Monday, September 29, 2008

HowStuffWorks: Can the government control a stock market crash? By Josh Clark

Source: http://money.howstuffworks.com/government-control-stock-market-crash.htm

In 1929, a stock market crash caused the Dow Jones index -- one of the main indices used to evaluate the health of the American economy -- to lose nearly 12 percent of its value in one day [source: New York Times]. From Black Tuesday, Oct. 29, 1929, to Nov. 13, 1929, $30 billion simply vanished from the United States economy due to falling stock prices [source: University of Wisconsin].

Banking Pictures

Hulton Archive/Getty Images
Panicked New Yorkers flood Wall Street during the stock market crash on Oct. 29, 1929. See more banking pictures.

Stock prices are based on the perceived value of the company or investment they represent. Much of the American economy is based on the wealth bought and sold on Wall Street. So when stock prices fall across the board, the economy falters, too.

Some historians think that a crash in the Florida real estate market was one of the factors that led to the crash of 1929 and the Great Depression that followed [source: India Daily]. In 1987, another stock market crash caused the Dow to drop 508 points in one day -- a loss of 22.6 percent of value [source: New York Times]. This crash is thought to have been generated by a weak dollar and a sudden fleeing of foreign investors [source: Reuters]. In 2000, the stock market crashed again when the dot-com bubble burst and highly inflated Internet and tech companies lost their value all at once. The total amount of value that tech companies lost that year came to an estimated $800 billion [source: CNN].

In 2007 and 2008, the American economy found itself once again teetering on the edge of another economic slide. This time, the economy was brought to the brink by something called the subprime mortgage. The federal government has made several efforts to keep the markets from falling. But despite the government's efforts to prevent another stock market crash, in theory, a free market society isn't supposed to have any intervention in its economy. How bad would things have to get for the government to step in?

The Subprime Fallout

The stock market is all about perception. When the market is perceived as healthy -- meaning the dollar is strong, the trade deficit is narrow, and the value of companies is high -- investment begets investment. When things look bleak, however, a chain reaction of misfortune tends to occur. The failure of one section of the economy can lead to another and so on. In 2007, things began to look bleak on the American stock market. This was thanks in large part to the subprime mortgage fallout.

Subprime mortgages offered home loans to borrowers who posed a high credit risk. Often, these loans were given with attractive terms, like low initial interest rates and no down payment. In many cases, they were given for amounts people couldn't otherwise afford. Many of these subprime mortgages were issued as adjustable rate mortgages (ARMs). The interest rates on these loans reset, generally after two years, and at a higher rate. This increased monthly mortgage payments, often to amounts a homeowner couldn't afford. As a result, home foreclosures in the United States increased 75 percent from 2006 to 2007 [source: CNN Money].

Joe Raedle/Getty Images
Foreclosures on homes, like this one in Miami, were expected to hit 1 million in 2008.

These foreclosures may not have had the sweeping effect on the American economy that they did had they not carried so many implications for other areas of the financial world. Under previous banking regulations, banks simply issued mortgages and kept them, accepting payments over 15 or 30 years until the loan was paid off. But in the mid-1990s, restrictions covering loans were eased as part of an effort to extend home ownership to more Americans. The result was that mortgages could be bought and sold easily. Many subprime mortgages were purchased by stock brokers, lumped together into portfolios, and sold as securities [source: Federal Reserve Bank].

Because financial institutions like investment banks and securities companies had purchased these mortgages, the risk from any fallout was spread across the financial spectrum.

Let's look at this dispersal like a metastasizing cancer. As interest rates on ARMs reset and increased, so, too, did monthly payments on home loans. Combined with additional factors, like auto industry workers who were part of a massive layoff and real estate speculators who had purchased homes with ARMs, some people simply walked away from their homes -- and the loans that went with them [source: Federal Reserve Bank].

But the huge mortgage lenders who actually paid out the money to borrowers to purchase these homes suddenly found that the revenue from their monthly payments was drying up -- quickly. The largest U.S. home loan lender, Countrywide, reported $1.5 billion in lost revenue during the second half of 2007 [source: AP]. In 2006, before the subprime fallout, Countrywide made more than $2.5 billion in profits [source: Fortune]. And since nonconsumer banks and institutions had become so heavily invested in the subprime market, almost all areas of finance became infected with worthless mortgages. Even worse, because investors around the world had purchased subprime mortgages as securities, the whole global economy suffered from the American subprime fallout.

Huge investment banks and major lenders began to go under. People braced for the worst: a stock market crash. Then, the U.S. government stepped in to try to save the sinking ship that was the American economy. But is there anything a government can do to control a stock market crash?

Government Action against a Stock Market Crash

Because the United States has a free market economy, theoretically, the highs and lows in the market should be affected only by supply and demand. According to the free market theory, any institution with enough clout to sway the movement of the market -- like the government -- should stay out of the way and let nature take its course. While the U.S. government doesn't directly intervene in the stock market (say, by inflating the prices of stocks when they fall too low), it does have power to peripherally affect financial markets. Since the economy is a set of interrelated parts, governmental action can effect a change.

Mario Tama/Getty Images
In a free market society, the value of stocks traded (like those on the New York Stock Exchange) is subject only to supply
and demand.

The subprime mortgage fallout is an excellent example of what a government can do to try to avert a crash or recession. In 2008, the U.S. government pulled out many stops in an effort to keep the economy from plunging into a nosedive. The government announced it would infuse money into the economy in the form of tax rebate checks, totaling a minimum of $600 per taxpayer [source: IRS]. The hope was that the money would spur Americans to spend on goods and services in America to help revive the economy.

Governments can also help the economy -- and thus guard against stock market crashes -- by infusing cash into banking institutions. The U.S. government's main instrument for cash infusions is the Federal Reserve Bank (the Fed), the network of independent, government-related banks that standardizes, regulates and aids commercial banks in the United States. In 2008, the Fed announced that it had created a new lending arm: the Term Securities Lending Facility (TSLF). The TSLF would offer $200 billion in loans to non-deposit banks (not your neighborhood branch bank). What was so significant about the TSLF was that it accepted debts as securities [source: Bloomberg]. In other words, banks saddled with subprime mortgage-backed securities could use the very same investments that got them into trouble as collateral on 28-day loans from the Fed.

The point of this move is to increase liquidity in the market. A liquid market has lots of buyers and sellers trading assets -- without those assets being discounted, like in a fire sale. The Fed can also indirectly infuse cash by lowering the overnight rate -- the interest rates that banks charge each other for overnight loans. The Fed cut the overnight by three percent from September 2007 to March 2008 [source: Financial Post]. With lower rates and more cash available, the Fed hoped that banks would be more likely to infuse the cash back into investments once again.

The Fed got more hands-on in 2008 when it guaranteed $30 billion of debt when JP Morgan Chase bought out Bear Stearns [source: AP]. Investment banks are the institutions that really inject cash into markets. When these large firms stop investing (or go under), the entire financial system can grind to a halt [source: Farmer]. Investment banks make their money on dividends from their investments, and when they have more cash to invest, the market is stronger.

While the government's intentions to keep the market from crashing may be to protect its citizens' interests, not everyone agrees that action should be taken. Correcting the market can simply prolong the problem, some critics say. The best course of action could be taking no action at all [source: Bloomberg].