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Investment bubbles and the Stock Market: Reclaiming Sunshine from Vegetables

In Current Events, Economics on December 6, 2010 at 17:18

I was doing research for a blog about the stock market lies, and I reread this blog I had on MySpace about 1.5 years ago. I am reposting it because it deserves more exposure. Besides, it is one of my best written serious pieces. It is updated but the basic themes of stock market manipulation, lies, and insider trading still apply. If you think we should allow brokers to invest our Social Security, I hope this changes your mind.

Investment bubbles and the Stock Market: Reclaiming Sunshine from Vegetables

The stock market is the world’s best wealth creator. It can make something from nothing, if you believe. When stock markets stabilize; the recession is over. So stop whining about unemployment and showing how you hate America, i.e. Wall Street.

Tulip Bulb Bubble

Ever since the days of the Tulip Speculation in Holland, stock markets have made people all over the world richer and richer. There is always someone who gets rich even if millions loose money in the stock market or it goes up or down, thus the stock market is a constant good in our lives. And certainly there were other parts of the world that were suffering under slavery and war, but as long as there is a stock market, everything is okay.

The Dutch East India company (sic) was actually the first to allow outside investors to purchase shares entitling them to a fixed percentage of the company’s profits. They were also the first company to issue stocks and bonds to the general public, doing so via the Amsterdam Stock Exchange in 1602 according to Britannica.

http://www.mint.com/blog/investing/the-history-of-the-stock-market/

The South Seas Bubble Bursts

The British also had their own speculative market burst in the early days of their stock exchanges. But remember, while millions lost their knickers, some people got rich, so it all turned out okay. And even though the Irish over the Irish Sea were being recolonized and losing their lives, land and livelihoods to the British, the world was okay because there was a stock market. After all, the markets were pulling wealth upwards, as they were designed to do, to the new royal class of bankers in Britain.

The British East India Company had one of the biggest competitive advantages in financial history – a government-backed monopoly. When the investors began to receive huge dividends and sell their shares for fortunes, other investors were hungry for a piece of the action. The budding financial boom in England came so quickly that were no rules or regulations for the issuing of shares. The South Seas Company (SSC) emerged with a similar charter from the king and its shares, and the numerous re-issues, sold as soon as they were listed. Before the first ship ever left the harbor, the SSC had used its new-found investor fortune to open posh offices in the best parts of London.

Yes. Investors bought and resold shares from the SSC in a trade venture before ships left the harbor.  This is similar to creating household mortgages and immediately selling them on a secondary mortgage market and them turning them into securities. Essentially, the mortgages were bundled together and sold to investors as collateralized debt obligations (CDOs) and other mortgage-backed securities (MBSs). http://bryblum330.wikidot.com/the-subprime-mortgage-crisis

By originating a loan and then selling that loan, you didn’t have to bare the financial responsibility for it. When there is a secondary mortgage market, originators of loans don’t have worry about the pesky details of credit histories, collateral, or down payments when loaning money. Their loans were now out of their hands and no longer their problem. Similarly, people who bought shares in the South Seas Company and resold them made large profits. Investors that owned the stock when the market collapsed lost their trousers much like those that owned mortgage backed securities took a bath when the housing bubble burst.

However, some of the mortgages get sold in a new form when the knowledge of these bad loans gets out,

These days, however, the bundles of home loans that were once highly rates and gave a good return on investment are no longer in demand. The solution for mortgage lenders is to repackage the bundles and sell them on in a different form. The way this is done it to shred the old portfolios of loans which were sold on as Collateralised Debt Obligations (CDOs) and repackage them. http://screamnews.com/repackaging-adverse-credit-mortgages/

The South Seas Company’s success brought in other companies and the people bought in.

Encouraged by the success of the SSC and realizing that the company hadn’t done a thing except issue shares, other “businessmen” rushed in to offer new shares in their own ventures. Some of these were as ludicrous as reclaiming the sunshine from vegetables or, better yet, a company promising investors shares in an undertaking of such vast importance that they couldn’t be revealed. They all sold. Before we pat ourselves on the back for how far we’ve come, remember that these blind pools still exist today. http://www.investopedia.com/articles/07/stock-exchange-history.asp And people still buy shares blindly in companies that have no tangible value. http://www.investopedia.com/terms/b/blind_pool.asp Bernie Madoff ran a very successful blind pool until investors asked for their returns. Soon they realized that Madoff didn’t have their money.

The amount the market declined from peak to bottom: Stocks in the South Sea Company were traded for 1,000 British pounds (unadjusted for inflation) and then were reduced to nothing by the later half of 1720. A massive amount of money was lost.

http://www.investopedia.com/features/crashes/crashes3.asp

But remember that the people who originated these stocks made out like bandits, thus it’s okay. The money flows upwards to the bankers and investors, and so all is good.

The Dot-com Crash in 2000

Turn the clock ahead almost three centuries and we see the blind pools still exist. Investing in dot.com companies is akin to investing in a boat that has yet to leave the dock. Both investments led to massive losses.

http://www.shadowstats.com/

Introduction: The Dot-Com boom

In the late 1990s and early 2000s, I kept hearing about how people were making millions of dollars with IPOs (initial public offerings) on Internet stocks. I was suspicious of the whole thing from the start. How could a company that didn’t make any of their own products, a company that sold goods online, goods that one could buy at a local store, make any money? Thus, the prices for the stock became immediately overvalued before the sites were up and running.

The poster child for Internet speculation was pets.com, but there were others. Pets.com raised $82.5 million in an IPO in February 2000 before collapsing nine months later. http://www.cnet.com/1990-11136_1-6278387-1.html

The most spectacular IPO and collapse according to CNET was Webvan. In a mere 18 months, it raised $375 million in an IPO, expanded from the San Francisco Bay Area to eight U.S. cities, and built a gigantic infrastructure from the ground up (including a $1 billion order for a group of high-tech warehouses). Webvan came to be worth $1.2 billion (or $30 per share at its peak), and it touted a 26-city expansion plan. Alas, the venture was doomed to fail. Grocery outlets have thin margins for profit and the venture couldn’t attract enough companies or customers to make a profit.

The lesson is twofold: don’t invest in something unproven even if they have a clever sock puppet (picture here) and don’t invest in an internet company that replicates what someone can do locally for less with a proven track record, i.e. sell kitty litter and groceries.

In 1999, Internet companies’ stock prices began to grow very rapidly. Supposedly, the competitive advantage of these businesses was the elimination of heavy investment in capital. Dot-coms aimed to be competitive through value added information elements, such as consulting or electronic commerce. Many analysts called this industry, “the new economy” because of the competitive use of technology and knowledge, as opposed to “old economy” companies, which are capital and labor intensive. Nonetheless, almost none of these companies were showing profits during that period. Balance sheet and income statement figures were not very promising either. On the other, hand stock prices here extremely high. For example the stock of Scient, an Internet consultant company, had a peak price of $133.75, which represented a 1238% increase from its Initial Public Offering(IPO) in 2000. One year later, its stock decreased to $2.94 .

http://econc10.bu.edu/Ec341_money/Assignments/stories_stock_market.htm

It was no surprise to me that a companies with no productive capacity, companies that didn’t produce anything you could put your hands on, tanked, much like the U.S. economy today. Too many people were relying on the new Internet technology that not everyone had bought into at the time.

In the decade since the Nasdaq stock exchange reached its all-time high at the peak of the Internet bubble, the tech-heavy index has recouped just half of its stomach-churning losses. On March 10, 2000, the Nasdaq closed at 5,048.62. On Wednesday, March 10, 2010, the Nasdaq closed at 2,358.95. http://srph.it/byHhAE

That’s just one more example that stock markets are based on speculation value and not use value.

Do you think that investment firms looked at Internet start-ups realistically during this dot com market bubble? After all, how could stock from companies with no track record of profits increase so dramatically in a “free market”? The answer is two-fold.

First, the market does not give us “perfect information” as economists used to claim, and second, insiders (traders along with the companies whose stock they sell) can manipulate stock reports and stock prices to their own benefit. Since companies that sell stock profit from each sale, there is an incentive to sell as many shares in an IPO as possible. That per share commission leads brokers to sell stock they don’t believe in to make a buck. Yes, can you believe it? During an IPO is when much of the stock will be available and big profits can be had selling as many stocks as you can. Why would you NOT recommend a stock that you get a commission selling?

…if demand is given faulty information, investors are biased towards stock that they would not invest in otherwise…information depends heavily on very few specialized firms such as Investment Banks and Analysts firms. These firms are capable of misleading the market, as it happened in the dot-com crash in 2000. Based on simple accounting and financial principles I propose that Investment Banks and analysts were not ethical during this bubbles because they did not value Internet companies as rigorously as they do with other start up companies.

The author concludes “During the dot-com bubble, financial intermediaries, analysts and investment banks did not provide accurate information to investors.”

http://econc10.bu.edu/Ec341_money/Assignments/stories_stock_market.htm

With the “experts” promoting and packaging dot com stocks in 401ks, pension and other large investment groups, the same expert that made a commission selling those stocks, the dot com market was artificially inflated.

Again, overvaluing future returns based on imperfect market information is reminiscent of the South Seas trading bubble of the 1700s.

Past Mistakes, Current Lies, and a New Economic Collapse

Skip ahead to the roaring 00s. There is an old adage: if your money isn’t making money, you are losing money. Money not invested is money losing value. People with capital, banks, investment firms, and large investors like Warren Buffet, are always looking for the next big investment opportunity. This time it was housing.

The Housing Bubble

There are several factors that led to the housing bubble and inevitable collapse. Among these are easy credit, subprime mortgages, lax regulations on the market, a loosening of lending criteria, the secondary mortgage market, and the deregulation of banks allowing them to speculate in derivatives and other non-banking functions.

However, that is a list of the mechanisms that allowed the housing bubble to get out of hand. The underlying cause of the housing bubble was greed. First, we have the greed of the lenders looking for a mark, a homebuyer. Since they made a commission that equaled a percent of the housing values, they earned more money the more the house was worth. That system can encourage large institutional reality firms to push the value of the houses. Small realtors that relied on word of mouth also benefitted, but they also relied on word of mouth and had to try to get the best deal for their clients, the sellers of homes.

Lenders benefitted from an overheated mortgage market as well. Even if interest rates were kept artificially low and cut into their profit, it was balanced by the high housing prices and the number of houses being sold. Interest rates were going down, and it attracted new homebuyers. That also led to higher demand for housing and higher prices. Moreover, homebuyers were sold on the idea that housing prices never dropped and thus this was a good investment. They were lured to housing with balloon payments and with adjustable rate mortgages with the confidence that they could easily sell their homes later at a profit if the interest rates went up.

Down payments were reduced from 20% to 2-5% in the subprime market because, of course, the market was going to go up. Millions of first time homebuyer signed a mortgage based on imperfect information and the myth of the never-ending increase in home prices. When they lost a job, got sick or had additional expenses, they were unable to pay their mortgages they had barely been able to afford in the first place. Millions of houses were not on the market having been foreclosed on. The market collapsed.

National housing developers also got into the act. They went into a building frenzy trying to keep up with housing demands in Nevada, Florida, Arizona, and California. Now many projects are on indefinite hold as they wait for the housing market to rebound.

The only way to stop this type of irrational speculation in the housing market is to make all parties involved in the process responsible for the loan, from the realtor, the owner/investor, and the originator or the mortgage as well as the holder of the loan. Otherwise, the profit motive is to great an incentive to fudge the numbers during the lending process.

At the end of the clip that is cut off, Warren Buffet admit, “Yeah, I blew it”. http://nymag.com/daily/intel/2010/06/warren_buffett_on_the_housing.html

So, if master genius investor billion Warren Buffet can be trapped by the housing bubble, how can the average real estate agent and mortgage banker know that the end is nigh. People love money, people are addicted to its aroma, lead to the rocks to crash by its siren song.  There’s nothing wrong with making money per se. However, too many people bought into the myth of the never ending increase of housing prices and we are living with the effect of the inevitable collapse: layoffs, foreclosures, unemployment like we haven’t seen for decades, bankruptcies, states cutting essential programs for lack of tax revenues, increasing debt, and so forth.

How Housing Bubble is like Buying Into a Blind Pool

Owning a house has been part of the “American Dream” since the fifties. Why is that? The idea that everyone should own a home fed the housing bubble, which in turn led to loose credit and a subprime market. Easy credit and the manufactured desire to own a home led to the housing crisis as did the secondary mortgage market and credit default swaps.

Mark Thorton in moment of prescience wrote this for the Free Market http://mises.org/freemarket_detail.aspx?control=500 in 2004,

Signs of a “new era” in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer explained to me: “It’s almost too good to be true.”

Yes, it was too good to be true. As the saying goes, what goes up must come down. Or as Lao Tzu put in 600 AD, and I paraphrase; That which is raised above its natural state will later fall. Because of market speculation and loose credit, the demand for housing shot up in the 2000s. Demand shot up costs and people everywhere were paying outrageous prices for houses in the belief that prices would continue to rise.

However, that is not the way markets work. Eventually, the market for any product becomes saturated and equilibrium prices (market prices) will fall back to a more realistic rate. Those that bought houses at high prices later discovered that housing prices do fall and owed more than their houses were worth.

http://mises.org/freemarket_detail.aspx?control=500

Other Problems with the Stock Market

Many times the Stock Market goes up when unemployment goes up, so the value of the market has no relation what so ever with employment or what’s happening a majority of Americans.

Shorting Stock or How to Bet Against Yourself and Win

Here’s how shorting works, in brief. Basically, it’s a “hedge” that the value of a stock or commodity will go down.

First, you borrow stocks through a broker with a guarantee that you will buy the stocks in the future at whatever the stock price is. This allows you to make money on stock if the price decreases.

Here’s an example:

You buy 500 shares of Tex Shelters, Inc at $20 dollars a share. That’s a $10,000 investment. You are confident that the price is going down. Therefore, you sell the stock immediately and wait. You have $10,000 dollars.

A few moths later, the stock price goes down to $15 a stock. You pay off the lender of the stock at the current stock price. The total bill for the 500 stocks is $7500 dollars. You sold the borrowed stock priced at $10,000 and paid $7500 dollars to the lender of the stock. You just profited $2500 on a tanking stock.

What’s wrong with profit you ask? Nothing’s wrong with profit, in theory. But shorting stock, some of which has been made illegal in Germany as they contemplate banning all short selling, is open to manipulation and insider trading. Not only that, but by shorting stock you are investing in failure, and if the stocks do fail, the lender of the stock loses. It also hurts economic growth for everyone in the nations while garnering short-term profit of a few people.

Some say banning shorting is interference in the free markets and that it will hurt investing. However, people that yell the loudest against regulation profit from manipulating the market while betting on failure. They don’t care about the economy; they care about profit. Moreover, the pretense of “free markets” is used to defend their manipulation of the same markets. These investors are the whores Ayn Rand salutes in her tomes. Profiting within a system you manipulate to your advantage is the opposite of free trade.  It’s a form of insider trading and should be illegal.

To continue the example: Let’s say I have news that one of Tex Shelter’s stocks in oil exploration is about to take a huge hit because a future site that we have been drilling in for a year is found to have no oil. Plus, I realize the public is turning against offshore drilling. So Tex Shelters Oil Property’s Inc is about to take a huge stock hit.

Therefore, I get TJ Snodgrass Investors, a subsidiary of Tex Shelters, Inc. with corporate papers hidden in the Cayman Islands, to short 1,000,000 shares that are currently selling at $100 a share totaling a $100,000,000. A week later, the news comes out that we wasted a year of exploring and came up with nothing. The stock plummets to $10 a share. We make a cool $90 million off of our failure. You think that doesn’t happen? Goldman Sachs made 3.7 Billion shorting mortgage securities that they helped originate. God bless capitalism when the rich get richer and the poor can suck on it.

Senate: Goldman Made Billions Shorting Mortgage Market

(MarketWatch) – Goldman Sachs made $3.7 billion betting against mortgage-related securities as the housing market started to collapse, according to an estimate released Monday by an influential Congressional subcommittee, MarketWatch reported.

One of the securities, known at Timberwolf I, was described as a “shi**y deal” by a senior Goldman executive at the time, Thomas Montag, according to an email disclosed by the Senate’s Permanent Subcommittee on Investigations.

http://www.myfoxdetroit.com/dpps/money/senate-goldman-made-billions-shorting-mortgage-market-dpgonc-20100426-mh_7258426

They made a lot of money betting against mortgage investments.

Now we learn that the crisis in Greece was also due to loose credit from Goldman Sachs.

Goldman Sachs arranged swaps that effectively allowed Greece to borrow 1 billion Euros without adding to its official public debt. While it arranged the swaps, Goldman also sought to buy insurance on Greek debt and engage in other trades to protect itself against the risk of a default on those swaps. Eventually, Goldman sold the swaps to the national bank of Greece.

http://www.businessinsider.com/goldman-sachs-shorted-greek-debt-after-it-arranged-those-shady-swaps-2010-2

And Goldman Sachs bet against the debt to Greece in equal shares as they bet for the return on profit, which means they were “flat”, or balanced in the investment when the loan Greece failed to return profit.

Because Goldman Sachs knew about the 1 billion dollar Euro loan that was hidden from public view, “Goldman was uniquely well-positioned to understand that Greek debt service obligations were higher than they would have appeared just by looking at its official debt levels, making Greece a riskier credit. This knowledge may have allowed Goldman to acquire credit protection on the trades on the cheap.”

http://www.businessinsider.com/goldman-sachs-shorted-greek-debt-after-it-arranged-those-shady-swaps-2010-2

Goldman’s ability to short their loans to Greece allowed them to loan without risk to Greece and help lead to the collapse of the Greek economy and a global crisis. And other banks that didn’t know about debt deal lost their shirts, and pants, and an arm and a limb. Do you still think shorting is a good investment practice?

Will there be future bubbles? I wish I could say that there will be no more. But humans have been creating investment bubbles at least since the 1600s, so how can I say there won’t be another bubble? Here is my prediction, in writing, for the next bubble in the next decade: carbon futures and green technologies. There will be a huge lead up and propaganda about how carbon trading and green technologies will save us, investments will outstrip technology and profit making capabilities of the market and actually use of technology, returns, won’t match investments, and the market will collapse.

Carry on in our bright and happy future. Remember, if the stock market is going up, all is well for the sector of America that counts, whether we create jobs or not.

Yours,
Tex Shelters

Reference:

http://www.antitrust.org/cases/pricefixing.html

 

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