I don't think I understand how subprime lending affects the overall stock market. Some companies will go bankrupt? Obviously people who have stock in those comapnies lose out. But how does that translate into market losses across the board?

What other factors are influencing the recent market conditions? I'm losing money in my index funds and I don't understand why.

I hope I'm not speaking out of school. I am after all a programmer and not a macroeconomist, but this is the best of my understanding.

Lending is of course based upon the belief that lenders will provide capital to worthy borrower. Risk will be assessed and based upon that risk an interest rate will be charged commensurate with that borrower's likelihood of successful repayment.

The subprime lending debacle has called into question the ability of the lenders to evaluate the risk of borrowers. As a result lenders are being more careful, one might even say skittish when it comes to lending, denying capital where once they might have lent, or doing so only at a higher interest rate, in other words no longer "boldly going where no banker would go before". This is not true for just Joe Blow who wants to buy a house with nothing more than his mediocre credit, 5% down, and a terribly tacky name. Lenders are denying or only offering to lend at unfavorable rates to corporations, hedge funds, and so on as well.

The market tends to depend upon liquidity (cash-money) to drive deals and often even major corporations don't have the kind of cash that would be required to buyout their rivals. Enter leverage. You've probably heard of a "leveraged buyout" on your favorite narcolepsy-inducing business channel. Leverage is basically a fancy word for wall street debt. Sure I'm a lousy bum debtor with my student loan, but those wall street fat cats they're just using leverage. I guess that's the kind of $2 terms they teach you in Harvard Business School. Alas, I digress.

Leverage is a clever word, that describes exactly what this debt is. It is a lever. Just like you might use the simple machine version, it magnifies results. Sometimes leverage magnifies good results (say for instance you used some leverage [debt] to finance your way through Harvard Business School). Sure you borrowed a lot of money, but look what you gained. In addition to nifty $2 terms like "leverage" you'd have a prestigious degree that would impress folks who use words like leverage to refer to their debt. But just as sure as you can use your lever for good you could use your lever for bad. For instance, perhaps you borrowed large sums of money to buy 8-track players in hopes of reselling them. And perhaps those poor fools didn't see the genius of the 8-track and wouldn't buy your product. This would be a very poor use of capital, and the lever magnifies the results. You're paying installments to a lender and you will never realize your dream of being the 8-track magnate that once you hoped to be. *sigh* But enough about me.

A particularly severe version of this kind of condition is known as a "credit crunch", which sounds like a breakfast cereal, but is not. In such a scenario borrowers have a hard time getting loans which makes it difficult for borrowers to re-invest in their businesses, homes, or 8-track player empires. Stocks fall because businesses will have difficulty growing without credit, and the bond market falls due to a lack of faith in existing borrowers. The result, "downward pressure" on the market

Please note I do not know anything about which I speak. I am simply a humble programmer who blathers like a fool for any who will listen in the GRS forums. Void where prohibited, offer not valid in Alaska, Hawaii, or Utah.

SDK,

I think you summed up a few things well about how the subprime debacle is going to affect credit markets. By tightening credit, an economy will naturally contract its growth rate (not necessarily negative growth, but slower growth). This housing bubble is different because many of the mortgages were combined into mortgage backed securities which were sold to investors or pension fund managers. The risk had been sliced up so no one knew what the risk was anymore. This is dangerous.

Because so much "free and easy" credit was given to borrowers who couldnt' afford it when payments reset, the lending business artificially increased consumption expenditures (financing your life through financing your home). When it comes to pay the piper, either you tighten your belt and pay or you default, for both individual borrowers, institutional borrowers, or the lending agents themselves.

It all boils down to the fact that things grew too fast, home prices clearly inflated, and now we have to slow down so that the natural run of things can catch up. One hopes we land softly, but with Cramer going off on MSNBC and what I'm seeing infect the so called Alt-A market now, I think we're in for several years of slumpage.

So, hedge your risk by moving investments to European or Asian markets, and thank the good lord that you have a fixed rate 30 year traditional loan.

Here are a couple of the better explanations I've read is as follows:





Now for your other questions.



In the long term, does it really matter? Right now we may be seeing a housing bubble burst. At worst so far, we've seen the Dow fall less than 6% from it's closing high of 14,000. As of market close yesterday, that loss had been cut to less than 4%. So maybe we're seeing a housing bubble burst due to the sub-prime mess; maybe we're not. In 2000-2002, we watched the tech bubble burst. Yet in 2007, we saw both the Dow and S&P500 reach new highs. The NASDAQ (which is tech-heavy) still hasn't recovered.

What does all this tell us? It tells us that given time, the market overall always recovers and over the long term, it will always trend upward. The NASDAQ story tells us that we probably shouldn't be overinvested in any one sector. And how do we avoid overinvesting in a single sector? By investing in an index fund that covers the total stock market. During the bear years of 2000-2002, I continued to invest on a regular basis. Let me tell you, it was plenty discouraging to see my balance go down every month even after I'd put in more money. There were times when I wanted to give up, but I stuck with it. In the end, not only did I recover every dollar I'd lost by 2007, but I'd made money (quite a bit of it) because every dollar I'd invested while the market was going down had gained while the market was recovering.

Are you going to have bad months? Of course! Last month was a bad month! Are you going to have bad years? Yes! I had 3 of them in a row! Most people did! But stick with your investment plan and you will be rewarded. This is about getting rich slowly. Now when the market goes down, I think of it as shares going on sale. I don't rush in and buy more though, because I have no idea where the bottom is. When the market goes up, I have no idea where the top might be. I just stay disciplined, investing according to my plan over time. I didn't have to figure out there the market was going or how long it was going to go in that direction. I just invested on a regular basis. It's boring, but it works. You can get even more diversification by investing in an international index fund to go along with your domestic index fund. That way you can be invested globally, not just domestically.

It's been a while since I was in DC, but Jim Cramer didn't have much truck with the policy wonks at the time. I'm not concerned that Bernanke and company might lower interest rates. What with liquidity clearly being one of the driving forces of this situation.

As for "slower growth" versus "negative growth" I wish I had your optimism.

He doesn't still, but it was funny to see. Alot of the bubble-bloggers were right about what's going on.

I don't have a whole ton of confidence in Bernanke, not because he isn't smart, but the guy got thrown in to the jobs right when a few wolves started to harass the sheep. It's going to take him some time to figure out what to do.

in addition to sdkramer's excellent synoposis, much has to do with the financial institutions' exposure to mortgage-back securities. there hasn't been a true evaluation of these securities, so when the fed is paying pennies on the dollar for them, when fund managers etc had been evaluating them far higher (and by far higher, I mean far higher), you see the delta between the two. What does this mean? It means that there is a huge difference between the income you thought you could generate and the amount of loans you could give out versus reality. Why is the market reacting so funny? the market is reacting because all of a sudden there isn't as much money out there as people thought, so the fed pumps money into the system. subprime mess means that these mortgage-backed securities take a huge hit, because now there is no cash flow in and there are all kinds of bonds out there purchased to backup all kinds of loans, and suddenly those bonds are worth oh so much less, which means (rather run on sentence) that creditors have much less money than they thought they had.

of course, there will continue to be wild swings in the near term, until a final valuation of all these mortgage-backed bonds, which will tell creditors exactly how much money they really have or don't have. companies that borrow from these companies, purchased these bonds, or have positions in these securities or loans now don't have an accurate picture of their accounting books. that's why you also saw the ECB pump more euros out and why BNP suspended funds that were heavily invested in mortgage-backed securities. this is also the reason why the fed pumped money into the system in order to alleviate what appeared to be less cash in the system than everyone thought.

the one thing investors hate is uncertainty. so you see all this movement in the stock market because of uncertainty in the status of all this credit and cash availability.