One Cause of the 2008 Financial Crisis

One Cause of the 2008 Financial Crisis

Nobody creates a strategic plan for system-wide catastrophes. Everybody forgot the lessons of how portfolio insurance magnified the losses suffered on Black Monday, October 19, 1987.

In the 1980s everybody managing money took out what was called “portfolio insurance.” It was software designed to track your portfolio of investments. If the market value of one went down by a certain percentage, the software would start selling it to stop the loss.

For one fund, for one falling stock, this is a good idea. Cut your losses early.

But when every fund has this same plan, it method that when the complete market starts going down, everybody starts selling. So the market kept going down.

consequently the software kept issuing more sell orders.

Forcing the market down already more.

The Dow Jones dropped 22% in one day, and automated portfolio insurance was responsible for a lot of the selling.

If you’re in a theater and a fire breaks out you know you should run for the nearest exit. What will you do if hundreds of people are blocking your path? Nobody on Wall Street thinks about that.

Something similar happened with mortgage backed securities (MBS), collateralized mortgage obligations (CMOs), collateralized debt obligations (CDOs) and structured investment vehicles (SIVs).

They were sold to investors and institutions around the world as a safe way to increase their return on investment.

In this case, the problem wasn’t caused by enormous selling, because these securities are not liquid.

However, their returns started dropping as large numbers of home owners around the United States started missing payments on their mortgages and going into foreclosure.

Nobody had ever seen so many American home owners default on their mortgage debts, but never before had so many complete people been allowed to buy houses despite no or low downpayments, unverified incomes and poor credit ratings.

Once the situation started escalating, institutions holding the MBS bonds found their sales prices dropping. Mark to market rules (enacted in the wake of the 1980s savings and loan crisis) in the U.S. forced them to spread their balance sheets at the end of every day.

Only JPMorgan Chase saw the danger. They began unwinding their portfolio of mortgage-related securities in October 2006.

edges, hedge funds and other financial institutions around the world had been buying up the MBS. If they didn’t own some, they probably owned stock in U.S. edges that did. Or they’d made loans to edges that did.

Plus, the world’s financial institutions and markets are interconnected by off the books derivatives. Most of them are highly complicate financial contracts designed to “manage” risk.

But remember, that these people think “risk” method “price fluctuation” not “danger.”

So they take out derivatives that position their finances so they will make a profit under almost all financial conditions.

I press “almost all” because it’s impossible to remove “all” danger from this world we live in.

consequently, there’s always a “highly doubtful” scenario which, if it happens, will make the derivative unprofitable.

These scenarios don’t happen often, but when they do, they cause enormous financial pain.

Derivatives are the financial equivalent of playing Russian roulette with a gun with only one bullet and 99 empty (that is, safe) chambers. The odds are highly in your favor, but if the one bullet is in the chamber when you pull the cause, you’ll nevertheless die.

On Wall Street, the damage from the crisis was emotional. Not too long ago, Wall Street had five investment edges that were like gods to the financial markets.

Now, Wall Street has zero investment edges!

In March 2008 two of Bear Stearns hedge funds failed and it was bought out by JPMorgan Chase.

In September 2008 Lehman Brothers was forced to declare bankruptcy.

However, also in September 2008, Goldman Sachs and Morgan Stanley were allowed to transform to bank holding companies. And Bank of America was persuaded to buy Merrill Lynch.

And American and many taxpayers around the world are being forced to feel the pain along with the financial quants or engineers who arrogantly thought they’d conquered risk.

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