The Obscure Guide to why the stock market is f***ing horseshit
By jesseon September 19, 2008 1:27 PM | Permalink | Comments (2) | TrackBacks (0)
[This entry is long, and I am irate. You have been warned.]
When a horse named Barbaro started the 2006 Preakness Stakes, he was a heavy favorite. Barbaro had already won the Kentucky Derby, and some horse racing experts were predicting that he be the first horse to win the Triple Crown since Secretariat.
There are bettors that like to bet large sums of money that huge favorites like Barbaro will "show" - that is, finish in the top three. A typical payout is that, for every $1 that you wager, you'll get 5 cents back. To make serious money, a bettor must lay out an incredible amount of cash. A $100,000 bet would win you $5,000. In horse racing circles, there is a name for these types of bettors. They are called bridge jumpers.
Barbaro did not win the 2006 Preakness Stakes. He did not place, and he did not show. He shattered his leg before the first turn, and despite several surgeries, he had to eventually be put down. The bridge jumpers were left to deal with the consequences of their decision.
Chumps. They should have been investment bankers.
The Great Depression was started by Wall Street investors behaving like bridge-jump bettors. Except in Wall Street lingo, it's called leverage. If you think an investment has the potential to increase in value but only by a small amount, you can still make alot of money if you "invest" (i.e. gamble) enough. If you buy a million shares of a stock at $100, and it goes up by $1, you just made a cool million!
And if they lose their money, they lose it, right? Sucks for them, but why is it a big deal for me? Well here's the thing: not everyone has that $100 million to make the initial purchase. That is where things get interesting. And by interesting, I mean totally f***ed.
Here's a cliched scene from every movie with a problem gambler:
Guy with gambling problem: "Listen, I need to borrow $10,000."
Successful yet easily duped relative: "What for now?"
GWGG: "There's this horse Barbaro, he's running in the Belmont tomorrow. If I bet him to show I can win $500 and pay back my bookie."
SYEDR: "Are you kidding? That is ridiculous! Let me just lend you the $500."
GWGG: "But he's a sure thing! He's won every race in sight! I'll have your money back tomorrow, he can't lose!"
If Barbaro was the stock market instead of a horse, you wouldn't be "borrowing" money. You would be purchasing on margin. And when Barbaro broke his leg and you couldn't pay back the $10,000, that would be called the stock market crash of 1929 that preceded the Great Depression.
When FDR took over the White House following the stock market crash, he put in place market regulations. One of these regulations is called a margin requirement. The margin requirement says you must have stock to put up as collateral that is worth at least 50% of the amount that you want to borrow (what a crazy idea!). This limits the losses that the lender is exposed to in the event that your investment tanks, and also makes an incredible amount of sense.
The stock market crashed because people borrowed money with no collateral to buy stocks, betting that they would go up in value. When they went down in value, the money could not be paid back, and everyone lost.
The thing is, investors are like children. They don't like rules and regulations. They want to run around doing whatever crazy shit they want. When Ronald Reagon was elected president, he started tearing down some of these market regulations. He (much like John McCain today) was a "de-regulator", someone who thinks that investors and businesses should be able to do whatever the f*** they want because... well... because...
I'll get back to you as soon as I figure it out.
Okay, so: flash forward to today. Margin requirements are still in place, but investors found another scam, called mortgage-backed securities. When you buy a house and get a mortgage, you pay interest on that mortgage. The bank makes money because you pay them more then they lent you over the life of the loan. A mortgage-backed security is when the bank sells your mortgage, along with a bunch of other peoples mortgages, to a third party. The bank gets less money, but they also eliminate the risk of holding the mortgage. The third party assumes all of the risk as well as the reward.
Well, Wall Street went absolutely batshit crazy for these mortgage-backed securities. Investors were like Depeche Mode: they just couldn't get enough. The thing is, there are only a limited pool of people who you should actually lend money to, called "prime borrowers". A prime borrower is someone who is a good credit risk, i.e. someone with verifiable savings and income who can actually pay back their mortgage. But Wall Street was clamoring for more mortgage-backed securities! More! More, goddammit!
So who was left? Well, there are a whole shitload of broke ass people - excuse me, I mean "sub-prime borrowers". A sub-prime borrower is someone who is a bad credit risk. Someone with no income or savings. Someone you should not be lending money to.
Yet they did. Banks would lend money to people without verifiable income or bad credit, and called it a sub-prime mortgage. Sub-prime mortgages had higher interest rates, often with an introductory "teaser" rate to entice the bad credit risk/f***ing m*o*o*n into buying a house they can't really afford. Some of these loans were even negatively amortized, meaning they accepted monthly payments lower than the interest amount - every month you would get deeper and deeper in debt, all in an effort to get people to take mortgages that they had no right taking. The bank then sold the mortgage as a mortgage-backed security to an investment bank, thus washing their hands of the whole affair and leaving the investment bank with all the risk.
I know what you are thinking: either "why did they do this?" or "why the f*** did they do this shit?" Much like with those investors from the 1920s who bought all that stock on margin betting that it would go up in value, today's investors were betting that the value of the homes sold to bad credit risks would go up. If the bad credit risk was unable to pay his mortgage but the value of the home went up, then either the bad credit risk would re-finance the home and use the equity to pay off the old mortgage, or the bank would foreclose and re-sell the house at a higher price then what they were owed on the old mortgage. Either way, they win!
Unless they lose. All this easy money drove the price of housing into the stratosphere in the early part of this decade, the so-called housing bubble. Then the bubble burst all over Wall Street's face and hair, covering them in red ink.
Now you have a situation where a bank lent someone $400,000 for a house that is now only worth $200,000. Who gets stuck with the $200,000 loss? The bank does, right?
Still with me? Not really? That's too bad, because you are about to miss the best part: you know who is actually getting stuck with all those losses? You, chump.
Gamblers can't gamble on margin. They have to put up cash. If they lose, cash is gone. Too bad. Or, a gambler borrows money. And when a gambler can't pay his debts, he gets his legs broken.
Wall Street made a bad gamble, and now they want you to pay their bookies. At this point, Bear Sterns, Fannie Mae, Freddie Mac, and American Insurance Group have all received taxpayer money from the government to continue operations, totaling hundreds of billions of dollars. So all those terrible loans that were made to people without the ability to pay? Your tax dollars have now been given out to keep these brilliant companies afloat.
So keep this in mind next time you hear a politician, businessman, or hobo shouting at the sky about de-regulation: these guys don't actually want true de-regulation. What they want is what is referred to as the privatization of profits and the socialization of losses. Put it another way: investment bankers thought they were making a delicious turkey sub, but instead they made a shit sandwich. But instead of eating it themselves, they put it in the mail and sent it directly to the taxpayers with a little note: chow down, motherf***ers.