By John W. Schoen Senior producer
updated 10/27/2008 4:54:26 PM ET 2008-10-27T20:54:26

The stock market's wild gyrations show no signs of letting up. As market indices rack up huge losses, a Florida reader is wondering: What happens if it just keeps going down?

What would happen if the stock markets went down to zero?
Malcolm J., Seminole, Fla.

The stock indices we're all riveted to these days are a rough measure of the value of companies that have sold stock to the public. (There are many companies — some very large — that don't show up in this measure because they haven't sold ownership shares to the public.)

The price of a company's stock reflects several factors. At a minimum, it represents a proportional share of the value of the assets owned by the company. These include things like buildings and equipment, along with cash or other investments on the company's books. This is sometimes referred to as "book value." No matter how badly the economy stumbles, these assets are still worth something. If the company folded tomorrow and sold off everything it owned, the proceeds would be paid out to shareholders (after creditors).

In some cases — when a company files for bankruptcy protection, for example — shareholders get nothing after those creditors are paid off. But in order for all shares of all companies to be worthless, the total liabilities of all public companies would have to exceed the combined assets of those companies. We're nowhere near that point, and it's hard to spin a scenario where we ever could be. (Though I'm sure we'll see a few in tomorrow's Answer Desk Inbox.)

In any case, very few stocks trade at book value because most companies are worth significantly more than their assets. The most important measure of a stock's value is the company's ability to make a profit — and to increase those profits in the future. If you invest in a company that pays dividends, the value of that income stream is reflected in the stock price. In order for all stocks to go to zero, you'd have to eliminate the earnings value of all stocks. While the total profits of all companies may go down in a bad recession, that number doesn't get anywhere near zero.

The last factor to consider is the collective psychology of buyers and sellers of stocks. While investors may study piles of data to gauge the value of a stock, they don't always behave rationally. The recent sharp drop in stock prices is based largely on the justifiably high level of anxiety about the banking system and uncertainty about how deep and long the economic downturn will be. Current stock prices may already reflect the worst-case scenario.

If they don't — and if we get even more bad news about banks or signs of a deeper recession — stock prices may fall further. But at some point, no matter how far they fall, stock prices reach a level where the risk of spending your last dollar to buy a share is more than offset by the odds that the economy will eventually recover and you will have made the investment of a lifetime. Investors who are stepping up as buyers today may be making just that kind of bet.

It's easy to understand that the Fed can buy securities to inject money into the system. But you never did answer the question of where does the Fed get its money from to do so?
H. H., Chicago, Ill.

The Federal Reserve has several ways to generate cash and other financial assets on its books, and lately it’s come up with an explosion of alphabet soup programs to make more. (More on those in a moment.)

To fund its own operations — making payroll, paying utility bills, buying new computers, etc. — the Fed relies on interest paid on Treasury notes it holds in its own account. The Fed also earns much smaller amounts from its foreign currency holdings, along with fees paid by banks for services like check clearing.

According to its latest annual accounting to Congress, the Fed spent $3.3 billion last year to fund its operations. It made $40 billion on its Treasury portfolio and about $1.5 billion from those other revenue sources. So it can easily pay its bills, with tens of billions left over, without having to ask Congress for appropriations. (The extra money generated by the Fed gets turned over to the Treasury to help pay general government expenses.)

But the Fed’s operating budget is a small fraction of the money that it moves through the financial system to try to keep the wheels of the economy well-greased. Until recently, the primary source of capital on its books came from issuing Federal Reserve Notes — the green pieces of paper in your wallet.

Like any note, currency in circulation is essentially a loan. When the Fed prints a new dollar, it lends it — via the banking system — and it can be used as “legal tender for all debts public and private” (just as it says right there on the dollar bill). For many years, those notes were backed by gold. Today, the notes are backed by the “full faith and credit” of the U.S. government — just like notes issued by the Treasury. If the Fed prints too much money, and people lose some of their faith in the government, the value of its notes goes down.

When the Fed “lends” a new one-dollar note to a bank, it adds a corresponding dollar to the assets on its balance sheet. Until very recently, the bulk of those assets were held in the form of Treasury securities that banks swap when they need more Federal Reserve notes (cash) to lend to customers or pay depositor withdrawals.

As the economy grows, the Fed gradually expands the supply of notes. If it didn’t, money would get “tight” and the economy would not expand as easily. Over time, the assets on the Fed’s books have grown; as of this summer, the Fed was sitting on about $900 billion in assets to fine-tune the amount of cash flowing through the system.

That was then. Since the financial storm hit the global banking system a few months ago the Fed’s balance sheet has exploded. As of last week, the Fed listed $1.8 trillion in assets.

Where did that nearly a trillion dollars come from? Mostly, it represents swaps of “good” assets like Treasuries for collateral that the Fed has never accepted before. Some the collateral is investment-grade paper like corporate and municipal bonds. The Fed is also accepting some “troubled” assets, like mortgage-related investments that can’t be sold. The Fed has also been swapping assets with foreign banks, pushing more dollar-denominated notes and into the global financial system in exchange for notes denominated in foreign currencies.

For every dollar’s worth of Treasury bills the Fed uses in these swaps, it takes back — in theory — a dollar’s worth of some other form of investment. The hope is that, when things settle down, and the assets the Fed is accumulating are seen as less risky, it can reverse the swap and get back to just dealing with the supply of Federal Reserve notes.

But it remains to be seen how all this credit swapping will be unwound. With the financial markets still in turmoil, there hasn’t been a lot of attention paid to the Fed’s exit strategy.

For readers who want to learn more about the Fed’s balance sheet, James D. Hamilton, an economics professor at the University of California at San Diego has written an excellent blog post on the subject.

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