Taz asked: When stocks crash, where does the money go?

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Taz asked this question a few days ago. I thought I'd take a whack at it. It really isn't a big mystery, but it does take a few paragraphs to explain.

If every purchase of stock was made with cash-in-hand and if stocks were never used as collateral for a loan, then a stock market crash would not really destroy any money. It would just be a series of exchanges of stocks for cash, and vice versa -- a zero-sum game with winners balancing out losers exactly.

The problem in a stock market crash is that stock shares are often intimately bound up with credit. Some stock purchases are made on margin - a loan. In the current stock mania margin debt has been increasing sharply. This is a red danger flag.

Also, an unknown number of middle class folks are taking credit card cash advances, or lines of credit secured by their houses, and simply gambling the proceeds in the stock market. This may sound like utter foolhardiness to you and I, but gambling (especially *successful* gambling) is known to be highly addictive. people are betting more than they can afford to lose.

Then there are corporations, the rich, and the super-rich. Both corporations and wealthy individuals often own such a large number of shares that they cannot liquidate them very easily. The very act of putting a large number of shares on the market depresses the share price. Imagine Bill Gates trying to liquidate his shares of Microsoft! As a result, both corporations and individuals often secure bank loans using their shares as collateral - more credit based on stock prices.

During a stable period in the stock market, the activites of margin-buyers and other speculators have only a minimal impact on share prices. During a mania or bubble, especially one as long-lasting as the US stock markets have experienced in the 1990s, speculation uses leverage to drive share prices much higher than prudence or reason would dictate. The use of margin debt leverages the prices up faster than they could move up, if no margin was involved.

There is also another inherent form of leverage in the stock market. That is, the nominal share price is set by the exchange of only a small percentage of shares each day. This mechanism magnifies price movements and leverages a small amount of economic activity into a mauch larger change in the market capitalization of the entire company. It doesn't take a billion dollars to move a market. But you can get a billion dollar move on much less investment. This fact also invites speculation.

As shares change hands at ever-higher prices, more and more money accrues to the sellers. The higher the price a share fetches, the richer all investors in the stock feel, whether they intend to sell or not. Corporations like the high prices, too, since they own many of their own shares.

This is the obvious, sunny side of a bubble. But there is also the dark side, when prices fall.

In a rising market, the price at which the "average" share was purchased rises, too. When the price of a share falls below the price the owner paid for it, that share is said to be "under water". In a bubble, reverting to a "sane" price puts almost everyone under water.

What usually gets the process going with a good head of steam is that the price of a highly-speculated stock falls below a certain level and margin loans are called. To get money for the margin call on the crashing stock, speculators have to sell their "good" shares to cover their losses, driving more share prices lower. As the first wave of speculators dumps stocks, the downdraft catches more of them in the ever-widening carnage. Now they must sell to meet margin calls. This is leverage in reverse. Connect the dots.

There are a host of effects when leverage reverses and stocks crash. As margin debtors are overwhelmed with margin calls that they cannot meet, they default and brokerages and banks *lose money*. Borrowers who secured loans with stocks also default on their loans and let the collateral revert to the bank. The bank *loses more money*.

The average non-speculator, who paid cash for stocks through a 401K, is now holding a bunch of shares that are deeply under water. At least those investors are solvent, but if they sell after the crash, they must realize a *loss*. That loss is all too real to them.

As both buyers and sellers dry up in the market, the velocity of money slows down. Slower velocity means money passes through fewer and fewer hands in a given time. This is the equivalent of a loss of money, too.

In a collapsing bubble large amounts of money are destroyed when loans default, some investors immobilize their money in underwater shares, and many other investors make their losses real over a short time. All of these have the effect of reducing both the money supply and its velocity.

That's where the money goes, Taz. I hope it is plainer to you than it was before.

-- Brian McLaughlin (brianm@ims.com), February 07, 2000


The above is true in a technical sense but Curly told me there is a much simpler answer. When you buy a car for $20,000 and it depreciates to be worth $10,000 three years later where does the money go? It is called depreciation and is the difference between the purchase price and the sale price. Where does it go? Who knows. The same thing may happen in the stock market. Some stocks go up and some go down based on peoples perception of many things such as value, income, perceived future income, etc. etc. Some stocks have a huge value when they have zero earnings. Others have a value where the price of the stock is only 6 times the earnings. Some people are smarter than other people.

Don't be a dumb person and borrow money hoping to buy stock and get rich. The market today makes September 1929 prices look cheap by comparison. Beware. It could crash next week, next month or next year but the values will go down. You can count on it.

-- Moe (Moe@3stooges.gom), February 07, 2000.

While we are on the Subject of Money,what ever happened to that 60 Billion(sixtythousand Million)that was printed to avoid Problems at the ATM Machines ????????Was it shredded or released to poison and water down our Incomes???

-- Pennyless ($$$@$$$.$$$), February 07, 2000.

Thanks Brian; I found this helpful...wondered the same thing myself a few times. Doesn't some of the money though, at least at first,go to alternate investments like precious metals and bonds and tangible things?

-- carolyn (carolyn@luvmyhub.kom), February 07, 2000.

--maybe I "got it" now, tell ya, received more economic understanding from this board...I'll do my "translation", it might be accurate, or close, somewhat:

You and three other doods have the tuesday night poker game. You all show up with 100 clams cash, start playing. By the middle of the evening, one guy is holding high, tweo medium, one guy is almost busted, so they take anote-an IOU-on his fture earnings and let him keep playing. they switch to poker chips instead of cash at this point, the real cash goes into pockets. they keep playing, the dumb guy loses big, he's so tapped he can't see straight, but the other guys don't know about this, and keep feeding him chips. end of the night, the real cash is where it went in the middle, two guys are losers, but they honor their debt because they got more cash at home, the last stupid guy just welches on his chip-debt. Now, greenskin and the Fed get to bail out the stupid guy, cuz he's married to greenskins daughter or something. The poker chips were never real, except to where it applied to both a real reserve of money, and that the debtors would actually pay it, not keep playing with more and more chips. Either of those two events not happen, then the game folds forever, or gets reestablished as cash only, no chips ever. If it was the market, it would be a crash, with the biggest debtors maybe getting bailed out, the medium debtors having to pony up or they don't get to play anymore, the "winner" only won a small part of what he thought he won, that's his tough luck for being trusting beyond reason. Is this close?

-- zog (zzoggy@yahoo.com), February 07, 2000.

>> Is this close? <<

Dang good analogy, Zog.

-- Brian McLaughlin (brianm@ims.com), February 07, 2000.

Pennyless, do NOT confuse the currency printed with money in the money supply. that 60 bil is now in vaults. If it is going to be released, it will NOT have ANY effect on the money supply as it will replace the digital dollars in bank accounts.


-- Chuck, a night driver (rienzoo@en.com), February 08, 2000.

Money now is credit. And is mostly electronic. When a crash, money just goes "poof". Bankruptcy. So-called "assets" just written off.

-- A (A@AisA.com), February 08, 2000.

Pennyless, I think they are giving all those 'dollars' to NEA grant recipients to make papier mache penises and vaginas.

Zog, thank you so much. That cracked me up...LOL

-- Kyle (fordtbonly@aol.com), February 08, 2000.

And for those who are acronymically impaired. I meant Nasshonul indoument forr theee fff...nope....arts not farts...not natshonul edifucation assassinat....nop I mean ass.....no I mean soshaysshun.,

-- Kyle (fordtbonly@aol.com), February 08, 2000.

Chuck could ya run that by us one more time?

And, I was wondering what is your favorite net?

-- Kyle (fordtbonly@aol.com), February 08, 2000.

And yet another answer. There is no money in the stockmarket (or for that matter, in any market). Shares are pieces of paper conveying certain legal rights with respect to a company, that are worth no more and no less than a buyer is willing to pay.

When you buy shares, the seller pockets your money and you acquire his legal rights embodied in the shares. When you sell, you pocket the buyer's money. Same amount of money before and after, just in different pockets.

If a market crashes it makes absolutely no difference to the amount of money that exists. All it means is that the percieved worth of what is being traded has fallen.

There are knock-on effects of course, but they don't alter ther fundamentals. THERE IS NO MONEY IN THE STOCKMARKET. None at all.

-- Nigel (nra@maxwell.ph.kcl.ac.uk), February 08, 2000.

Nigel said:

>> When you buy shares, the seller pockets your money and you acquire his legal rights embodied in the shares. When you sell, you pocket the buyer's money. Same amount of money before and after, just in different pockets. <<

What Nigel seems to be doing is defining money as the M1 money supply, the narrowest definition. Using this definition, there is "no money" in anything but coins, currency, savings accounts and checking accounts, and a few other cash equivalents.

Nevertheless, Nigel is correct, as far as he goes. Stocks are not counted in M1. Therefore, stocks are not money.

OK. But this disregards the liquidity of the shares market. Compare selling 100 shares of IBM to selling your house. Converting IBM shares to cash can be done in a matter of seconds. This compares favorably to the amount of time it takes to write a cheque or get cash from an ATM. Converting a house to cash may take six months to a year.

Anyway, this was beside my point. As I indicated, if all transactions for shares were conducted for cash-in-hand, and credit was never involved, then it would be a true zero-sum game. A crash in share prices really would have very little effect on the larger economy, except perhaps on the velocity of money. The major ripple effects from a crash in share prices are carried into the economy by the process of margin calls and other loan defaults.

P.S. Try telling a homeowner he has "no money" in his home. Then duck.

-- Brian McLaughlin (brianm@ims.com), February 08, 2000.

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