“No Halting the Market’s Avalanche,” reads a headline in the Boston Globe. In the last year, the world stock markets have turned from business as usual into what the Motley Fool recently called “the stock market week from hell.” Despite the fact that the economy is top news right now, most people aren’t clear on what caused the crash in the first place.

Are things really as bad as the pundits would make them out to be? You be the judge…

To look at the causes of our current market mayhem, we’ve got to go back to 2006. That’s the year the housing market peaked. For five years, real estate prices had been going on a tear of double-digit increases in home value as more and more people entered the world of home ownership. By 2004, the home ownership rate had reached 69.2% — an all time high.

Demand for homes was also booming; realtors couldn’t seem to keep up with the barrage of business coming to their doorsteps, but that was about to change…

As abruptly as it had come, the housing bubble burst in August 2005 sinking housing prices and delivering a 40% blow to stocks of U.S. homebuilders.

The Aftermath of the Housing Bubble

By 2007, the housing crisis was becoming the biggest problem on the horizon — Treasury Secretary Henry Paulson entered the scene just a year after taking office, calling the housing market “the most significant risk to the economy.” And indeed it turned out to be. Despite the Dow’s ascent past 14,000 for the first time ever in July, tides were turning on Wall Street.

In September, major lenders like Countrywide, Ameriquest, and American Home Mortgage were facing serious financial troubles as credit became harder to come by. By October, housing prices had fallen for 10 consecutive months in what the National Association of Realtors noted was “the first price decline in many, many years and possibly going back to the Great Depression.”

By March 2008 the Dow Jones Industrial Average had fallen 20% in just five months, and Bear Stearns sold itself to JPMorgan for 1.1% of its $170 high the year before. Fast forward today to the first week in October, when the Dow plummeted further than ever in what’s now being referred to as Black Monday 2008.

What Caused the Subprime Run-up?

One of the biggest causes of our current financial crisis was the popularity of subprime mortgages among financial institutions. Subprime loans are loans made to people who are high-risk. Subprime loans carry higher interest rates — meaning higher profits for the lender. But things suddenly changed when the credit market locked up and many consumers were unable to pay their mortgages. Lenders like Ameriquest soon found that the loans they’d made couldn’t be paid off and were next to worthless.

Unfortunately, the fallout wasn’t limited to banks…mutual and pension funds bought subprime debt too, because they had such high rates of return. When those mortgages became worthless, millions of Americans with nothing to do with the problem lost money overnight.

Many people believe that predatory lending was largely to blame for the collapse of the subprime lending market — lenders convinced consumers to sign off on loans that had complicated payment schedules (often increasing over time) and very long payment horizons.

And despite the windfall they found themselves in for a short time, banks soon got caught holding the bag on the subprime fiasco.

The Road Ahead

Just a few days after Wall Street’s worst week, things aren’t looking as bleak as they once were. Uncle Sam’s been intervening, ensuring that the economy doesn’t deteriorate any further. Recently, Secretary Paulson announced that the government would be buying stakes in U.S. banks to the tune of $250 billion.

The news sent stocks on their biggest-ever gain on Monday October 13, the Dow ending 936 points higher than Friday’s close.

Just where our economic crisis will end isn’t sure, but as liquidity slowly comes back to the credit market, chances of a stronger 2009 look better.

Cheers,
Jonas Elmerraji

October 20, 2008

P.S.: There’s a lot of volatility in this market that you can take advantage of. Until midnight tonight, we have the best way to exploit it.

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

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