The Big Meltdown

This Krugman piece, The Big Meltdown, appeared recently in the NY Times. As I have said before, there is a lot of irrational behavior going on in both the public and private markets. Debt remains high, all asset classes have seen big rises and investors, hungry for the rush of another "hit", stretch further and further up the risk curve seeking yield. Until last week, the VIX (index of market volatility) was pinned down at 10, which is excessively low by historical standards. Risk has become a thing of the past and complacency reigns supreme.

Unfortunately, it is impossible to predict when the chickens will come home to roost. In Chaos theory, you can determine that a system has entered an unstable period, but it is usually an unexpected, non-linear factor that bumps the market to its next steady state. As long as equilibrium remains in the "Goldilock" economy with all parties agreeing to do their part, this could stretch on for some time.

That said, the sudden drop in the China market, followed by all other global markets falling show that the law of physics still exist and that our global systems are intricately connected.

I believe that the blood will start to flow in the Web 2.0 world this year as the 10 other plays in each space that were not acquired will struggle to gain revenue and funding. Furthermore, as more and more companies come onto the market with an "advertising based" revenue model, running a successful advertising network or revenue flow will become increasingly difficult. Too many ad sales guys pounding on the doors of the besieged ad firms.

Boring and focused is what works here. Opportunities to apply new technology/architectures to existing old processes and industries is the name of the game. If you can do it in a capital efficient manner, you can gradually scale the business without having to change much human behavior.

Buckle up for an interesting year…

March 2, 2007
Op-Ed Columnist
The Big Meltdown

By PAUL KRUGMAN
FEB. 27, 2008

The great market meltdown of 2007 began exactly a year ago, with a 9
percent fall in the Shanghai market, followed by a 416-point slide in
the Dow. But as in the previous global financial crisis, which began
with the devaluation of Thailand’s currency in the summer of 1997, it
took many months before people realized how far the damage would spread.

At the start, all sorts of implausible explanations were offered for
the drop in U.S. stock prices. It was, some said, the fault of Alan
Greenspan, the former chairman of the Federal Reserve, as if his
statement of the obvious — that the housing slump could possibly cause
a recession — had been news to anyone. One Republican congressman
blamed Representative John Murtha, claiming that his efforts to stop
the “surge” in Iraq had somehow unnerved the markets.

Even blaming events in Shanghai for what happened in New York was
foolish on its face, except to the extent that the slump in China —
whose stock markets had a combined valuation of only about 5 percent of
the U.S. markets’ valuation — served as a wake-up call for investors.

The truth is that efforts to pin the stock decline on any particular piece of news are a waste of time.

Wise analysts remember the classic study that Robert Shiller of Yale
carried out during the market crash of Oct. 19, 1987. His conclusion?
“No news story or rumor appearing on the 19th or over the preceding
weekend was responsible.” In 2007, as in 1987, investors rushed for the
exits not because of external events, but because they saw other
investors doing the same.

What made the market so vulnerable to panic? It wasn’t so much a matter
of irrational exuberance — although there was plenty of that, too — as
it was a matter of irrational complacency.

After the bursting of the technology bubble of the 1990s failed to
produce a global disaster, investors began to act as if nothing bad
would ever happen again. Risk premiums — the extra return people demand
when lending money to less than totally reliable borrowers — dwindled
away.

For example, in the early years of the decade, high-yield corporate
bonds (formerly known as junk bonds) were able to attract buyers only
by offering interest rates eight to 10 percentage points higher than
U.S. government bonds. By early 2007, that margin was down to little
more than two percentage points.

For a while, growing complacency became a self-fulfilling prophecy. As
the what-me-worry attitude spread, it became easier for questionable
borrowers to roll over their debts, so default rates went down. Also,
falling interest rates on risky bonds meant higher prices for those
bonds, so those who owned such bonds experienced big capital gains,
leading even more investors to conclude that risk was a thing of the
past.

Sooner or later, however, reality was bound to intrude. By early 2007,
the collapse of the U.S. housing boom had brought with it widespread
defaults on subprime mortgages — loans to home buyers who fail to meet
the strictest lending standards. Lenders insisted that this was an
isolated problem, which wouldn’t spread to the rest of the market or to
the real economy. But it did.

For a couple of months after the shock of Feb. 27, markets oscillated
wildly, soaring on bits of apparent good news, then plunging again. But
by late spring, it was clear that the self-reinforcing cycle of
complacency had given way to a self-reinforcing cycle of anxiety.

There was still one big unknown: had large market players, hedge funds
in particular, taken on so much leverage — borrowing to buy risky
assets — that the falling prices of those assets would set off a chain
reaction of defaults and bankruptcies? Now, as we survey the financial
wreckage of a global recession, we know the answer.

In retrospect, the complacency of investors on the eve of the crisis seems puzzling. Why didn’t they see the risks?

Well, things always seem clearer with the benefit of hindsight. At the
time, even pessimists were unsure of their ground. For example, Paul
Krugman concluded a column published on March 2, 2007, which described
how a financial meltdown might happen, by hedging his bets, declaring
that: “I’m not saying that things will actually play out this way. But
if we’re going to have a crisis, here’s how.”

One thought on “The Big Meltdown

  1. I think that Mr. Krugman may have jumped the gun by a couple of days on what will likely be starting point to any meltdown, which I sincerely hope does not occur. Gretchen Morgenson describes well the event that is leading the downturn in the sub-prime sector as follows:

    “On March 1, a Wall Street analyst at Bear Stearns wrote an upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and its stock, at around $15, had lost half its value in three weeks.

    What happened next seems all too familiar to investors who bought technology stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New Century said it would stop making loans and needed emergency financing to survive. The stock collapsed to $3.21.”

    While this single event won’t lead to a market crash, it is leading to a tightening of credit for the weakest sectors.

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