Know These Crisis Dates

September 15, 2008. It’s just past the 10-year anniversary of Lehman Brothers swirling down the tube. The company had $639 billion in assets and $619 billion in debt. That’ll do it…

The S&P 500 had already fallen from a 2007 peak of 1,576 to around 1,250. But Lehman’s failure kicked off a six-month period that you had to live through to believe…

It’s not even fair to call it a panic. People weren’t running around like their hair was on fire. There was numbness, as if it wasn’t real. Like I imagine the short walk to the gallows might feel like. Except the walk didn’t seem to have an end.

Of course, we now know every Wall Street bank and many insurance companies owed each other insane amounts of money. And all their cash was tied in assets that were losing value at an exponential rate and that couldn’t be sold. Like a huge option trade going bad. 

If you’ve ever traded options, you know what I mean. A stock option is just a contract between two parties to buy and/or sell a stock. Like, say you think you want to buy some Amazon stock. You can pony up $19,450 right now and buy 100 shares at the current price of $1,945. Or you can spend $2,200 and have the right to buy Amazon at $1,945 until the end of the week.

If Amazon rallies $50, you’re making money. If it doesn’t, you can’t lose more than the $2,200 you spent for the option contract. But the price of that option can change quickly. If Amazon shares don’t move, it could be down 50% tomorrow. And another 50% after that. And of course, after Friday, that contract ceases to exist.

Options get used all the time. You can get an option contract on a house you’re thinking of buying or a script you want to make into a movie. They aren’t particularly risky, if you use them correctly…

Wall Street Screws it Up

Leading up to the financial crisis, Wall Street was having a field day making mortgage loans, packaging them into huge bonds called mortgage-backed securities, and selling them to each other. They could mix in some really high-quality loans with some sketchy, high-yield subprime loans so the whole mortgage-backed security could pay a dividend. 

At the time, mortgage bonds were just about as good as cash for a bank’s capital reserves. They could plow billions into Treasuries and get 4% or put billions into these mortgage bonds and get 7%. Win-win.

And even better, the Wall Street banks could then go to an insurance company like AIG and buy insurance on the default risk of the mortgages, at which point the bonds really were as good as cash because the default risk was covered. They could then make more loans with these bonds as collateral, and the whole process starts again.

Problem was, nobody had the full picture. Even AIG didn’t know it had written a couple hundred billion in insurance for those mortgage bonds. And Wall Street banks didn’t know exactly how much of the bonds they owned were made up of those risky subprime loans…

When borrowers started defaulting on their mortgages, it meant all those mortgage bonds stopped paying dividends. So their values fell. And when all the values fell, it meant banks’ asset bases plummeted overnight. They didn’t know what the bonds were worth, and they couldn’t sell them because no one had any money.

This was about the time we were advised to go to an ATM and get some cash because we might not be able to the next day.

And when AIG got hit with something like $200 billion in claims for the bonds it had insured, well, it didn’t have it. (Bailouts to AIG went right out the back door to banks like Goldman Sachs to pay off the claims.)

The Not Knowing

Stocks were melting down, the economy was falling apart, and solid information was very hard to come by. Because, of course, the banks were doing their best to hide what was going on. The only reason it was Lehman that went down instead of, say, Citi is because Lehman did a less good job of hiding how bad off it was. 

Add in the stock declines, and the world lost something like $50 trillion in about a year. It’s like a family getting the triple whammy of a layoff, an illness, and a foreclosure, and ending up homeless. 

Now, let’s shift our attention to May 6, 2010. 

That’s the day the Dow dropped over 10% in about five minutes. The Flash Crash. 

This was after the financial crisis. People were still nervous. And computer-based trading had basically taken over. 

The simplest explanation of computer-based trading is that computers are programmed to go seek out buy and sell orders. Anybody wanna buy Bank of America at $30? What about $29.99? What about $29.98? 

On the day of the Flash Crash, there basically were no buy offers for stocks. So the machines probed lower and lower. I recall there were cases where the machines couldn’t find a buy order until a stock was down 35%, 45%, or more than 75% simply because there were zero offers to buy.

Yes, curbs have been put in to stop this kind of thing. And the index officials will cancel trades that are deemed invalid. But start preparing your brain now for crazy moves in the next bear market. 

Because the one thing the Flash Crash and the financial crisis had in common was a loss of confidence. What happens in a machine-driven market when all they are doing is looking to sell or buy really low? It’s not like we can just turn ’em off at this point…

Now, $50 trillion in losses is bad. But I can imagine the losses coming even faster the next time around. I can imagine markets being closed for days or even weeks… 

I’m not trying to scare you off. Really. Life and business go on, crashes recover. Ten years ago, you could’ve bought the S&P 500 under 660. It’s nearly 3,000 now.

Point being, there’s always opportunity. There’s no way to predict the next one. But everybody should have a game plan. My colleague Christian DeHaemer says the time is coming pretty soon. Read what he has to say, and make sure you’re ready.

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.