Thursday, November 20, 2008


Ok, let's go back in time for a moment.

Well, let's stop. I was going to give you the common legend about bartering and then money being a fair arbitrary progressive step afterwards, but some historians (anthropologists and some linguists) think it apocryphal and think money existed before bartering in some societies. But I will tell it anyway because I think the order of bartering and then money did happen in some societies.

I've talked about the progression from agrarian societies in the context of African history. But the process usually goes like this. When we left the stone age to go to the iron age, the farming tools were so much better, stronger, more efficient, that there was more time. More time to prepare food, more time to hunt for food, more time to specialize. If you have more time to specialize you can make better tools, better dwellings, better anything. As people began to specialize, there was a need to use products of other people. Let's put it in our terms.

I am the shoe maker and you are the chicken farmer. You come to me because your new born baby (your first child) needs tiny shoes. I make them for 30 eggs. We trade. After 3 days (I have a large family) I need more eggs. I go to you, but you tell me you don't need any more shoes. WHAT! What do I do. So I go to roof maker and offer him some shoes. He only needs a pair for his wife. I ask him to repair your roof so I can get more eggs from you. He agrees and you get your eggs, but you see the problem with bartering. Different products are needed at different rates and for different lengths. Not only that but how do you rate services when they enter the picture later. Bartering became impractical. We need a fair tool to use to buy and sell to trade goods and service. Enter money.

The problem, today, is that macrofinance (a subset of economics) is ridiculously complex that most people don't understand it (including me). The wonderful thing about being a teacher is that you can test out macroeconomics on a small scale and see it work with students—inflation, supply and demand and price change, etc. This especially works for games in behavioral economics. But you have to tie people's concerns into real goals. You must tell the kids that if they live and survive the fake game, they will receive actual cash, double what they have at the end (get some funding for this). That makes it real and they really fight to stay alive, to keep their business open, to keep buying food at the end of the day. The store owners actually raise their prices at the end of the day when they realize more people want their food.

I wish we could try some of these exercises with 10 people to show how it works. I had a conversation the other day with a guy who believed there was no actual methodological basis for the beginning of inflation. He can see how it is perpetuated but he cannot see how it starts. This is what I mean. So let's get started and define some terms so we can begin to understand in a basic sense what happened.

Money - what is offered or received for the purchase or sale of goods and services

Liquidity - Market liquidity is a business or economics term that refers to the ability to quickly buy or sell a particular item without causing a significant movement in the price. The term is usually shortened to liquidity. (so if you don't want a refrigerator anymore, and you cannot quickly sell it and get rid of it, it's not very liquid if you get my meaning; liquid things are things you can change into cash really quickly)

Commercial Bank (this is a bit harder but you use them) – financial middle-man/institution (can be private or state) that takes credit from lenders (when you put money in the bank, economists say the bank is BORROWING money from YOU, the LENDER) in the form of cash deposits and that lends money in the form of loans. So a bank takes deposits from people and gives out loans to people. It makes it money by holding a portfolio of securities (portfolio just means all the things you've invested in, like a folder in school when I ask “what are all the subjects you've invested time studying”--you open your folder and show me). in other words, a bank makes money by investing the money you give it. When you loan the bank money (when you deposit money in the bank) through a savings account the bank give you a low interest rate, but takes your money and invests it to make money for itself at a higher interest rate. Some of the money it must pay back to you (it's borrowing the money so you get interest). But since it earned a higher rate, in the end it has made money.

Securities – (economists call them instruments) financial instruments like stocks, bonds, mortgages, notes, etc. Let me explain “instrument”. An instrument allows the holder to claim ownership in a corporation (a stock does this), or allows a creditor (someone who gives credit—this means lends money) relationship to a company/government/agency (a bond does this; if you buy a bond you are lending money to the government; the bond is an instrument that says you have a lending relationship with the government and the government will pay you back plus some interest) So all of these types of securities are things that commercial banks invest in to make money using your money. Bonds give fixed returns, shares (stocks) give variable return.

Stocks – (shares or equity) ownership in the company (if you own a share or a stock, you own a percentage of the company)

Bonds – A fixed interest IOU from the government or an agency. For lending the gov/agency money (buying the bond) they promise to pay you back plus the fixed interest (that won't change)

Investment Bank – (primary difference between a commercial bank and an investment bank is that a commercial bank makes money by issuing loans from its pool of deposits [and invests money, too] while an investment bank brings both debt and equity to the market for a fee) a bank that issues securities, run markets for previously issued securities (so run markets for buying and selling of securities), maintains broker/dealer operations (brokers sell and buy securities for a client, dealers due it for a company using company money), advises investors, and handles corporate mergers (two companies joining) and acquisitions (one company taking over another or buying another), corporate restructuring, and private equity placements (selling of new equity/shares). Whew! Investment banks do not work with individuals. That's why you don't see them.

economic vehicle – a fund or joint venture (two individuals or companies join together to share risk and profits—think of any partnership) that generates a lot of cash flow

Collaterized Debt Obligations (CDO's) – it's an investment security that is backed by (the money is invested in) a pool of bonds, loans, and other assets. They are unregulated, and usually a hodge-podge of debt and credit but are usually non-mortgage loans or bonds

Debt and credit are the same thing. In a transaction, one person sees the flow of money as credit, the other sees it as debt.
Banks operate on the premise that not everyone will request their money from me at the same time. If that were possible, then banks couldn't take your money and invest it; they would have to keep it because everyone could ask for their money all at once and leave it with $0. So the higher percentage of its assets a bank plays with, the more risky we label its actions. If a bank invests 50% of its money (assuming that on any given day only 15% of the money will be asked for) then we say it is acting less risky than a bank that invests 65% of its money (also assuming that only 15% of the money will be asked for). If a situation ever arose where everyone wanted its money back, a bank would fail.
the way things work in economics, the higher the risk, the higher the yield (the return, the money you make). It's not just economic law, it works in all areas of life. If you want to run a marathon in 2.5 hours (high yield or return) you have to put a LOT of work to get there (high investment). The same thing works in money. Usually crazy risky ventures and ideas cost a lot of money to get going and working, but they will also produce a lot of money. On the other side, the government is usually good for it's money (remember the government, say of the U.S., does not have to balance its budget like most U.S. State constitutions require) so you can buy a cheap bond and get a LOW return (the government pays you back only a little extra for borrowing your money [giving you a bond]). IF something were very risky but low-yielding, it would not make sense to invest because you could always find low-risk low-yield securities instead.
Oh one more thing, the Federal Reserve bank is the top bank in the US, the central bank for the country. they also do not interact with people, but they lend money to banks. They also set their own interest rates and this is usually what you hear in the news. But they are not setting the interest rate that your commercial bank charges you. They are setting the interest rate they charge to lend money. But it's a chain reaction. If a bank borrows money from the Fed at 1.7%, they will charge you a higher percentage to borrow money from itself. That's why the Fed's rate matters. It trickles down to you. Just like the Retailer (your shopping store) adds more money to the computer or chair or shirt they buy from the manufacturer so they make money, so the bank charges you a higher interest rate to make some money.

Ok, let's get started with part one. It all started eight years ago. I hate saying that because it sounds like I'm blaming the Bush regime, but all I've read says that. During the 90's during Clinton's administration we had a huge boom and by 2000 we were sitting in quite an amazing position as the lone superpower, admired by most and loved by many.

The global economy had been growing at this point, but returns were low. This was because the interest rate was low. (This is where greed sets it) The bottom line in this system is to maximize profits. And if there is a way, people will find it. So to get higher returns, investment banks came up with investment packages. Some of the packages were vehicles like CDO's. The point of the package is to spread risk around. Remember CDO's are a mix of credit/debt securities. So if there is bad debt out there and say biotech bonds go bust, you are not hurt as bad because you have a nice mix. Person A gets hurt a little, Person B gets hurt a little, Person C gets hurt a little. You get it?

But the debt packages hurt us in the end. Instead of protecting banks, they spread bad debt everywhere to everyone. These packages had been combined and bundled up and sold and re-sold (so now Joe Shoemakers loan is in several different places across the country) it was difficult to rate how much bad debt was carried. It's like eating a a dessert and asking where it came from. Well, it was Tres Leches so it uses three type of milk; one was imported from Canada, another from China, and another from the U.S. But the U.S. milk came from a goat that was brought to the US from Pakistan to breed with a US species, and that goat is actually not indigenous to Pakistan. . . not to mention all the other ingredients. So it's difficult to tell how much of the dessert came from US products (I didn't get to the eggs, sugar, vanilla extract, etc.). That was the problem. Moody's and Standard & Poor's usually help traders by rating bad debt.

So in this new era, the system was not ready. The sub-prime mortgage crisis hit. Many homeowners in the U.S. defaulted on mortgages. They did not have the money to pay it back after mortgage companies went through a period of excessive predatory lending with (this is key) LOW interest rates (this is why companies normally give high interest rates to people with less money [still doesn't make sense in my head]). Now the sub-prime crisis showed how much bad debt people really had. It was EVERYWHERE! Banks started writing off billions of bad debt (write off means you call it a loss; you realize you are not getting that money back; write it as a loss and go on). Share prices started falling. Banks values dropped.

Are we ok so far? We're almost there.

The last thing to know is that all of this crisis came about because people overhyped, oversold, overbought, overtraded nothing—like thin air. It's the way investment banks work. How much you do it is what makes some people call you reckless. Investment banks (the biggest ones) depend on trading vastly more money than they actually have in assets. To do this trading, they get short-term loans that are (key) EASILY extended to them. Faith can move mountains, and in this case it makes a way for investment banks to always get the money they need and ensure that they can make up losses with future trading (so if I didn't make money today, it's ok; I'll just borrow some money and trade some more tomorrow with money that's not mine, and it will be fine and I'll make up the money I lost). Can you begin to see the problem?

So word spreads or fears spread that bad debt is spread further and deeper than people realize. What happens? (Earlier we spoke of banks not wanting to lend poorer people money; if they do they give high interest rates because they see it as a risk, but below a certain point they do not) Banks were more hesitant and cautious in lending money to other banks. If you are an investment bank and you can't borrow money to make money even though you are buying and trading with borrowed money (not real money) you're in trouble. This was a type of death sentence for banks like Bear Stearns and Lehman Brothers. So doubts began to grow about the solvency of banks. This caused share prices to plummet (even if doubts or beliefs are not true; it (even if artificially) changes price because price is ONLY based on what you believe; If I have a prize winning cow but everyone thinks she has cow's disease I cannot sell her for lots of money because of this FALSE belief. I must lower my price. If people think your bank has a lot bought a lot of debt that will not recover and now that same bank is not able to get money to borrow to trade, then you might want to pull your money out. And you might want to do it NOW! If you wait until it fails, you have lost your money). When share prices fell, normally banks could build up its assets through daily trading, but no one wants to loan money to a bank that is about to die (whether true or not). So watch this. If people think a bank is going to fail, the withdraw money. If you withdraw money you cause it to fail. Do you see how it works? So the rumors grew until they became a reality.

(UCT Globalist listing)
Bear Stearns—one of world's biggest independent investment banks. Collapsed in March, acquired by JP Morgan Chase in May 2008
Lehman Brothers filed for bankruptcy in September 2008; 1 of 5 largest independent investment banks

Fannie Mae (Federal National Mortgage Association) – created in 1938 to provide easier housing loans in the post-Depression years. Publicly traded company, it's backed by loans in secondary (ask later) mortgage industry, Government took over (and took over Freddi Mac) this year

Freddie Mac (Federal Home Loan Mortgage Corporation) – created in 1970's as a competitor for Fannie Mae in 2ndary mortgage industry

American International Group (AGI) – one of world's largest insurance firms, bailed out by Federal Bank of New York in September 2008 after suffering liquidity crisis

Bank of America(BoA) – U.S.'s largest commercial bank after acquiring Merrill Lynch (largest financial services firm in the world)

Merrill Lynch – large independent investment bank that was sold to BoA in September 2008

JP Morgan Chase – one of oldest traditional bank holdings companies in the world. Purchased Bear Stearns in May 2008

Goldman Sachs & Morgan Stanley – the 2 largest investment banks in world; due to recent market developments, changed their status to bank holding companies in order to be eligible for emergency government funding

I probably did assume some things so if you have questions feel free to ask or to ask me to put it in the next one. I think we'll look at a few specific examples next time.

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