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What Caused The January Waterfall Decline ? at Trader’s Narrative

The stock market just is. Trying to find reasons for it’s gyrations is usually a harrowing exercise. And pinpointing a single cause is pretty much a futile effort.

By now, the event that is most prominent in everyone’s mind is the multi-billion Euro Societe Generale fraud, perpetrated by Jerome Kerviel but before being eclipsed by the largest trading loss in history, there were other events. Let’s review all the potential causes for the precipitous market decline we saw in January:

Bank of France Comment

The International Herald Tribune published an article on Friday, January 18th 2008, with the headline “French regulator sees ‘partial decoupling’ of U.S. and E.U. economies”. It included a comment from the governor of the Bank of France and member of the ECB’s governing council, Christian Noyer:

“I’m reasonably confident that French banks will weather this turmoil without major trouble even though they are clearly, like all banks, in the world still in the process of marking down assets”

This seemingly innocuous comment was interpreted by many that the upcoming profit reports of European banks would be hit by write downs. This, even though Noyer was obviously trying to sound an upbeat tone by arguing that the slow-down in the US would not effect the EU because of what he saw as a “decoupling of economies”.

In any case, the European exchanges were flooded with sell orders, especially for banks. SocGen and other French banks closed down an astonishing ~8% by the end of the day.

Bank of China Sub-prime Report

Monday morning, before trading started, there was news from the South China Morning Post that the Bank of China was expected to announce a “large fourth-quarter write-down on investments backed by U.S. sub-prime mortgages” and “to lower the estimated value on $7.95 billion in subprime-backed securities and set aside additional funds to cover potential losses”.

All four of the large state-owned banks in China have varying degrees of exposure to sub-prime assets. The Bank of China has the most of any Asian bank and it has been watching it melt in value faster than a snowman in June.

Although the fiscal year reports of the Chinese banks is due in April, this rumour was able to take down all financial stocks and especially Chinese banks in early Monday trading in Asia. The selling continued when North American exchanges opened for trading.

SocGen Trading Fraud

On January 24th, Societe Generale released a statement that they had been the victims of a fraud by one of their traders to the tune of €4.9 billion. They had discovered it on Friday, January 18th, 2007 and had been able to close all the positions within three trading days.

Not only were the fraudulent trades the largest loss in trading history, the position which lead to it was significantly larger than the whole capitalization of the bank!

As it is with all of these cases, Kerviel had been at it for some time. At one point he was actually up €1.4 billion. Which means that from the high watermark, he in fact lost € 6.3 billion !!

Apparently he was long €30 billion in the Dow Jones Eurostoxx 50, €18 billion in the DAX and €2 in the FTSE. Those are monstrous positions but even so, Kerviel was not able to buy his way into profits. Anyone who believes that the markets are manipulated is welcome to observe how this much buying power had no effect in turning the market.

eurostoxx societe general feb 2008

dax societe generale feb 2008

SocGen had the unenviable task of getting out of a massive long position in a short time while the stock market was spiraling down. I guess a good analogy would be trying to get out of a sinking ship that has also caught on fire.

Although many would like to blame Societe Generale’s hurried exit from the multi-billion Euro long position for exacerbating the market decline, after the fact analysis done by the French Ministry of Finance, they did not account for more than ~8% of trading in any of the three days. Maybe SocGen’s trading didn’t cause the fall on Monday but it certainly didn’t help.

US Fiscal Stimulus Package

The American government announced plans for a fiscal stimulus on Friday, January 18th, 2008. On February 7th, 2008 the US congress voted 380 to 34 in favor of a $168 billion package. That’s about 1% of US GDP.

Bernanke should be happy. In a 2003 speech he recommended “explicit, though temporary, cooperation between the monetary and fiscal authorities” for the Japanese economy.

With both fiscal and monetary policy lax, you’d assume the market would celebrate. But for some reason, when Bush announced the fiscal plan, it had the opposite effect. Maybe it smacked of desperation. Or maybe the market thought it was too little, too late. By all accounts, we are already in a recession and it will take us at least a year to come out.

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