Supply and demand curves with elasticity, price floors and ceilings

Supply and Demand Curves With Elasticity, Price Floors & Celings,

The article "Risk returns with a vengeance" provides a clear analysis of the current mortgage crisis that has occurred at a global level, showing the underlying causes of the crisis, the direct effects and the possible future consequences. While benefiting from the experience of the likes of Warren Buffett or Wilbur Ross, the article points out to risk mismanagement or too much confidence on the market as one of the main reasons for the crisis.

In terms of confidence, the current crisis follows a period when money was cheap and when there was a great supply of cash on the market. With the 2000 stock market crash and the terrorist attacks on 9/11 and the immediate recession that followed at a global level, Alan Greenspan, then Federal Reserve chairman, opted for a policy of interest rate cuts with the objective of resuming economic growth and stimulating investments in the economy.

With interest rates as low as 1%, Greenspan's measures stimulated the economy and the companies were able to amass large profits, invest borrowed money due to the low cost of capital and keep the economy growing. However, this type of economic environment created a sense of false security for investors. Due to the low volatility levels and to the profits that investments brought, the investors began to mismanage risks and to take on more than they could handle.

One of the most dangerous aspects was that investors seemed to perceive credit risk at lower perspectives than previously. In fact, they seem to have acquired a certain amount of "fearlessness" about borrowing cheap money. In theory, the cost of capital needs to be lower than the return on the investment made with that money, if the investment is to be profitable. Due to the cheap money on the market and the reduction of risk premiums, this sound evaluation simply mattered less than before.

Besides the usual trend to commit to leverage buy-outs in such economic conditions, many have used cheap money to invest in real estate. However, while profitable at the beginning, the bubble soon burst, with the house prices crashing and decreasing the value of the investment to the point that it made it no longer a profitable investment. About the same time, the price for credits went up, which meant that not only the investments made with the cheap cash were less profitable, but also that the cash wasn't so cheap anymore.

As we can see in the figure below, the price for houses gradually increased during the period 1997-2007, reaching the highest value around the beginning of 2007. However, after that point, the drop was immediate and very pronounced. In economics terms, this meant that the investment, if made prior to the point of accelerated decrease, would become less valuable, affecting its overall return to the point where it would become unprofitable.

In my opinion, the current financial and economic crisis greatly resembles many from the past, when investors simply neglected risks associated with their investments and borrowing policies and where they overlooked the capacity of the market bubble to burst in just a couple of month. Basic economic risk management instruments, such as hedging, were simply not used, because the confidence was uncontrollably high and investors never believed that prices would go down or that credits would become more expensive.

The important issue is whether or not the economy is following a recession at this moment and, especially, if the stock market is currently bearish as much as it was bullish in the past years. The article "5 ways to know if the bull is over" concentrates on clarifying these aspects and on identifying the traces that a bear market would leave in the current market situation.

According to the article, the first signs that a bull market is over includes lower consumer spending, concerns about the subprime mortgage loans etc. This is currently the case in the present and the stock market is keen to capitalize on all of these. Indeed, the Dow Jones index has closed above 14,000 points in July 2007, only to take a dive afterwards and decrease with up to 9.8% in the subsequent months that followed. As we can see from the chart below, in just under a month, the Dow Jones value has gone down from over 14,000 to well under 13,000. This is not a singular case, with the S & P. index losing all the gains from the previous year.

More indications of a possible end to the market bull currently identified in the article include the increase in oil price (with prices going over $80 a barrel), a decrease in overall consumer spending (which has started to be felt indeed on the market) and a slowdown in corporate earnings growth, which is something that the corporate reports for 2007 are likely to show.