Saturday, October 4, 2008

Let Me See if I Understand This

Ok, so I'm trying my best to follow the panic of 2008 and the bailout/rescue plan. My understanding is that people got caught up in a price spiral that was actually speculative in nature.

So instead of houses, let's pretend that they were buying Beanie Babies. When my daughter was in late elementary school Beanie Babies were all the craze. At first people bought the cute little stuffed toys for their kids to play with. The manufacturer, sensing a fad, starting releasing "limited editions" and otherwise manipulating the availability of particular versions. So a toy that started out costing $5.99 or so was being re-sold for much more than that. People bought special plastic covers for the heart-shaped tags in order to keep the tag neat because that would add to the value of the toy as a collectible. Many people kept their special ones in custom-designed clear plastic cases and never let little grubby hands near them. The belief was that a $5.99 toy bought today would probably be worth $100 in the near future. A few people actually paid $100 for a single toy.

So suppose I got caught up in that mania. I notice that $5.99 toys can be sold for $12 in a few weeks time. Geez, that's a fast profit. So I buy 1000 of the things. Invest $6000, expecting to sell them later and get $12,000 back. Easy money! A lot of other people are also buying them at the same time, which is one of the things that is already making the price rise.

After a few months, I try to sell my Beanie Babies. But the fad has passed and the market has cooled. It turns out that there are not too many people who really want $100 toys after all. Now I'm stuck with items that aren't worth as much as I expected. In fact, I start seeing them at yard sales for $1.

Well, lesson learned. Now I have a garage full of mistakes.

Except that, unfortunately for me, I didn't actually take that original $6000 investment out of my savings account. I actually borrowed it. Paid for it with my credit card, in fact. And I still owe--well, thanks to the miracle of compounding, I actually owe more than $6,000. I owe $7000. So I have a $7000 debt and a pile of collateral that's worth less, maybe a lot less, than $7000. How much is it worth? Well, in order to answer that question accurately, I have to find a buyer or buyers for 1,000 Beanie Babies. Maybe there aren't any buyers at all. Maybe if I hold a yard sale or put them on ebay, the selling price will be only 5 cents, because the intrinsic value of them is basically nothing at all. No one needs a Beanie Baby.

If this were a story about houses and mortgages, that last sentence wouldn't be true. Housing is a need and houses do have at least some intrinsic value, or at least the land does. How much land is worth depends, of course, on where it's located and what else is around it. There may be lots of land between 2 meth houses in some depraved suburb or inner city that have essentially no worth under present conditions. The taxes on it would be more than its useful value. But for the most part houses are worth something.

What is scarier than houses is paper. Specifically, Credit-Default Swaps, which if I understand the story correctly, were bought and sold like Beanie Babies, except they can't even be played with by bored children. They are promises, backed by nothing at all, that were sold for millions of dollars.

And sometimes they were "leveraged," ie bought with debt.

I think that's what's really gone wrong. Not housing, which people value for a reason, but financial instruments that were of less real value than a Beanie Baby.

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