Lets create a Market for IBM stock. Lets say there are exactly 1 million holders of IBM stock
and there all in bed one very fine morning when the Markets open, that is except for exactly 2
owners of the stock who are wide awake and pondering their money problems. One guy
figures, if only I had more money I could buy a pack of smokes, where in the name of god am
I going to find $1 dollar to buy a pack of smokes. Then he remembers he owns exactly one
share of IBM stock. By this time his nicotine fit has driven him up the wall and he is tearing
his hair out, somebody give me a cigarette he shouts. Enough is enough, he's taking no more
bull so he decides to sell his 1 share of IBM stock. He calls his Broker and sais "Sell my 1
share of IBM stock "AT THE MARKET" a legal stock market term for accept anything you
can get, normally the spread is fairly tight except for the other 1 MILLION less 2 owners of
the stock are in bed so there are no standing offers in the Market except for MR Scrooge the
other guy in the story, he's wide awake and wants to buy IBM for little or nothing, so he
already has a standing offer in the Market for exactly 1 share of IBM stock for you guessed it
1$...yes thats right one dollar. The Broker repeats back the order to "Sell At The Market" and
Mr Nicotine Fit sais yes let it fly.
And so there you have it Mr Nicotine Fit has just sold IBM stock for exactly one dollar,
it was previously trading at $100 dollars, yes you read that right 100 dollars. What happened,
how can that happen. Well the other 1 Million owners less 2 were in bed and there was only 2
people in the Market and it only takes 2 people to agree on price or value. Mr Nicotine Fit
established the new value of 1$ for 1 share of IBM stock.
So the other 1 Million guys wake up and check their share price and scream blue murder
" What happened".Therin lies the lesson of you got it "LIQUIDITY"
LIQUIDTY or NO LIQUIDITY is the absense of particpation in a market such
that transactions cannot be concluded.
Thats how America went broke, first starting with Enron, then Long
Term Capital Management, and you got it the Mortgage Market Meltdown
ALL BY THE USE OF DERIVATIVES IN THE PRESENCE OF
NO LIQUIDITY.
The difference between the example of Mr Nicotine fit selling IBM stock which was worth
$100 for $1 a 99% drop and Derivatives are miles apart in the sense that a 5% move will
wipe out any Derivative bet so it doesnt take much imagination to figure out how a 5% move
can happen in any Market like the Mortgage Market. I used to trade Options on Stocks and
Indices like the Dow Jones Industrial Average and then came the the Crash of October 19th
1987 and the Dow dropped 508 point or 22% in 1 business day. So you see a drop of 22%
would wipe out any Derivative bet 4 times over.
So now you are probly wondering, thats crazy , who invented or allowed these Derivatives
to happen and be traded by Banks with DEPOSITOR'S MONEY I might add.
To understand that we need to travel back in time and the year was 1933, just at the bottom
of the crash which began in 1929.
Crashes or Booms and Busts has always being a feature of Markets going back to the
Roman Empire, and throughout European history including the Tulip Mania and the
Mississipi South Sea Bubble. There is always a different reason for a crash each time, it just
so happens that derivatives were at the root cause, but you must remember at the end of the
day its a game like football and for any game you need a referee that enforces the rules, ah yes
the rules, we forgot about the rules, but who sets the rules.
1933-THE GLASS-STEGALL ACT
The act was brought into play to create a chinese wall between Banking
as we used to know it and Investment Banking meaning Banks at that time
investing in Stocks and Bonds with depositors money which left the banks
broke when the Market crashed in 1929.
It was a very wise act and imposed strict rules on Banks and their limitations
to gamble with depositors money.
Then just like the NFL the Game began, but we need some players, so lets
pick some of the players involved. The NFL has its Rules until their changed
that is, so who changed the rules in the Markets.
WHO CHANGED THE RULES.
The Markets recovered from the crash of 1929 but not before many mini
crashes along the way.The American Economy was chugging along with lots
of Dollars flooding the World. The year is now 1971 and then President
Richard Nixon decided that Gold then pegged at $35 an ounce was an impediment
to progress because there was not enough Gold in Fort Knox to back all the
Dollars flying around the World being held by Foreign Governments so Nixon set
Gold free from the Dollar. Gold soared to over $800 an ounce by 1981 and then
came along the Reagan Era now thats where the real story begins.
REAGAN ERA.
Reagan decided that the de-regulation of Markets was the way to go to enable free
trade so he set out on a course of action that would put America in Peril and bring
it to its knees with the aid of Clinton.
It was during the Reagan Era that it was proposed to repeal or cancel the
Glass-Stegall-Act to allow Banks to invest in exotic instruments which were invented
in 1973 by the financial engineers.
Reagan was being advised by guess who, you wont believe it Milton Friedman and
under Clinton who was advising Clinton, you guessed it Alan Greenspan.
Both economists were from the School Of Rational Expectations in which Markets
find an Equilibrium the way water floats in a pool.
Clinton repealed the Glass-Stegall-Act in 1994 because he agreed fundementally
with Reagan that Markets must find their own equilibrium and so now
THE REAL GAME IS ON, BRING OUT THE PLAYERS.
We need some players so lets create a wee list of the culprits.
STARTING AT THE TOP.
REAGAN AND CLINTON
FEDERAL RESERVE
INVESTMENT BANKS:
JP MORGAN
MORGAN STANLEY
LEHMAN BROTHERS
BEAR STEARNS
AIG
FANNIE MAE
FREDDY MAC
FDIC
So now with the Glass-Stegall-Act removed the investments banks set
their financial engineers to work.
As an aside issue, Alan Greenspan was working diligently as a Director
of JP Morgan before he became Federal Reserve Chairman and he
lobbied very hard indeed to have the Act repealed.
Continued tomorrow.......
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