Jon Stewart, one of the most astute and insightful commentators of our time, explains the May 6th 2010 Flash Crash in this video from the Daily Show: A Nightmare on Wall Street
If you are a day, swing, or momentum trader, how would you trade in this market? Did trading on May 6th blow through all the sell stops on the order books?
Well, I have one friend who is an accomplished trader and he related his strategy regarding this issue. He refrains from trading if the market moves too violently or if there isn’t a clear reason for the market movement (e.g. a war, terrorist attack, major corporate bankruptcy, etc.)
One supposed benefit of an electronic marketplace and program trading by black box algorithms (algos) is market liquidity that would prevent just this type of collapse. The October 19th 1987 Black Monday crash was supposedly caused by computer program trading. It happened again this time — did we learn anything?
Or, as the saying goes:
History is the same events happening to new people who experience it for the first time as though it never happened before.
On Thursday May 6th the stock market took a unexplained and terrifying plunge down 10% during the day.
This highly unusual event called the “Flash Crash” can be seen in real time on CNBC as Erin Burnett is interviewing Jim Cramer on Street Signs.
There are many (some conspiracy) theories as to the cause of the “flash crash,” which call into question the robustness of our nation’s financial systems.
How robust and sound is our financial system when the stock market can fall 10% intraday or about one trillion dollars?
Here are a few of the reported potential causes and conspiracy theories that may have triggered the crash.
A trader made a “fat finger” error and pushed the wrong key on his keyboard selling a unusually large amount of contracts which exceeded the supply available. This is essentially a typo error.
There was a large legitimate sell order on the S&P e-mini futures contracts which caused all markets globally to react and recalibrate to a lower futures price.
Dow component Proctor & Gamble (PG) was either misquoted or mis-priced much lower than it should have been. (Cramer notices this on the video.)
The market makers on the NYSE shut down for a few minutes to pause and reflect on the day’s previous 3% fall in prices. This sent existing sell order to smaller exchanges which couldn’t find enough buyers and thus prices fell dramatically.
I bet you thought that was it. But wait there’s more!
There were fears over the European sovereign debt crisis and the crashing Euro.
Related to the European crisis were images on TV of Greek citizens rioting because of the new fiscal austerity measures placed upon them.
Computers trading with each other in fractions of a second all simultaneously decided to sell (similar to the October 1987 market crash). This isn’t so improbable as you might expect, because most of those system’s algorithms (“algos”) were programmed by a similar set of computer and math genius who went to similar schools and were taught similar economic and financial theories.
And finally, my favorite: The whole affair could have been orchestrated by TPTB (The Powers That Be) on Wall Street to fleece profits from the masses (triggering stop loss orders at low prices) AND scare Washington into diluting the Financial Reform Bill being debated on Capital Hill that very day.
Here’s what should bother and scare us:
First, no one knows what caused the crash.
Second, an incredible amount of wealth, greater than some nations’ GDP, vanished into thin air over 15 minutes. How safe and secure should we feel?
There are even other possible issues which could have caused this crash and they should cause us to thoroughly examine and rebuild our financial system to be better able to absorb shocks.
Perhaps we’ll find that, like most catastrophes, it was a combination of errors and systemic issues that caused the 10% intraday stock market plunge. The stock market could handle and has handled issues in the past of similar magnitude to those listed above. However, if a few of these occurred during one day, it is doubtful order could be maintained with the current systems in place.
P.S. Does anyone still believe in the efficient market hypothesis and that stocks are ALWAYS perfectly valued?
How about the theory that “there is a buyer at every price point?”
Warren Buffett calls derivatives “financial weapons of mass destruction.” Do you believe him?
Derivatives are financial instruments whose prices are derived from underlying assets. One example would be a futures contract between a farmer and a food processor. In this case the underlying asset is the grain harvested by the farmer and the derivative is the contract to deliver that grain at a specified price, time, and location.
This all sounds reasonable enough. So why would Warren Buffett call derivatives “financial weapons of mass destruction”?
What if a Wall Street trader could make financial bets that rewarded the trader with bonuses and the firm with earnings all without setting aside capital or assets to cover that bet? How many of those bets would you make? How many would you make when you get immediately rewarded for wins and little or no apparent penalty for losses in the unforeseeable future? Finally, how many would you make when your expert with a PhD from MIT says his mathematical model shows those bets are risk free?
Now that you’ve thought about those questions, watch this video from Khan Academy regarding Credit Default Swaps (CDS). Listen for the part about a cascading failure which starts in one location and ripples through the whole system, ultimately destroying everything that looked seemingly safe and sound.
Was the great real estate bubble of 2000 – 2007 preventable?
Who won and who lost?
Why weren’t the inevitable crash and current historic recession preventable or predictable by the best the brightest among us?
The following video from CNBC’s “House of Cards” (ht – Alan Sun) contains interviews with people in all parts of the real estate food chain: from borrowers to loan officers to lenders to wall street bankers to hedge fund operators to bond ratings analysts.
Wall Street will create what they can sell until there are no more buyers. This generates seemingly safe fee income which boosts quarterly profits and of course also produces undeserved multi-million dollar bonuses.
It is hard to believe now, but the banker’s financial models predicted 6% to 8% annual housing price increases forever into the future. How was this sustainable when household income wasn’t rising and probably wouldn’t rise much with global wage arbitrage? Many of the people on the front lines of this historic boom were young home buyers, recent MBA grads at Wall Street firms, etc. They had never known a down real estate market. It couldn’t even occur to them from experience that real estate goes anywhere but up in price.
The boom couldn’t start without Wall Street securitizing loans and selling them off to investors (many of them overseas). What type of WS culture creates an environment where there is strong incentive to sell what the market will buy and book a trading profit or fee income? No one had any incentive to stop the lucrative money train.
- Home buyers bought more house than they could afford.
- Loan officers originated more loans and earned significant income for basically just helping borrowers fill out a form (loan app).
- Wall Street bankers generated massive bonuses for themselves and quarterly profits for their firms.
- Rating agencies earned more fees rating mortgage backed securities (MBS) as AAA.
Isn’t it startling that nowhere was a fundamental issue like a borrower’s ability to service a loan and pay on time for 30 years ever discussed or considered?
The economic boom was NOT about fundamental value creation but solely a product of easy credit. Housing prices historically rise about 1% a year in line with increases in household income. They will revert to the mean over time. Essentially, there is no new economy or new economics. When we hear that in the MSM (mainstream media), look for the unsustainable bubble and prepare for it to end.
Why couldn’t Alan Greenspan, our economic “maestro”, our foremost authority on finance, interest rates and a stable economy, have warned us about the unsustainable boom and subsequent global economic collapse? He didn’t see the bubble. To make matters worse, he says:
“there is no doubt that somewhere in the future, we’ll have this conversation again. It will not be for quite a period of time, but it will occur because the flaws in human nature are such that we cannot change that, it does not work.”
Will you remember that all booms go bust?
Will you remember that what cannot go on forever must end?
Will you remember what your parents taught you? Just because everyone is doing it, doesn’t mean you have to do it too.
If history is any guide, almost all of us will forget what we learned by the time the next boom starts. Scary thought, isn’t it?
Someone wrote a good summary of credit derivatives.
(Hat tip Eric Overfield for pointing this out)
At last, what we’ve all been waiting for, an understandable explanation of derivative markets.
Heidi is the proprietor of a bar in Detroit. In order to increase sales, she decides to allow her loyal customers – most of whom are unemployed alcoholics – to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).
Word gets around about Heidi’s drink now pay later marketing strategy and as a result, increasing numbers of customers flood into Heidi’s brand soon she has the largest sale volume for any bar in Detroit. By providing her customers’ freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume increases massively.
A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Heidi’s borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral. At the bank’s corporate headquarters, expert traders transform these customer loans into
DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then traded on security markets worldwide.
Naive investors don’t really understand the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, their prices continuously climb, and the securities become the top-selling items for some of the nation’s leading brokerage houses who collect enormous fees on their sales, pay extravagant bonuses to their sales force, and who in turn purchase exotic sports cars and multimillion dollar condominiums.
One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due his negativity), decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar.
Heidi demands payment from her alcoholic patrons, but being unemployed they cannot pay back their drinking debts. Therefore, Heidi cannot fulfill her loan obligations and claims bankruptcy. DRINKBOND and ALKIBOND drop in price by 90 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. The decreased bond asset value destroys the banks liquidity and prevents it from issuing new loans.
The suppliers of Heidi’s bar, having granted her generous payment extensions and having invested in the securities are faced with writing off her debt and losing over 80% on her bonds. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 50 workers.
The bank and brokerage houses are saved by the Government following dramatic round-the-clock negotiations by leaders from both political parties. The funds required for this bailout are obtained by a tax levied on employed middle-class non-drinkers.
