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By John W. Schoen Senior Producer
msnbc.com
updated 7/30/2007 3:54:05 PM ET 2007-07-30T19:54:05
COMMENTARY

Part of the blame for last week's stock market plunge was pegged to jitters about the ongoing fallout from the housing mess. Which has some readers wondering: Why should the stocks in my retirement fund get clobbered just because some bankers made a bunch of bad loans to home buyers who couldn't pay them back?

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Why all the worry about the housing market? It gets what it gets if the bank loses money because of being greedy. … I think we as American people and stockholders in 401k accounts should not lose our assets because lenders wanted more money, and they let people that could not afford the payment get a mortgage. They should have to pay for their stupid action.
M. M. Welch, W.Va.

Plenty of players in the mortgage lending frenzy have already gotten burned. Dozens of the companies that went overboard lending to people who couldn’t handle their monthly payments have already paid the price: going out of business after being swamped by losses from an avalanche of bad loans that went bust. In many cases, the investors who bought shares in these “subprime” lenders also lost money.

More recently, a lot of Wall Street’s best and brightest got burned after putting a little too much faith in their computer models — which told them that they could insulate themselves from the risk of lending to people with bad credit. Those computer models — and the increasingly complex financial structures used to churn out paper that was sold to investors by the boatload — are now creating huge losses for some Wall Street firms that bought and sold these so-called “mortgage-backed securities.” And some of the people who bought these bonds — including hedge funds who gobbled them up — are also turning out to be big losers.

The problem is that when it comes to the financial markets, we all have to drink from the same well. Though much of the loss has been felt most heavily by the principal actors in this play, the paper they churned eventually flows into the same financial market that hosts your 401(k) account. Though stocks and bonds often march to different drummers, trouble in the bond market — where all these rotting mortgage pools ended up — can spill over in the stock market. One reason for the rapidly rising prices paid for stocks you may hold in your retirement account, for example, was widespread belief in the assurances from the Wall Street computer wizards that they had come up with new ways to control lending risk.

For a few years there, it looked like these new Risk Reduction wizards were right. Investors began buying up all kinds of risky paper – from subprime mortgage pools to debt from Third World countries — with little more insurance (in the form of higher interest rates) than they got from the safest investments like U.S. Treasury bonds. It was as if somehow, in this new world of interest rate swaps, credit derivatives and risk management models, a basic law of finance had been repealed: that you should always get paid substantially higher interest rates to protect yourself from borrowers who had a worse-than-average track record of not paying your money back.

A number of market watchers have been warning that this could end badly. The so-called “credit spread” — the difference between interest rates on the safest and riskiest bonds — has shrunk sharply in the past three or four years. Now, as investors rethink the assurances from the risk managers, the markets are getting more cautious – and demanding higher interest rates for risky paper. And when credit gets more expensive, that often hurts both stock and bond prices.

A lot depends on how much more bad news is lurking among the investment banks and hedge funds that may be holding bonds based on shaky loans. Since these hedge funds are not regulated, and don’t have to report their financial holdings like your 401(k) does, no one is quite sure just how much wider these mortgage–related losses will be. A lot also depends on how long before the housing market recovers — and just how many more subprime borrowers eventually have to throw in the towel and default on their loans. That process takes time to work through the system before the investors who bought bonds based on these mortgages take the final hit and report their losses.

It could be that the worst of the storm has passed. If the bond market continues to adjust — gradually — to a new view about the realities of risk, the markets could emerge from the latest downturn none the worse for wear.

The problem is that no one knows for sure what lies ahead. And if there’s one thing the financial markets hate, it’s that kind of uncertainty.

What does the DOW number actually represent?
— Mary, Berlin, Md.

By itself, not a lot. The Dow Jones Industrial average — though it is the most widely followed measures of the performance of the U.S. stock market — actually tracks just a handful of the thousands of stocks traded minute-by-minute on Wall Street and around the world. Developed over a 100 years ago by a fledgling financial news service, there were originally just 12 stocks used to calculate how market prices moved. Over the years the company developed multiple averages, including the Dow Jones Industrial average of 30 biggest companies. Only one — General Electric — remains on the list.

In their day, the Dow averages were an innovation that financial analysts relied on to track market trends and develop forecasts. One average tracked transportation companies — mostly railroads; another followed utilities. In the days with the growth of the U.S. economy was based on large manufacturing companies, powered by electricity and moving goods by rail, the Dow averages provided a comprehensive overview of health of the U.S. stock market.

Today, the Dow Jones Industrial average is something of a relic — “industrial” activity like steel and auto manufacturing now makes up a much smaller portion of economic activity and stock market growth. To keep up with the times, the keepers of the DJIA have replaced heavy industry with companies that better represent the overall economy. But while 30 stocks represented a reasonable portion of the hundreds of stocks traded in 1900, the numbers of companies with public shares is now measured in the thousands. No matter which companies are included, the Dow is only a snapshot of a relatively small corner of the overall market.

One of the advantages of a price-weighted average is that it’s (usually) pretty easy to calculate. You just take the closing prices of stocks in the index, add them up and divide by the number of stocks on the list. But, over time, as stocks split or get replaced, things got a little more complicated. To make the math work, you have to add up the prices of those 30 stocks and then use a special devisor that takes these changes into account. Today, instead of dividing by 30, you have to divide by a number less than one (currently  0.123017848 to be precise.) Because dividing by less than one makes a number bigger, not smaller, the current DJIA is a huge multiple of the sum of the closing prices of the 30 stocks that make up the average.

Other market indices, like the Standard and Poor’s 500, give a more complete picture. But the Dow is the oldest, with the longest set of historical data to relay on for market analysis. Because “the Dow” over the years has become shorthand for the stock market, most people still rely on it as the basic benchmark for the market performance.

The durability of the DJIA may also rest, in part, on a decision in 1882 by founders Charles Dow and Edward Jones to keep their company’s name short. To the great relief of headline writers and broadcasters since then, the name of a third partner, Charles Bergstresser was not included.
 

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