where we are now…(iv)

external shocks

Speaking in the broadest possible terms, stock markets tend to be driven by the ups and downs of listed company profit growth. Profit growth, in turn, is a function both of the skill of company managements and demand for their products/services and of overall macroeconomic conditions + government maneuvering (through interest rate and public spending policies) to achieve maximum sustainable GDP growth.

Every once in a while, markets are subject to external shocks, meaning anything not in the previous paragraph, that can, for a while at least, have a substantial depressive influence on stock and/or bond prices.

The pandemic is a major recent example. The Russian invasion of Ukraine might be another, although its chief stock market-related impacts have been on oil and gas prices and on the EU economies that depend directly on Russian supplies.

The two other big systematic shocks in this century were the popping of the internet bubble in 2000 and the housing loan/bank insolvency crisis of 2007-08. My understanding is that both involved popular delusions plus a healthy dose of securities fraud.

–the housing loan crisis started out with the apparently innocent observation that people who owned their own homes live happier, healthier lives than those who don’t. So it became a government priority to encourage home ownership. That meant banks making mortgage loans. Rather than keeping the mortgages on their books, modern banks typically collect a processing fee and package loans in large bundles to sell to pension funds and other institutional investors. A popular variation on this theme became sorting bundles by the riskiness of its loans and maximizing the selling price by offering different risk tranches to insititutions with different risk tolerances.

Once all the “safe” mortgage loans had been made, banks began to make riskier loans. Then the after-action and press reports I’ve read say the banks began to pressure the rating agencies to give high ratings to low quality loans ,,,which they did. Then, ratings were given to a specified package of loans but in the product then offered to institutions the rated loans were replaced with inferior securities. Another source of trouble, somewhere along the line loan originators began to “improve” the financial qualifications of borrowers. And with all this extra demand, home prices began to rise, making loan to value ratios much iffier. Then borrowers began to default. Then the US banks realized that even after unloading the most toxic junk on EU banks, they retained enough exposure that they were effectively bankrupt. Yes, they had some insurance coverage, but the issuer was as insolvent as they were.

More bad stuff: companies in, say, China that shipped goods to California relied on letters of credit issued by US banks stating that the customer had money on deposit and the shipper would be paid once the goods reached the US. But what good was that if the bank went under during transit. So world trade came to a screeching halt. Also, tech-ish companies still smarting from not having laid off more workers sooner after Y2K started massive layoffs.

This was the worst economic time since the Great Depression.

tomorrow: Y2K, the other market pothole

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