The Fearful Rise of Markets

Prologue



1954: The World Recovers from the Great Crash World stock markets at last recover to the level they first reached in 1929 before the Crash. US households' debts account for 40 per cent of the economy half a century later, when the crisis breaks out, this will have risen to 140 per cent. This is the year when people decide stocks are worth more that bonds. Economists have started to publish the theories that will lead to the efficient markets hypothesis, the foundation for modern finance, which says that risk can be controlled, and stocks will always do well in the long run.



Let us look at the world as it now appears; it is divided into three camps, the Capitalists, Communists and the Third World, which rarely interconnect; the world is young, with the Baby Boom generation still being born, and workers can look forward to generous guaranteed pensions; capitalism is anchored by the Bretton Woods system of exchange rates; the dollar is tied to gold; and the strict regulations over finance brought into force after the Crash of 1929 remain in force. The world appears very risky. Many believe a nuclear war is inevitable. The developments of the next half century will be a big victory for the optimists, helping markets to rise and investors to get rich and complacent.



Chapter 1



1971: Nixon Leaves the Gold Standard Once Nixon ends the Bretton Woods era, currencies will float, and the dollar will be backed by governmental fiat, rather than hard cash. This was the result of the decade-long inflationary build-up of the 1960s, as Americans tried and failed to pay for the Vietnam War. The gold standard was a deflationary force, while Bretton Woods required the US to stockpile even more gold to meet international obligations. Both had to go. Nixon's move follows many other opportunistic moves to balance the US budget. President Johnson had taken Fannie Mae, the government mortgage bank, off the federal balance sheet; from now on, its managers will be trying to make a profit, backed by a perceived guarantee from the government.



Chapter 2



1978: Paul Volcker Declares War on Inflation Paul Volcker arrives at the Federal Reserve, almost by political accident, and declares war on inflation. After the 1970s, when an oil spike forced the western world into "stagflation", he assumes that nothing else will work. In place of the gold standard, the world will instead have to place its faith in the anti-inflationary zeal of the Fed. After extreme pain, bond yields start falling. Thatcher and Reagan follow, pushing back unions and driving corporate profits upwards.



Chapter 3



August 1982: The Volcker Bear Market Hits Bottom And Mexico Collapses; The bear market that Volcker had provoked finally hits bottom and stocks are no higher, after inflation, than they were in 1954. Excesses have now been squeezed from the system. Confidence gathers from here that inflation has been beaten. Then the First Mexico Crisis comes in its wake, and gives us the first "modern" crisis. Excessive lending across borders led to a currency crisis when US rates rose, and thence to a banking crisis when the banks' loans went sour. It shows that capital flows could tip over emerging markets and that the big US banks had a knack for irresponsible behaviour.



Chapter 4



October 1987: Black Monday; The world's stock markets fall 20 per cent in a day, as the first big boom based on the assumption that inflation was vanquished comes to a sudden end. What triggered the crash? A scheme using derivatives known as "portfolio insurance" that was meant to help investors to use futures to "hedge" against a falling stock market. It ended up forcing them to sell even more as the market went down.



Chapter 5



March 1989: Michael Milken Arrested; The "junk bond" era ends as Michael Milken, who pioneered the offering of high-interest bonds by risky companies, is arrested. Junk bonds took a job once done by bankers, lending to risky companies, and gave it to the market. Rather than do homework on the risks they were taking, the theory was that investors could buy a big range of bonds, and "diversification" would see them through some bonds would default, but most would survive. In this era, the market also takes over from banks the job of financing mortgages, as they are packaged into bonds, and sold on to the market so that, again, the people who ultimately took the risks of default were divorced from those who decided to make the loan in the first place.



Chapter 6



New Year's Eve 1989: Japan peaks and History ends. Japan's stock market reaches an all-time high, when it is worth more than that of the US, amid an era of euphoria the Berlin Wall has just come down, and according to Francis Fukuyama, History itself has ended. In China, months after Tiananmen, the new deal is guaranteed economic growth, in exchange for continued lack of democracy. Eastern Europe has ended communism. Global markets will have to deal with the emergence of many new players at once.



And now comes Japan's crash after the familiar pattern of intense capital flows and excessive credit leading to a hangover. The damage to the banks will bedevil the Japanese economy for two decades, and to prove to the rest of the world that even without the gold standard, deflation can happen. Banking crises are now endemic. As Japan responds, it weakens the yen, setting up a new safe game for currency traders the "yen carry trade".



Chapter 7



1992: Sterling's Black Wednesday - Soros Defeats the Old Lady George Soros shows that hedge funds can drive exchange rates by betting aggressively that the British government cannot maintain the pound's value. The Bank of England raises rates twice in one day, from 10 to 15 per cent, to try to keep the pound in line with the German mark, and then gives up. The next day, it instead cuts rates to 9 per cent, in a reverse of its entire economic policy. The lesson; try to keep a currency fixed in the new market environment, and someone in the market can bet against it.



Chapter 8



December 1994: The Tequila Crisis. Mexico changes government, and immediately suffers a devaluation crisis that sends the whole of Latin America into economic chaos. It leads to a banking crisis. What caused it? Alan Greenspan in the US is playing to the Volcker playbook, and has just prompted a bear market in bonds by hiking interest rates aggressively. The result is a crisis somewhere else, following a huge inflow of money. That crisis is caused by derivatives unknown to Mexican regulators, domestic banks have swapped out of peso liabilities, and into dollars. A move they thought would cause pain for American banks instead causes death for Mexican banks. And, once more, there is a bail-out to deal with the problem.



Chapter 9



December 1996: "Irrational Exuberance" Reaches the Tiger Economies. Alan Greenspan tries to check the latest nascent bull market by publicly worrying about "irrational exuberance" in trading rooms. He follows through with a rate hike, but it has only a brief impact. The reason - small retail investors in the US are pouring money into the stock market through mutual funds. They believe in another Greenspan phrase, the "New Economic Paradigm". When the Asia Crisis hits in 1997, it shows mutual fund investors' new power. A scare in Hong Kong creates such a sell-off on Wall Street that the New York Stock Exchange is forced to close early; next day, the retail investors buy and the market powers on. In the US, the lesson is that there will always be money from retail investors (many of whom are Baby Boomers and now saving heavily ahead of their retirement). But the lessons drawn in Asia are different after their currency crisis, and the harsh measures of the IMF, they decide they will need to hoard dollars.



Chapter 10



April 1998: An Unholy Holy Week - Citigroup is formed by the merger of Citicorp and Travelers on Palm Sunday, while the week ends with NationsBank buying Bank of America. They create huge banks that are far too big to be allowed to fail, and force the abandonment of the old division between investment and commercial banks. Instead, banks are trusted to regulate themselves, and to out-source all their "due diligence" on credit quality to the rating agencies. The Basel II agreement does not even mandate how much capital they need to keep to guard against risks, as banks are allowed to trust their own models to do this. The transformation from the era when investment banking was controlled by partnerships is complete.



Chapter 11



September 1998: LTCM - Genius Fails Long-Term Capital Management, the most brilliant of the new breed of unregulated "hedge" funds melts down, and nearly takes the financial system with it. Rather than let that happen, the Fed bangs the heads of Wall Street chieftains together, and engineers a bailout. Only Bear Stearns, the most unpopular bank on Wall Street, refuses to help out. What had LTCM done wrong? It had piled up huge leverage behind bets that tiny anomalies in markets would correct themselves over time. When the Russian default sent markets hurtling in a different direction, they stood to lose everything and this caused the entire credit market to freeze, because all the big banks that had lent to LTCM were now themselves in danger of huge losses; and everyone in the market knew that LTCM was desperate to sell the investments it had. Paul Volcker predicted the worst by intervening, he said, the Fed was stoking "moral hazard," or the belief that there would always be a bail-out for a risk that went wrong. With markets still frozen after the bail-out, Greenspan cut rates to make sure the markets got going again and ignited the dot com bubble. .



Chapter 12



March 2000: The Dot Com Bubble Bursts The dot com bubble finally bursts. It had already looked manic, but went into hyperspace shortly after LTCM, with the IPO of theglobe.com, which rose by 900 per cent on its first day. Low rates to save Wall Street had created a bubble in tech stocks. The Y2K scare, which prompted the Fed to get even easier with money, only made the problem worse. At the peak, the stock market was even more insanely overvalued than it had been before the Crash of 1929. From March of 2000, executives of recently floated companies started trying to sell their shares, while researchers started looking at the weak cash flows of the companies. The Nasdaq market crashed, paper fortunes were lost, and mutual fund investors found you could lose money on stocks. Hedge funds, which can bet on share prices to fall, manage to make money as the Nasdaq crashes, ensuring that the next decade will belong to them, not mutual funds.



Chapter 13



October 2002: Cheap Money Wins The Worldcom scandal follows Enron, the US prepares for war with Iraq, and the stock market pivots and rallies. Why? The Fed is desperate to avert deflation in the wake of the dot com bust, and cuts rates to 1 per cent. The result, as with the cheap money to help banks that spurred the Nasdaq bubble, is to send money pouring into places that don't need it, and to weaken the dollar. Anything that can be a hard asset to protect against inflation, or that can be bought with cheap debt, sees its price shoot up. That means bubbles in housing, commodities, and emerging markets. Long-term metrics suggest stocks need to fall far more to flush out the excesses of the internet boom but the flood of cheap money stops this from happening.



Chapter 14



April 2005: Delphi Downgrades Debt Derivatives The decades-long pressure on US auto-builders finally becomes unbearable. The debt of General Motors and Ford is downgraded by the big rating agencies while Delphi, their biggest components supplier, goes bankrupt. That creates a critical test for the market for credit derivatives, which the big banks had developed to enable them to swap default risks among them. The market now has a notional value of many trillions of dollars, but has never been tested by the collapse of a big company. The market wobbles but pulls through. Credit derivatives foster the belief that credit risks can be spread around, and virtually vanish altogether. That makes debt much cheaper, and companies start borrowing all the money they can to buy back their own stock. Hedge funds also borrow more, and use the money to make ever bigger bets. Greenspan's Fed raises rates gently, but long-term interest rates don't budge. This is because foreign governments, led by China, are buying US bonds. All of this debt-driven financial engineering pushes up the stock market. Despite unprecedented cheap debt, volatility reaches an all-time low.



Chapter 15



February 2007: Shanghai Surprise World markets have their scariest day in a decade. Shanghai falls 9 per cent; then bourses fall across the world, capped in a terrifying afternoon on Wall Street when the Dow falls by 200 points in a minute. Because the selling started in Shanghai, it is blamed on China people think it is a re-run of the Asian Crisis. But this sell-off was triggered by a wave of bankruptcies for subprime lenders in the US, which had happened as house prices in the US began to fall, having finally touched unsupportable levels. The incident ends the "Great Moderation," as volatility moves above its historic lows, and stays there. Many clever financial models that rely on stable prices no longer work. Yet the credit binge continues for five more months.



Chapter 16



July 2007: An Accident at Bear Stearns The credit market finally and sharply falls, as the price of insuring against default on subprime mortgage bonds, and a range of other risky credit, suddenly rockets upwards. Bear Stearns creates panic by announcing it cannot put a value on two of its hedge funds, because it could not put a price on the credit in the fund. This is the "Emperor's New Clothes" moment investors ask how much their own credit holdings are worth and head for the exits. Now, we find out how interconnected world markets have become. Quantitative hedge funds, which make microscopic bets on the relative performance of different stocks, lose a third of their money in two days even though they supposedly had no exposure to the market. All were using borrowed money to hold the same stocks. Once one fund was forced to sell, the prices were forced down for everyone. But despite this growing chaos, hedge funds got a concession from regulators they had been requesting for years, with a change of rules that made it much easier to sell short, or bet that a stock will go down.



Chapter 17



August 2007: Cramer-Day; CNBC commentator Jim Cramer proclaims: "We have Armageddon in the fixed income markets". Countrywide, the biggest US mortgage lender, is in desperate trouble, and threatening to bring down the system. "Release the pressure," Cramer yells. Banks no longer trust each other, and the rates they charge each other for short-term loans shoot up. And the market no longer wants to buy short-term loans known as commercial paper from companies. Many rely on this funding to pay wages each month. Should banks be allowed to fail? Bill Poole, a Fed governor says punishment has been "meted out to those who have done misdeeds and made bad judgments". Cramer calls him shameful. In the end, the Fed gives up, cuts interest rates and gets Bank of America to rescue Countrywide the stock market zooms upward as traders assumes the script after LTCM in 1998, and WorldCom in 2002, is being replayed). But the credit market remains stricken.



Chapter 18



September 2007: Northern Rock Hits a Hard Place One night Mervyn King, governor of the Bank of England, excoriates the European Central Bank for caving into moral hazard. The next, he has to announce a huge rescue plan for Northern Rock, one of the biggest retail banks in the UK. That does not prevent the first bank run in England since the age of Charles Dickens, as queues of anxious depositors form around Northern Rock branches across the country. What happened? BNP Paribas freezes three of its money market funds, because it is not sure how much they are worth. The European Central Bank responds by flooding the market with cash. And, for Northern Rock, this is the day "the world changed" as the credit crunch goes international.



Chapter 19



October 2007: Partying like it's 1999 The emerging markets, led by China, go on a last huge surge, as investors bet that cheap rates from the Fed will mean more money going to places that are already healthy (just like in 1999 before the Nasdaq crash). They are also betting on the "decoupling" thesis that the big emerging markets have decoupled from the West economically, and can keep growing whatever happens elsewhere. Wall Street sells the emerging markets remorselessly to its clients. China's boom is fuelled by locals who have suddenly discovered the joys of investing in stocks. And then, the boom begins to collapse under its own weight.



Chapter 20



November 2007: Hallowe'en and the top of the market The big fall from what now proves to be the market's top on Hallowe'en 2007 comes when Meredith Whitney, a little-known banking analyst, publishes research suggesting the losses from bad mortgage debt could be so severe that Citigroup will have to cut its dividend. Much worse is, in fact, in store. Investors realise that the bad debts have not gone away, but remain sitting on banks' balance sheets. Worse for confidence, the debts were so dispersed by the markets, and are now so opaque, that nobody knows who is holding them. The US launches its plan for a "Super SIV" (a vehicle that will buy up all the commercial paper and other debts that nobody wants to touch). But it never happens. The problems are insuperable. But the market still manages to rally into the end of the year once it hears the Abu Dhabi Investment Authority has invested in Citi the high oil price has means that it is holders of petro-dollars who truly wield power.



Chapter 21



January 2008: Jerome Kerviel Frightens the Fed: A rogue trader at Societe Generale piles up bets that European stock markets will continue to go up; and when the banks finds out and sells them, the markets swoon. The economic news is turning bad. In New York, monoline bond insurers are scaring everyone. They guarantee many mortgage-backed bonds. Without those guarantees many investors will have to sell the bonds and it appears the insurers are about to go under. The swoon in Europe panics the Fed into a huge and unprecedented emergency rate cut. Then news comes through that the authorities in New York are brokering a monoline rescue and the market suddenly surges upwards once more led by commodities.



Chapter 22



March 2008: A Disaster At Bear Stearns Word gets around that Bear Stearns, heavily involved in all the areas that provoke most concern, is in trouble. Short sellers attack it, forcing down the share price and making it harder to raise equity. Clients try to take their money out. Bear is so heavily leveraged that it swiftly runs out of money. It threatens to declare bankruptcy, which would mean disaster for anyone holding on to debt or credit derivatives issued by Bear Stearns. The Fed instead arranges a fire sale to the stronger JP Morgan and gives Morgan money to make the deal happen. Then a speculative attack starts on Lehman Brothers; but it dissipates. Bear was unpopular on the Street, but Lehman has friends. And the Fed cuts rates once more, while promising to take many forms of mortgage-backed bonds off banks' hands. Markets rally again. Investors convince themselves this was a moment of catharsis. The oil price goes into orbit.



Chapter 23



July 14, 2008: Bastille Day Ends the Inflation Scare, A great inflation scare peaks on Bastille Day, and collapses under its own weight. Traders were betting simultaneously that the US banking system would collapse, and that cheap money to fight the US crisis would push up oil prices. Those high oil prices put the European Central Bank and the Fed at loggerheads, as they threaten to raise rates to rein in inflation. They take their eyes off the banking crisis (which would normally cause deflation), and there is a huge run on bank stocks as short sellers bet that many banks will go bankrupt. Fannie Mae and Freddie need a rescue and the world loses its faith in "decoupling" as investors in the commodities market charge for the exits.



Chapter 24



September 15, 2008: Lehman's Lost Weekend The roof falls in. Lehman Brothers files for bankruptcy: nobody knows the extent of its losses, nobody is prepared to fund it any more, and the US government refuses to help. At last it has to draw a line under "moral hazard". Barclays nearly buys them but pulls out and gets a large chunk of Lehman for cheap a few days later. Bank of America pulls out when it gets the chance to buy Merrill Lynch instead. AIG asks for help and is allowed to lend money from its (boring and healthy) insurance businesses to its stricken Financial Products division. Wall Street is shaken. How will markets respond?



Chapter 25



Sep 17, 2008: Panic Wednesday; AIG receives a huge bail-out, spreading even more confusion over the government's intentions; and the Reserve Fund, a money market mutual fund, announces that it will have to "break the buck" and fail to make its investors whole. It had been holding debt issued by Lehman. Investors had always assumed that such funds could not lose money; they desperately pull their money out. Hedge funds find they cannot access funds and securities held by Lehman, so have to sell everything else; and a speculative attack starts on the biggest investment banks. "Deleveraging" starts everyone simultaneously calls in their debts, forcing others to sell their investments in order to repay them, and pushing the market down all the more. Amid total panic, the yield on Treasury-bills, the safest investment there is, drops to 0.01 per cent. Safety has not been so expensive since Pearl Harbour. The yield on almost all riskier forms of debt shoots up to by far its highest levels ever. The stock market tanks and earns back all its losses in the next two days as short-selling is banned, and word leaks that there is a plan for a government bail-out.



Chapter 26



September 29, 2008: Trouble Under the TARP Wall Street gets its biggest ever shock, as the $800 billion bail-out is voted down by the House of Representatives. This showed to the market that the political class still had not a clue what had hit it- even though Washington Mutual, the archetypal "Main Street" bank has just suffered by far the biggest bank to collapse in US history. The result in the minutes after the vote is the biggest and most sudden wave of selling in the history of the US stock market. The country is thrown into angry political debate, the politicians take two days off for the Jewish New Year, and vote in the bail-out on Friday; but the damage is done. Stocks sell off anyway.



Chapter 27



October 6, 2008: The Stock Market's Slow-Motion Train Wreck By the end of another terrifying weekend, with European and Asian authorities also trying to stave off disaster at a series of stricken banks and institutions, and hedge funds now in deep distress, there is no alternative investors start getting out of the stock market. No single day gives us the hallmark crash, although the most sickening sell-off comes on the Jewish Day of Atonement. By week's end, the world's stock markets have suffered their worst week ever. Never before have all the world's markets fallen so severely and in unison. This gives us a blow-by-blow of the week; incorporating remarkable historic parallels with other great crashes



Chapter 28



October, 2008: The Carry Trade Crashes With so many investors now suffering huge losses from the stock market crash, they rush to sell investments and bring money home. That means buying dollars (because most investors are based in the US) and paying down debts in yen. So as equities crash, every currency in the world falls against the dollar and, particularly, the yen. These trades were all supposed to be uncorrelated; in fact traders had made the same bet in many markets, inflating a super-bubble.



Chapter 29



October, 2008: Then Emerging Markets Crash From Korea to Mexico, from Brazil to Russia, emerging markets suddenly find themselves in deep trouble. The collapse of the carry trade, and the exit of cash from their nations as investors look to repatriate their assets, suddenly makes it impossible for many companies to pay their debts. Many had taken out "hedges" against this happening that proved counterproductive, and inflicted greater losses on them. Many are forced into bankruptcy. Meanwhile the cost of borrowing for their governments skyrockets, as nobody wants to take the risk of lending to emerging markets. They had been doing all the "right" things this time, but events still follow the playbook of the great crises of the past. The Fed comes up with money for emerging markets, too and suddenly they begin to rally.



Chapter 30



November 21, 2008:Citigroup's Near-Death Experience Yet another lost Wall Street weekend as Citi lurches into trouble again. Why? Because Hank Paulson decides to change the Tarp, and not to buy troubled assets with the funds voted to him by Congress. If the government will not buy troubled assets, nobody believes Citigroup can survive. So the stock market heads for another sickening low, until the Fed comes in, yet again, with a huge new bail-out for Citigroup. The news breaks just before the Thanksgiving holiday, and that seems appropriate as the stock market gains 10 per cent in a day.



Chapter 31



January 2009: Out Come the Pitchforks With markets calmer, news of a free-fall in the real economy comes in. It is the biggest one-off shock in history. Across the world, businesses slash production, consumer stop spending, and trade freezes. Protectionist sentiment rises around the world. President Obama takes office, and his new treasury secretary swiftly shows that he does not yet have a plan to deal with the banks. That sets off another deadly tailspin for the market, while the population once shocked and in denial, gets angry. Demonstrators fill the streets of London during the G20 summit, they vandalise the homes of executives in receipt of bonuses from AIG and big pensions from the Royal Bank of Scotland, and the US chat show host Jon Stewart humiliates Jim Cramer, telling him he had encouraged people to treat investment as a "f***ing game".



Chapter 32



March 2008: Bounce

When all hope has been given up, Citi announces that it has made a profit in January and February, the market rebounds, and keeps rallying. Why? The Obama Administration succeeds in taking the heat out of the banking crisis, buying time by conducting "stress tests" while waiting for confidence to resume. Low interest rates help banks profit, and rebuild their capital; so do relaxed accounting standards. Total financial meltdown seems to have been averted. In China, traders see signs that growth has resumed, and money pours into the emerging markets once more. With disaster averted, optimism takes over.



Epilogue



The World in 2009: Recovering from the Second Great Crash. Confidence and "animal spirits" have returned. And yet the prognosis is still troubled; mortgage defaults are likely a long way from their peak; the world is ageing and a crush of Baby Boomers now want to retire; households have barely started to shift the historic burden of debt that they had accumulated; and companies have only started to repair the damage to their balance sheets. Central banks face the risk of inflation, and must soon confront the dilemma of when to start taking raising rates once more. Protectionist forces remain strong. And the job of reforming the banking sector, where power is unhealthily concentrated in a few giant institutions, has not even started. A Great Depression has, it appears, been averted; a Great Recession looks hard to avoid.