Posts tagged with finance

Cross-posted in my Daily Kos diary, where it will be almost certainly ignored (because kossacks mainly care about breaking news).

A Metaphor

Suppose I had a car company, Woodside Cars, Inc., and we discovered an amazing new way to power cars using a miraculous substance called unobtanium. We'd roll out a line of new cars, and everyone would buy them, because they never have to be filled up. People would buy shares in the company too. The cars are great, they're well made, they save money, and have a high resale value. But then, after 3 years, suddenly the cars start to fail. It's mysterious. Some of the unobtanium is corrupted. It's unpredictable. Some of the cars just stop, others keep going. Overall there's a 50% failure rate but no way to predict which ones will die and which will keep on going. Suddenly the resale market vanishes, no one wants the cars, and the stock price collapses overnight.

Why did the stop price drop so precipitously? The problem with unobtainium existed all along. But no one knew about it. One morning everything was fine, Woodside Cars was worth $50 billion, the next morning, it was worth $25. The details aren't important, the important thing is: the world collectively decided that the company wasn't worth as much as they thought. The wisdom of the market took care of the rest.

Now we might pity poor Grandma Joe who had her life savings tied up in Woodside stock. But only stupid people invest their net worth in the shares of a single company, right? Not so fast. Many people had their money in Woodside. Woodside has been making cars for 70 years and has always been stable before. Even charities, and small companies, have their money in Woodside shares. In fact, millions of people had their money in Woodside. Fortunately, they still have half their money left.

And then the lawsuits start. People are mad that their cars are broke. They start a class action suit. And it looks like that suit could drag down Woodside's remaining business in regular cars, even though those regular cars run on gasoline and electricity. This is bad news for Woodside shareholders. They run the risk of Woodside's "toxic business" dragging down its regular business and making their shares worth a big fat zero.

So the government steps in. "Woodside is too big to fail" say prominent business leaders and politicians. "Just think of the economic damage that it could do." First they loan Woodside money to buy back the bad cars, and then the split Woodside into two companies – one to carry on with the good business, and the other one to deal with the broken cars and the lawsuits.

Of course, in reality very few people would put all of their money in a company like Woodside. Woodside was free to develop and trade in new kinds of cars, based on any kind of fuel they like. Banks, on the other hand, have restrictions. They are regulated and insured and subject to constant scrutiny. Banks aren't companies... they're banks.

They used to be.

Now they are companies.

In fact there's even a phrase for it: the "shadow banking system". It sounds scary, and it should because it's regular companies, with all of their exposure and foibles, pretending to be banks. These so-called "financial services companies" are just as innovative and subject to unexpected losses as any high-tech, manufacturing, or services company, just as they wormed their way into the heart of the world's monetary system.

Too big to fail? Yes, Dorothy, they are too big to fail. Like Woodside, if they fail, suddenly a lot of individuals and businesses – perfect good citizens who truly believed that they were investing their money wisely – are going to be broke. And through no fault of their own. The effects will spread. People who never touched a Woodside car will suffer.

Yes, the executives should be axed. Yes, the regulations should be changed. But the company is really a bank, whether it's Woodside Cars, or AIG, and needs to be treated as such. If it's allowed to fail, then the economic costs will be massive. Certainly the company made mistakes, and there's good reason to punish it for that. But. They didn't break the law. Unobtainium was legal when it was introduced. Maybe it shouldn't have been, but it was.

Of course the real situation is much worse. It's like unobtainium has been added to the fuel of every car that anyone makes or drives, except that no-one knows which cars are good and which cars are bad. Unobtainium has become so essential that there's no way to quickly remove it from the transportation system – it will take years. Car companies are struggling to figure out which of their suppliers have tainted parts. Even the government can't figure out which parts are good and which are bad.

That's more like the actual banking crises. Unobtainium is bad debt. Oh, there's a million ways to name it – CDOs, MBSs, CDSs, etc., etc., but it's all fundamentally bad debt. These shadow banks, running amok, have infected the entire system. When no one knows which accounts are good and which are bad, they won't borrow and they won't lend.

The knee-jerk reaction is to save the system by destroying it. Let them fail. That is short sighted. All of our so-called money is inside these companies. If they fall, we fall. Yes, we must fix the system, punish anyone who broke the law, and  change the rules so this won't happen again. But that's a very big job and won't happen overnight. In the meantime, unobtainium has infected the system so badly that it needs heroic measures to stave off total collapse.

Next time I'll talk about why the fundamental rules of executive compensation created this problem, and how I think they must be changed to make sure this "never happens again".

It seems like the truth is slowly emerging about all of the horrific things that went on during the boom times and are now emerging from the muck as the swamp is drained. Someone like Bernie Madoff can always cover his debts while the market is rising, but suddenly his ponzi scheme fails when it crashes. It seems that there is now a laundry list of semi-legal crap that is similarly being outed.

A lot of these terms might sound like stupid jargon but they are actually useful jargon, because they are the name for a specific thing, and that thing is fucking up your bank account and making you lose your job.

You should probably already know a few terms of useful "jargon". To start off with, "debt" is not just what you have on your house, it's something you can buy and sell. The value of the debt is based on someone (a ratings agency, a market)'s assessment of how likely to be fully paid over time, and how much the interest is. So the "best" debt (most expensive) would be say a government bond at 10%. Options (e.g. call and put), and Short Selling (which is much like a "put option"), these are both kinds of Derivatives. Briefly, options and short selling allow you to make a stock market trade where you benefit if the stock goes DOWN. Think about how evil that is for a moment, will you? Normally you only buy shares if you think they're going to go up. Derivatives is a broad category, including options, which allow you to trade things on the stock market which aren't actually company's shares. So, you can trade options, or you can trade debt, or the price of oil in 10 years, or whatever. "Downside risk" is the bad stuff that happens if the market does poorly, people default on loans, or whatever.

Secrecy

Underlying all of the below is that no-one knows what the fuck is going on. Most of these tricks don't require reporting to anyone, any market operator or regulator. You can mess with the stock market in so many ways without telling anyone. Maybe the insiders at the other big financial companies on Wall Street will figure it out or hear rumours. But the general public, and even CEOs of normal companies, rich people, readers of Wall Street Journal, normal people, poor people—know nothing until years later.

Naked Short Selling

You can short sell stock you don't own? Are you kidding me? Have a look at The Story of Deep Capture. Basically, I own a big financial company, say a hedge fund, and I want to kill your company. So I short your company and naked short sell it, which adds massive number of shares to the pool, driving down the prices of the existing shares. Then I transact my real shorts or put and make a killing while your stock suffers big time.

Credit Default Swap

OK, this one is a kind of insurance. I loan money to someone but I'm not sure if they'll pay me back. They might go bankrupt and default. So, I get "debt insurance" (like a CDS) and if the default happens, you the insurer pays me instead. Except that CDS isn't exactly like insurance, because (a) I don't actually have to be the lender and (b) you don't have to actually be a regulated insurer. In addition, there is no central place where CDSs are tracked, and you can resell them on and on, making it VERY confusing to know what they're really worth. Which is one of the reasons why banks won't borrow or lend right now, because they have no idea what their CDSs are worth. And of course, they are priced based on "normal" default rates, which go out the window when there's a crash. Why is that a big deal? Because EVERYONE has their money in them ... CDSs were recently valued at $55 TRILLION. Needless to say, Bear Stearns, Lehman and AIG were huge into credit default swaps.

Collateralized Debt Obligation

Wonderful stuff. Long ago, in a galaxy far away, the bank that loaned you money was personally responsible if you defaulted. But no longer. Now that bank can package up your loan and many others into a "CDO" and sell it to other people. Theoretically they will tell you which CDOs are good debt and which aren't so good. But, to be honest, they don't care. They sell someone else the debt, and then it's not their problem anymore if the borrower defaults. So, people get sloppy. And then, the various companies that are supposed to asses the risk in a CDO did/do a very bad job of modelling the downside risk. So when for example the housing market drops by 20% suddenly the CDOs are completely underwater and no one knows any more what they're worth. Maybe they're worth nothing. Who knows? And it doesn't help that some CDOs are actually made up of ... you guessed it ... other CDOs.

Synthetic CDO

Hey, let's kick it up a notch. The above are so boring. They're not, you know, complicated enough. So the financial geeks decided to make CDOs which contained, not actually debt, but Credit Default Swaps! Get it? Hilarious eh? Why would anyone want to do this, I don't know.

The Annual Bonus

I think this one is ultimately responsible for all the others. Financial company performance by the executives is measured on a YEARLY basis. That means, if you are CEO or whatever and you are making a decision, you think only at most ONE YEAR OUT in terms of what it will do for your company. You never think beyond a year, because you are getting paid in at most one year for your decisions, never beyond that. As long as you get your bonus before the shit hits the fan, you're laughing. I think that if these financial firms re-arrange their compensation system so that decisions have to bear fruit for a longer term—maybe 7 years—a lot of the shenanigans would never have happened. You could do that, for example, using employee stock options, locked-in shares, and I'm sure that the wizards can figure out other ways as well.

Well there you have it, my shit list for the financial market circa 200X. And if you want to read so much that your head will explode, try The Economists's Jan 22 Special Report on the Future of Finance. It's 25 pages (in the magazine) and the index is on the right side of your screen. See especially When markets turn. And don't be scared to learn a little more financial jargon. It might save us all next time.

Update 1: And let me add just one more thing. The banks don't know what their own assets are worth. In case you didn't get that above, a lot of banks own a lot of CDOs, CDSs, etc., etc. They don't know what they're worth. That's why there's a "credit crisis" ... they don't trust each other, because they don't even trust their OWN balance sheet. No one will borrow or lend. And that's just how bad it is.

Update 2: You might find useful this video on CDOs and this one on CDSs from Marketplace.

Image from worthbak.