The Coming Crash of 2008: A Result of Overleveraging

by: Matt Dubuque

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 (NYSE: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.

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