What Would Happen in a Stock Market Crash?

By: Money_Morning

Shah Gilani writes: Hang onto your hats. It's getting windy out there. Stuff is blowing all over the place.

Oh, that's not wind! That's a giant fan. Well then, that must be why this "stuff" stinks so bad.

What stuff?

How about the Dow Jones Industrial Average falling more than 1,000 points from multi-year highs reached only a few weeks ago?

Or that the Dow has nosedived 5%, ever since the fateful morning last week when we found out that polls don't mean anything, that Republicans don't have memories like elephants, and that Obamarama is still the game we're playing?

Or that the Nasdaq - you know, that tech bellwether index that a lot of analysts believe is our economic canary in the coalmine - is down 10.6% (technically in "correction" territory) since reaching its highs back in late September? Or that it's down 5.5% since the elation, I mean election?

That's not only stinky stuff; it is scary stuff.

Supposedly the reason the market is going down is that we're nearing the fiscal cliff and may be heading over it. But that outcome doesn't worry me.

My colleague Martin Hutchinson - a brilliant banker - isn't worried about it either.

He just came out yesterday morning with the following reality check: "Contrary to all of the media caterwauling, [the fiscal cliff is] not a dreadful fate. In fact, it is exactly what we ought to be doing, since it solves 77% of the deficit problem in one fell swoop."

You can follow Martin's argument for facing the fiscal cliff right here.

Even Warren Buffett said yesterday that going over the fiscal cliff wouldn't be as bad as everyone is making it out to be, and that if we go over it we'll bounce back like we're attached to a giant bungee cord. That's comforting - to Warren, that is. That's because he likes to buy when things hit bottom. He's a clever one, that Warren.

What Would Happen in a Stock Market Crash?
Here's a heads-up for you: The biggest "cliff" we have to worry about is the market falling.

After all, the market has been the primary instrument of interest and intention, as far as the Federal Reserve's articulated policy of pumping it up with cheap money (that's also known as leverage, people), so we all feel good about our pensions and 401(k)s and all our investments.

Then, when we're brimming with confidence, we will all go out and consume again, and again, and again, and borrow to do it - kind of exactly like what our government does.

And then there's the Fed's other policy prescription: massive giveaways to banks to buy the government's debts. (Hey, isn't that what they're doing over in Europe?)

Banks then "repo" that debt (that's short for "repurchase agreement," which is when you lend your treasury bills and bonds and get cash, and agree to repurchase your collateral later to close the loan) to get more money to buy more treasuries, and so on and so on.

Oh, and sometimes they lend out some of their money. After all, they are banks, not hedge funds, you silly people.

So what happens if the market does fall off a cliff?

What's the Fed going to do then to build up our confidence? Are they going to pay off the margin calls we get when our brokers call us for more dope because we were on dope when we believed the Fed could engineer a rising market with leverage but no downside?

The Fed is out of bullets. If the market crashes, we are in deep doo-doo.

Big Trouble at the FHA
You know what else stinks? This $100 billion shortfall at the FHA.

The Federal Housing Administration (FHA) - speaking of a canary in a coalmine - is in dire straits. That spells another round of trouble for real estate. No, we're not out of those woods yet.

When the mortgage crisis hit and Fannie Mae and Freddie Mac had to be bailed out, the whole game of the government backstopping, aiding, and abetting mortgage origination and dissemination came to a grinding halt.

Things were so bad that the government decided to do something about it. So they punted all the problems Fannie and Freddie created, but couldn't stomach, over to the FHA.

The FHA doesn't lend money. It insures lenders against borrowers defaulting on the mortgages they get. Since lenders weren't able to originate mortgages and sell them off to Fannie and Freddie, everyone was afraid there would be no mortgage money and, therefore, no homebuyers. So the FHA was told to take in the poor, tired, and broke potential homebuyers by insuring lenders who gave them money to buy homes.

What's interesting about the FHA is that they are there to insure mortgages for people who have a hard time getting mortgages. Which happens to be pretty cool now that everyone has a hard time getting a mortgage.

You only have to put down 3.5% when you get an FHA-insured mortgage. And you don't have to have a good credit score, either. It used to be you could get away with a 550 FICO score. (It's a little higher now.) That's what I call a score!

But, best of all, new legislation allowed the FHA to raise the amount of a loan they can insure from the previous level of $362,790 to a new total of $729,750.

I want my MTV and my McMansion!

Anyway, the FHA has been insuring lenders right and left. They have insured something like $1.1 trillion worth of mortgages. But, alas, now it seems that close to 10% of the mortgages that the FHA insures are seriously (90 days and more) delinquent.

Let's see, 10% of $1.1 trillion is a little more than $100 billion, right? So the FHA could potentially have to back lenders to the tune of how much, $100 billion? And how much do they have in their reserve tank? Oh, that would be about zero. They're supposed to have at least 2% in reserves, but they haven't had that in more than four years now.

Don't worry, the FHA can borrow as much as they want from the Treasury, so they're cool. Don't you feel better already?

But what is happening with delinquencies on new mortgages is not cool.

The FHA hitting the spotlight, in a dark way, brings into question once again what the heck the government is doing in the mortgage business in such a big way when they have no idea how to fix, sell, or dismantle Fannie and Freddie. And it could put another dagger into the back of housing... just as it tries to climb out of the hole it's been in.

This all stinks. And there's more. But this column is getting long, and you're getting scared.

You should be.

P.S. I promised I'd follow up with you soon on prepaid cards and the like... and I will. I haven't forgotten. It's just that this other stuff hitting the fan is more important right now.

Source :http://moneymorning.com/2012/11/16/with-the-fed-out-of-bullets-a-stock-market-crash-will-really-hurt/

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