Reflections on a turbulent week

Last week the US stock market delivered the most dramatic losses and gains since 2002.  For the week, the S&P 500 gained 0.3%.  Substantial changes have occurred, however, in the fundamental financial system of the United States.

Timeline

·         2000-2003 - The US Federal Reserve Bank lowers Fed Funds from 6.5% to 1.0% to boost the US economy following the bursting of the "tech bubble," aftermath of 9/11 attacks.  Rates are kept unusually low, which boosts consumption of, among other things, residential construction.

·         2000-June 2006 - US housing prices double; millions of new homes built, many new home-owners, lending standards relaxed or abandoned, hundreds of billions of mortgage backed securities (MBS) issued, hundreds of billions of derivative securities issued against MBS.

·         July 2006 - August 2008 - housing prices fall 18%, delinquency and foreclosure rates soar.

·         July 2007 - Two hedge funds invested in MBS and managed by Bear Stearns fail, costing BS 1.6 billion.

·         September 2007-May 2008 - after gradually raising rates to 5.25%, the US Fed aggressively drops rates to 2%.

·         October 2007 - US stock market makes a new all-time high, slides 10% by year end.

·         February 2008 - Lending limits increased Fannie Mae/Freddie Mac, which now underwrite 80% of all US mortgages.

·         March 2008 - Bear Stearns, the fifth remaining broker-dealer, faces virtual bankruptcy as clients withdraw assets, forced into a merger with JP Morgan.

·         July 2007 - Stock market hits a one year low as Citigroup, Merrill Lynch, Morgan Stanley, Bank of America announce additional write-downs on MBS.  IndyMac, a California mortgage bank, is taken over by the FDIC in the most expensive bank failure to date.

·         August 2008 - Stocks rise modestly, gaining for the first quarter in four, as the crisis seems to dissipate.

·         September 6th, 2008 - Fannie Mae and Freddie Mac are unexpectedly taken over by the US Treasury as their combined $85 billion in capital proves insufficient to support losses on a $5 trillion loan portfolio.

·         September 12th, 2008 - Lehman Brothers, already weakened by its own MBS losses, is brought to its knees by short sellers, client asset withdrawals.  Over the weekend Lehman fails to find a buyer, declares bankruptcy.

·         September 15th, 2008 - Merrill Lynch, seeing the writing on the wall, agrees to merge with Bank of America, leaving only Goldman Sachs and Morgan Stanley as the two remaining independent broker dealers.

·         September 17th, 2008 - AIG, an otherwise healthy insurance company, is brought down by exposure to "credit default swaps" (details below) and is forced to exchange warrants for 80% of the company in exchange for an $85 billion loan from the US Treasury.  US stocks hit a two year low, international and emerging stock markets fare even worse.

·         September 18th-19th, 2008.  US stocks stage an explosive rally as the SEC prohibits short sales of stock in over 800 banks.  US Treasury prepares a plan to purchase up to $700 billion in MBS through reverse, auctions, taps a $50 billion fund to back-stop money-market mutual funds.

·         September 21st, 2008 - Goldman Sachs, Morgan Stanley announce their conversion from broker-dealers to banks, submitting to full regulation by the US Treasury in exchange for permanent access to the Federal Reserve's discount window (which readily makes inexpensive funds available on an emergency basis.)

Read the entire commentary here.