Tuesday, September 30, 2008

Robert Feinman explains the financial crisis

The Crisis Explained - Really:
"Analogies are never perfect, but here's one using horse racing. Don't expect a perfect correspondence to the banking situation, but I think it is close enough for government work.
Joe goes to the track and bets $2 on a horse.

Two guys standing nearby get into a discussion and Fred says to Sam, "I'll bet you $5 that Joe wins his bet."
Next to them are Bill and Bob. Bill says: "I'll bet you $10 that Fred welshes on his bet if he loses."

Next to them is Sally. Sally says: "For $3 I'll guarantee to Bill that if Bob fails to pay off, I'll make good on the bet."

Sally then goes to Mary and borrows the $7 needed in case she has to ever pay off and promises to pay back $8. She doesn't expect to every have to pay since she believes Bob will always make good. So she expects to net $2 no matter what happens to Joe.

A quick calculation indicates that there is now 2+5+10+3+7 = $27 riding on the outcome of the horse race.

Question how much has been "invested" in the horse race?

Answer:

$50,000 by the owner of the horse who is expecting to recoup his investment from the winnings of the horse and other future deals. Everyone else is gambling, not investing.

The issue with the home market is that the only "investor" was the person who bought the home. All those engaged in the meaningless derivatives spun off from this are gambling. You can see how quickly the face value of all these side bets can exceed the underlying investment. Who is holding these side bets - not the homeowner? It is the people at the failing investment banks, hedge funds and similar enterprises. Notice that the bailout is being directed at them not the homeowners.

The real world is, of course, even more complicated. Over the last 30 years people have been allowed to place bets on everything starting with the value of stock averages. They might as well bet on the temperature in Newark at 8:00 AM.

So when you hear everybody saying this is a crisis caused by the housing collapse, be skeptical. We are in the midst of a classic pyramid or Ponzi scheme and there is no way out except for people to lose a lot of money. All that is different this time is that it is the taxpayers who are being asked for the cash."

And Dean Baker on the bailout Why Bail? The Banks Have a Gun Pointed at Their Head and Are Threatening to Pull the Trigger:
"In other words, the worst case scenario is that we have an extremely scary day in which the markets freeze for a few hours. Then the Fed steps in and takes over the major banks. The system of payments continues to operate exactly as before, but the bank executives are out of their jobs and the bank shareholders have likely lost most of their money. In other words, the banks have a gun pointed to their heads and are threatening to pull the trigger unless we hand them $700 billion."

What do I know? We paid off the house mortgage and in about ten years, the price went up five times. People around said that I was wasting my resource; I should borrow money on the house and invest. They also said if I do not have at least fifty thousand dollars an year, retirement will be hard. I did not invest since I did not want to get in to some thing which I did not understand and I am getting much less than fifty thousand a year but it seems more than enough to survive comfortably and even send some money for charities. Now the retirement funds are hit and I will probably get less. May be I will grow more vegetables, keep plenty of cash and provisions to ride out a few months of crisis.

1 comment:

Tabula Rasa said...

great post, thanks!