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Bill Freehling is a business writer for The Free Lance-Star and Fredericksburg.com. This blog is on Fredericksburg-area business. Send an e-mail to Bill Freehling.

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When stocks fall, reasons tend to be complex

Three final points from Roger Lowenstein’s "When Genius Failed" before moving on to the next topic:

Last week I wrote that the collapse of hedge fund Long-Term Capital Management in 1998 and the recent subprime mortgage market troubles seem similar in their level of greed and lack of focus on risk management.

Here are some other interesting points from Lowenstein’s book.

  • In September 1998, global markets were crashing in the wake of Russia’s defaulting on its debt. Banks were realizing they stood to lose hundreds of millions of dollars if LTCM–to whom they’d loaned money without proper protection or compensation–went under.

The general public was mostly in the dark about the behind-the-scenes panic on Wall Street. So what did the mainstream media blame for the market’s malaise?

The Monica Lewinsky sex scandal with President Bill Clinton.

Only through Lowenstein’s meticulous reporting are we able to see the real factors pushing down stock markets. And his book wasn’t published until 2000, two years after the fact.

In other words, the factors that cause markets to rise and fall are far too complex to explain in the moment. The institutional investors who move markets with their billions of dollars aren’t going to tell the little guy what’s really going on.

But that doesn’t prevent financial writers from having to come up with some explanation. So take it with a grain of salt the next time you read something like "Stocks fell 0.2 percent today as investors digested the latest housing data and earnings from General Electric."

  • After four years of fantastic returns, LTCM came crashing down. A group of banks bailed out the hedge fund with fresh capital rather than let it bring down the whole financial system.

Less than a month after the bailout in September 1998, the Federal Reserve twice cut interest rates and settled down markets. Banks got their bailout money back.

LTCM was run by some of the brightest financial minds of the time. They came up with models to protect investors in all market conditions. For a short time in 1998, roiled markets didn’t do what the models said. And by the time they returned to normalcy, LTCM was out of the game.

That’s the problem with betting the house on anything. When things are going well, profits soar. But the one time you’re wrong, you’re done. Lowenstein compares it to playing Russian roulette. He’s right.

Think about it as a blackjack game. Casinos have table limits to prevent gamblers from ceaselessly doubling their bets with every loss. In theory, eventually you’ll win and be back at even. But not if doubling takes you past the table’s limit. Then you’re out.

Prudent investors will never be so dependent on being right. Unless it’s a sure thing (such as "Does 1+1=2?"), set limits.

  • The Federal Reserve didn’t put public money into LTCM’s bailout, but it did bring together the major banks to organize a solution. That drew the public’s ire. Why should a fund such as LTCM get government protection, people wondered?

Many people have criticized current Federal Reserve Chairman Ben Bernanke for the same thing. Isn’t the Fed just slashing interest rates to save the Wall Street banks, they ask? Shouldn’t capitalism be allowed to work without government interference?

As "When Genius Failed" points out, it’s not so simple. Allowing an LTCM, Countrywide Financial or major bond insurer to fail could wreak havoc on the Main Street economy. So the Fed is faced with a tough choice–bail out reckless financial institutions and encourage reckless behavior in the future, or bring the economy to its knees by holding steady.

Like Michael Lewis’ "Liar’s Poker," Lowenstein’s "When Genius Failed" paints a vivid portrait of the inner workings of Wall Street. And the picture seems as real today as it did a decade ago.

Permalink: http://news.fredericksburg.com/businessbrowser/2008/03/02/when-stocks-fall-reasons-tend-to-be-complex/

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