A Threat From Wall Street

This article is a fun read. It's fairly generalized, but apparently The Street feels threatened by the middle-class. It certainly gave me a good laugh.

The funny thing about this article is that the author credits The Street as being a contributing hero in making the "...market [roar] to 14,000 and everyone's 401k [double] every 3 years." Weren't they just responsible for a massive algorithmic trading scam?

DOW Sinks 1000 points in 20 Minutes

When the Dow Index sank 1000 points in roughly 20 minutes on May 7th, most people were shocked. Many articles and television shows blamed the increasing pressure on Greece and the lack of a bailout. However, the plunge goes much further than international worries and buries itself on the bottom of the ethical totem pole.



Ever hear about an algorithmic trading platform? How about high frequency trading? Well, we'll be talking about each in this next blog post, and how it related to the crash.

High frequency trading computer servers are able to beat other computers because they are located at the exchanges. They take crucial advantage of the finite speed of light and switching systems to run the market at the front of the lines. They also gain information on orders and market movements more quickly than the market as a whole.

US Debt Clock

I found this US Debt Clock through a friend and found it to be wildly interesting and revealing. Mouse over a specific value to get a description at the top (NOTE: most values are year to date and not totals).

The Oven That Burned the Pie and All the Houses Down: Mortgage Backed Securities

If you're accessing my blog for the first time, be sure to read from the bottom-up. This way, you'll understand what the heck is coming from my mouth.. or fingertips.

The last main ingredients to the crash, mortgage backed securities and financial deregulation, are some of the major ingredients which lead to the Great Recession of 2008. However, let's quickly recap the series of events that led us to the meltdown:

As previously stated in my blog, the Federal Reserve lowered interest rates and inflated the dollar, driving the housing market up and creating a bubble. Additionally, the low interest rates caused foreign nations to buy US debt (US Treasuries) in the trillions. Lastly, an inflated dollar and deflated yuan caused US importers to buy less while simultaneously decreasing the purchasing of US goods in foreign nations (a dramatic increase in the trade deficit was inevitably the result).

In 1933, the Glass-Steagall Act, or the Banking Act of 1933, was enacted to control speculation, or the lending of money, purchasing of assets, equity or debt in a manner that has not been given throrough analysis or has high risk of default. In other words, the government wanted to control the loose buying and selling of assets/credit and enforce increased analysis to ensure that safe investments are in play. However, in 1999, a provision that prohibited a bank-holding company from owning (buying stock, for example) other companies was repealed under Bill Clinton.

In 1987, those that were against the repealing wrote the following argument:

"1. Conflicts of interest characterize the granting of credit (that is to say, lending) and the use of credit (that is to say, investing) by the same entity, which led to abuses that originally produced the Act.
2. Depository institutions possess enormous financial power, by virtue of their control of other people’s money; its extent must be limited to ensure soundness and competition in the market for funds, whether loans or investments.
3. Securities activities can be risky, leading to enormous losses. Such losses could threaten the integrity of deposits. In turn, the Government insures deposits and could be required to pay large sums if depository institutions were to collapse as the result of securities losses.
4. Depository institutions are supposed to be managed to limit risk. Their managers thus may not be conditioned to operate prudently in more speculative securities businesses. An example is the crash of real estate investment trusts sponsored by bank holding companies (in the 1970s and 1980s)."

Mortgage Backed Securities:

Anywho, the Glass-Steagall Act was, for the most part, nonexistant because of this one repeal. It enabled companies like CitiGroup to build and sell investments called mortgage backed securities. Mortgage Backed Securities are essentially a group of mortgages that are combined into one security (like a stock symbol) and sold in the marketplace. So, say for example we're all eating pie in our respective houses that have mortgages. The money owed on our house goes to the bank who provided the mortgage. Well, a couple companies by the name of Fannie Mae and Freddie Mac take all of our mortgages and buy them from the bank. They then pool these mortgages together (say, 10,000 mortgages) and then establish a single value on all of the mortgages based on how much we owe on our homes, everyone's credit, the likelyhood that we'll pay our mortgage (plus interest) in a timely manner, etc.

In other words, mortgage backed securities are like stocks, but instead their value is derived from home owner's debt obligations to banks. They are divided between various classes, including subprime loans, prime loans, high risk, low risk, etc. Fannie Mae and Freddie Mac were the two major issuers of MBS's, but private banking institutions like CitiGroup, Bear Stearns, Wells Fargo, Washington Mutual, Goldman Sachs, etc. were allowed to buy the mortgages from other banks to create and sell MBS's. Because of the repeal of the Glass-Steagall Act, (financial deregulation) the amount of speculation (or analysis) in these MBS's was VERY limited. No one really knew how risky they were unless you had an idea of what was going on behind the scenes (as described in this blog). Therefore, the rating agencies like Moody's, Standard & Poor's, Fitch, etc. were giving these sub-prime, high risk mortgage backed securities great investment ratings.

Many bank holding companies, eager to get their hands on the surging house-market, invested heavily in mortgage backed securities. They even took loans out on their cash reserves to invest as much as possible in MBS's. Now, consider this: before the repeal of Glass-Steagall, only 5% of all mortgage loans were subprime (high risk, low credit scores, high likelyhood of defaulting, etc.). During the 2008 meltdown, that percentage nearly hit 30. 30% of all mortgage loans in the US were subprime! And the repeal of the Glass-Steagall Act was the reason why.

When interest rates rose, the dollar deflated, the housing bubble popped and prices started decreasing (deflation), the mortgage backed securites started tanking in value, and the investors and major institutions that were heavily invested in them started to fall fast.

It doesn't take much to see why our economy is in its current state. Overbetting on risky investments without proper diversification and speculation is almost asking for failure. Additionally, poor monetary policy and volatile interest rate fluxuations, along with financial deregulation and tempting access to credit is bound for failure.

The Other Pie Eaters: Exchange Rates

If you're just accessing my blog for the first time, you're already behind. Be sure to read the first post before you read the second so you're not confused or bored with my writing. If you haven't followed my directions yet, I'm assuming you're too lazy to scroll down and read, so I'll sum it up for you:

Interest rates have a direct impact on inflation, or the value of the dollar. When interest rates (the value that is charged to loan money) are low, inflation is higher because money is easy to loan and ultimately spend. Contrary to low interest rates, high interest rates cause consumers to save because loaning becomes more expensive.

The impact of high inflation is an increase in prices. This is not necessarily because companies want to earn more profit, it is mainly because the value of the dollar is less than when the dollar could buy more (low inflation). Since 1913, the value of the dollar has shrunk to 2 cents of its face value ($1), which means that your dollar could have bought 50 times more than what it can today.

The main argument with the stock market is whether or not interest rates and the money supply are one of the main indicators. While companies' stock prices are usually higher during inflationary periods, the money supply in the economy is largely credit, and therefore bubbles are created on loaned money that eventually will need to be paid back. I'll get into bubbles and how it inflates the stock market at a later point in my blog.

My second post will discuss exchange rates and their impact on the economy of the US. An exchange rate is the value of one currency against another (for example, the US Dollar against the Chinese yuan/renminbi). One of the main indicators of our economy's strength is our trade with foreign nations, more specifically China (as we are a major importer or Chinese goods). If the US dollar is inflated (buy less for more) and the Chinese currency is deflated (buy more for less), it means that the US has weaker purchasing power for Chinese exports, or in other words, Chinese exports become more expensive to buy because the dollar is less valuable in yuan/renminbi terms. Equally, American goods in China are more expensive because the US dollar is inflated, and ultimately, major US companies that export to markets like China (Microsoft, Intel, etc.) lose big time.

From 2001 to 2004, the US trade deficit with China doubled from roughly $80 billion to $164 billion. This was largely due to low interest rates during that period. The federal fund rate, or the rate at which the Federal Reserve loans money to banks, went from 6.24% in 2000 to 1.35% in 2004. This inflated the US dollar, making US goods more expensive, (in the US and around the world) as well as made Chinese goods more expensive to buy for American importers. This ultimately increased the budget deficit with China dramatically. Currently, the US has a trade deficit of about $227 billion with China. The US is currently trying to lower the trade deficit it has with China by pushing the Chinese government to deflate the price of the yuan. This would decrease the amount of imports the US receives from China, (US importers would buy less because it is more expensive) yet make US goods cheaper in China (US goods would sell more), ultimately lowering the trade deficit. An article on this issue can be found here.

During the beginning of the decade, the Chinese began buying US debt because the interest rates were low and it was attractive to borrow US money. This also stabilized the exchange rate of the US/yuan, because when the demand for US treasuries decreased via a massive purchase, interest rates remained low to avoid paying high yields. If you're confused on that part, just e-mail me and I'll be happy to elaborate. Onwards: In 2001, the Chinese owned $215 billion in US debt. When the US interest rates began their decline, the Chinese purchased enormous amounts of US debt (US Treasuries, or government bonds). In 2004, that amounted to a total of $609 billion. As we can see, when interest rates are lowered, money is cheaper to loan, and therefore, money is borrowed and invested.

Exchange rates are directly related to the interest rates of each country. Interest rates will value a currency, which then is revalued based on another currency. Most countries are dependent on trading with each other to ensure they meet the domestic demand. This has a direct impact on the cost of goods, and therefore, countries must strive to keep stable interest rates and monetary value to avoid extreme inflationary/deflationary periods.

This, or a lack of stability is what sparked the Great Recession of 2008. Our US dollar was inflated, the trade deficit seemed to be growing exponentially, and interest rates remained low. What triggered next was the banks borrowing massive quantities of money via the Federal Reserve's low interest rate, who then began lending to anyone and everyone. These lenders purchased homes largely on credit. Because interest rates were low, housing prices were rising (due to inflation, or goods becoming more expensive because the dollar buys less for more) and people saw this as a housing boom. In actuality, this was a massive housing bubble which was bound to collapse.

PIE, INTEREST RATES and INFLATION

So, I graduated college about 3 months ago, and already my education exposure is dwindling. My productive life is hidden somewhere between facebook and my macbook hardrive, and needless to say, it's pretty pathetic. Whatever. Main reason why I'm creating this blog is because I've tired of the mainstream media and how it focuses less on what's going on in the world (more specifically, the financial world) than on Jessica Simpson's breaking news: love advice (which is on CNN's website's front page. if you really care: link).

Obviously my ADD hasn't subsided since graduating. Back on topic: the financial markets. I want to start at a neo-base to educate and inform everyone why we are in this current economical cluster. Here it goes:

PIE, INTEREST RATES and INFLATION:

The best comparison I can think of to tie inflation and the value of money is the following: if I have 10 hungry friends over and 1 piece of pie for sale, that piece of pie is desirable by many and therefore more valuable. However, if I have 30 pieces of pie and 10 hungry friends over, everyone can eat excessively, so therefore, the value of the pie is much less. It's best to spend money on the pie when the pie is abundant and cheaper so that when there are less, you have more. When the government wants more pie buyers (spending), they bake more pie so that people eat. In other words, they make money more accessible by lowering interest rates.

A few things you should know:

If there is high inflation, it means that money is less valuable (more pie) and interest rates are probably extremely low (easy to get a loan). When interest rates are low, returns on investments like bonds, savings accounts, CCD's, etc. are low, so saving money isn't the best option and spending is more attractive.

Now, let's look at interest rates and how it shapes investments. Interest rates (more specifically the fed fund rate, or the rate at which the federal reserve loans money to banks) are essentially the rates that are charged for the use of money. Most importantly, the federal fund rate is used to control inflation. When the rate is high, inflation is low because money becomes harder to obtain (paying back loaned money at higher interest rates makes money more valuable, or very little pie for sale with many hungry people). When the Federal Reserve has low interest rates, borrowing money is very attractive because it is very cheap to pay back.

Interest rates are a major part of the current and future value of our economy. When rates are low, people spend more because money is easily accessible. However, when rates are high, more people save because spending and loaning money is much harder on the pocket.