would be much-easier - to tar and feather them - and
run them out of town ....

...

[Rabbito]

peak oil is coming, and the result will be small to negative GDP growth for years to come

[Jxyzzy]

hmmmmmmmm!! how to make sense of this nonsenseical pratter? godzilla is attempting to come on shore and eat all
the fiat currency. My solution personally was in January "on my -0- debt home, to borrow 65% on a first @5.75 30 year fixed and a heloc 25%@ currently 4.99 then bought a wall of silver/gold coins that godizilla and the fed will look at in a curious manner and look elsewhere for a meal.
within 5/10 years my home will be free and clear again.
you can do the math. simple common sense, and yes I invite your ommniscent insight.

[nukldrager]

drmalaka... you can see the post mortem photos of these bankers in the right panel of the tryptich by H Bosch called "The Garden of Earthly Delights"

[Philly Jim]

This Fed is very concerned and involved. Getting down the national debt and invigorating domestic manufacturing is working so far; when we are out of this sub-prime mess, they will probably attack the price of commodities and allow the dollar to strengthen some. Further down the line, we could expect much more regulation but at the same time, more innovation or more involvement by regulators in assisting with innovation which will put the U.S. back on the edge of the financial game.

[venividivici]

Good post. I am no doomsdayer. I did fantastically well trading the market last year. But I agree with you. There is something very ugly coming down the track.

[AndrewHorowitz]

If you would like to hear from HARRY DENT about this, he was on with David Gaffen (Wall Street Journal) this week's - The Disciplined Investor Podcast - they tells an amazing story..

www.thedisciplinedinve.../

[goatfarmer]

'gargantuan' is a great word. But the author is most likely on pantagruelian.

[User 166212]

Oh Boy...another knucklehead claiming the sky's going to fall. It's the end for sure.

[AJ,WashingtonDC]

You're right about the derivatives dwarfing the 'real' markets and we all know the Hedge Funds, Commercial and Investment banks are highly leveraged to the point that an 'investor run' can bring them down like a house of cards.

That said, are you just going to make the movie about the Crash of 2008, or are you going to suggest any way to get out from under the Derivative Mountain? If the markets do crash, you wont have the funds to make and distribute your documentary film, and I certainly wont be able to afford to pay to see it :)

What the Fed is doing is shoring up th supports, but unless there is concerted action from other Central banks, notably ECB, China, and Japan and UK, there wont be any significant progress. In fact, once the dominoes start falling, people will see that the European economies are just as fragile and leveraged. Italy and UK's cracks are already showing, Germany and France are next.

What really worries me is the high proportion of LEVEL 3 assets the banks are holding. They have no idea what these securities are worth, and I have a feeling we are about to find out the hard way.

[blah blah]

Every time a recession hits people claim it's the end of the world. But guess what, history repeats itself, over and over and over again. We have some problems to deal with in financial markets right now, stocks/bonds are getting revalued. But most likely we are looking at nice run in stocks, maybe this summer, when people realize many equities are undervalued and the massive current short interest starts covering.

Then we are looking at 4-5 years of anemic growth (in the U.S. anyway). And thats assuming no new breakthroughs in technology.

Please enough of the doomsday B.S. there is no historical precedent for it. The FACT is that things are always getting better.

[nyka]

After reading your advice peace, I'm going to call my broker tomorrow morning and have him sell my 100 shares of Bear Stearns.

[special1person]

Don't know if anyone here grew up on a farm, but...

...when hogs are led to be slaughtered, they have no idea what will happen in the future.

Apparently, neither does the typical American investor know how much the Geniuses on Wall Street have led them down the path to be sacrificed on the altar of the Golden Calf of Mammon.

[gaucho]

There are three stages of a recession
1 Denial
2 Acceptance
3 Capitulation

Several people in the above messages are still at stage1. I agree this has the potential to be a disaster. The real-estate market will fall another 30% wiping out trillions in perceived and real wealth. This bubble in real-estate is the largest in the history of the United States. The leveraging/derivatives size is many multiples of the real-estate and leverage many times over. This is disaster waiting to happen. When it collapses the US will no longer be the financial capital of the world. It will take at least 7-10 years for us to recover. This country will never be the same.

[mynameis]

It's been 79 years since the great depression. And It's not unreasonable to expect another one! Having watched all 3 of the videos I'm inclined to agree with Matt. The goverment must agree as well as they have been scrambiling to find a fix ever since the "sub prime issuse" rasised it's ugly head last summer. I for one started by putting my investments in nice safe FDIC insured CD's then. And have continued that process this year. I feel fairly safe now. We've had a number of resessions over the past 60 years since coming out of WWII but never a Depression. So you nasayers can go on your way blind to the real facts of the upcoming year.

[swaps]

IOver leveraging through derivatives. Warren Buffeet said this in 2002:)


I view derivatives as time bombs, both for the parties that deal in them and the economic system.
Basically these instruments call for money to change hands at some future date, with the amount to be
determined by one or more reference items, such as interest rates, stock prices, or currency values. For
example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple
derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts
are of varying duration, running sometimes to 20 or more years, and their value is often tied to several
variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the
creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record
profits and losses – often huge in amount – in their current earnings statements without so much as a
penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because
today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for
many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the
parties to derivatives also have enormous incentives to cheat in accounting for them.

[ArkansasPhil]

I personally think the next bubble to bust will be the Credit Card Banks.
Frivilous rules are leading to lack of trust. Bankruptcies and banking practices are leading up to big pop. There was a day when the bankers job was to review one's finances and see if they were able to
pay a loan. Now, the credit card companies are offering money to citizens who may or may not be able to pay. Similar practices busted the real estate bubble. I personally think banks are entities not to be trusted. Greed has prevailed. Our government will probably bail them out like the real estate folks. They should be held accountable!

[packratfromvt]

ultimately, the derivatives are worth $0, just like they are now. The mark to market accounting required for untraded and illiquid assets is folly. how much is the future services of my wife worth if she stays home and takes care of the kis? what if she works for Emperor @ $2k/ hr? how does this value impact the value of a quickie at the Lincoln Tunnel? Can I get a swap? A synthetic hooker for her services?

Consumers show little regard for deleveraging, denial or delayed gratification. How's your house set up for HDTV next year? Gotta spend to get TV.

The Bear was brought down by Carlyle who looked at the choice of ponying up margin on agencies, and said "eat it. You want to f@ck with us, we can quit. You can't. Take these loans and shove it. "
In a more rational time, Bear's creditors would have looked at the AAA collateral and allowed time to unwind. Today, with Goldman having bet against the same book, they had to jump off the building. Into JPMS. Their largest counterparty. Life is good, markets work, the Fed matters.

THe mortgages going bad are bout 1/2 frauds- guys buying in FL, CA & NV hoping to flip for a profit. Pri didn't go up, I'll walk. Te FRBBoston reviewed subprime mortgage apps from 2007. 1/2 would qualify for conventional. they reviewed loans that defaulted during 2007- 9 of 10 were fraudulaent.

Look at your parents and grand parents situation today. They are so rich and spend money like sailors in Bangcock on holiday. The 1st baby boomer to retire was lamenting in USA Today that there won't be anything for her kids to collect, but she and her husband were collecting immediately to defer hitting their retirement accounts. They were both teachers(not paying SS unitl the mid 80's) owned 3 homes worth $1.2M and a $500k boat . I should have been a teacher. Screw my kids

There won't be a collapse, because there won't be a selloff. The options cushion the drops and generate income for the current period for mutual funds. We'll muddle through, somehow.

[Leser]

Congratulations, Matt! You got a discussion going.
I am amazed at the comments people write. (And scared, a little, too, by what they write.)
Your videos--I saw all three--sound to be and honest throughtful effort to help. I think I'd better go the Suzi Orman route and start paying down debt. Would that be part of the answer--everyone paying back debt as efficiently as possible? Sorry, that sounds like some of the facetious comments and questions above. Well, thanks for giving a sincere effort to alert us to the problem.

[sammyg123]

Thomas Barta writes as if he is on Obama's payroll. He also writes as if our global competitive edge will be magically restored if we withdraw from Iraq. Chaos in Iraq sends oil and gold through the roof, and withdrawal at this point in time would send oil well past $150, given that terrorism undermines oil security. This in turn will mean inflation in the United States, given our dependency on petroleum products in manufacturing and transporting virtually everything we make. Obama's pre-mature withdrawal strategy is an economic disaster to pile on top of the problems we already have. Further, he is a demagogue, and if economic horrors is his idea of "change," then I'd much prefer the status quo. Hegemons thrive with the status quo, so I guess what he is saying is that we need to no longer be the most powerful country in the world, because that will be good for the economy?

Obama's message is disconnected from geopolitical realities. He will destroy our country, IMHO.

Barta, this is a financial website. Silly socialists, finance is for capitalists.