by Archie M. Richards, Jr.
August 27, 2007

The stock market's fierce down-draft during the last two months is over. Here's the sequence of events that caused it:

From 2001 to 2003, the Federal Reserve Bank created an enormous amount of new money. (The Fed doesn't mint dollars and coins. It simply enters numbers in the bank accounts of institutions and individuals that sell U.S. Treasury debt to the Fed. The debt sold disappears, and the new money can be spent as the recipients please.)

The Fed probably didn't overdo the money creation. After all, the U.S. was suffering a recession and embarking on war. But the plentiful money supply did cause real estate prices to rise.

Oh yes, the public wanted real estate, not stocks. The severe bear market from 2000 to 2003, the recession, the War on Terror and the threat of attack made many people scared of stocks. They wanted real estate instead.

Laws and regulations of the Clinton Administration enabled more low-income Americans to own their own homes. This created an extra demand for real estate.

Partly with the government's encouragement, the finance industry lowered the requirements for obtaining mortgages. Mortgage banks no longer checked as carefully whether borrowers could afford the payments. During the first two years, the payments required were very low, often interest only. Borrowers no longer needed downpayments; they simply signed an additional note to supply it.

Low-quality, or "sub-prime," mortgages proliferated. They remained a small percentage of all mortgages (about 1 percent), but there were many more than before.

The companies that originally placed these mortgage loans sold them to investment bankers, like Lehman Brothers. The originators, with their coffers replenished, could then go out and sell more mortgages.

The investment bankers combined many mortgages of similar types and sold them in the form of bonds to financial institutions and mutual funds. Bonds backed by mortgages are riskier than other types of bonds. As the underlying mortgages are repaid because of refinancing or real estate sales, the mortgage bonds are partially redeemed. The uncertainty of maturity makes mortgage bonds tricky.

Some financial institutions, especially hedge funds, held the bonds with significant leverage, meaning they borrowed large amounts to buy additional mortgage bonds.

To reduce the risk, they created complex financial arrangements, called derivatives, which enabled some of the risk of default on the mortgages to be transferred to others.

Both mortgage bonds and derivatives were sold all over the world. Some of the derivatives were so complex that they couldn't be valued currently. Institutions simply guessed at their values. When conditions were favorable, the guesses were on the high side.

What's new about all this is that more capable computers and more sophisticated financial instruments enabled risks to be spread farther and wider than ever before.

This is where the chickens came home to roost: From 2003 to 2006, the Federal Reserve gradually slowed the creation of new money, causing real estate prices in late-2006 to begin falling. The debt of homeowners who'd paid too little for their mortgages exceeded the value of the property, leaving the mortgages partly unsecured.

For many sub-prime mortgage holders, the two years had passed. Mortgage payments rose to levels that the homeowners could no longer pay. Defaults and foreclosures increased substantially.

Suddenly, fear shot through the world's financial institutions. How far would U.S. real estate prices fall? How many mortgages would be defaulted? What were those complicated derivatives really worth? Even though sub-prime mortgages were only a small portion of all loans, the spread of risk and the uncertainty cast doubt on the lending institutions of the entire world.

But take heart. Real estate problems will take time to cure, but they'll be contained mostly within the industry. The Fed is making the right moves to reduce fear. The U.S. economy is resilient, and the world economy is blossoming. Everywhere, the potential for profit exceeds the cost of borrowing, stimulating investment in productive resources.

Stock market indicators show that the market has attained a significant bottom. The decline is over. Stock prices are cheap.