Global Crisis- Part 1/4
(This is the result of my own attempt to understand the developments in the global financial system, and then I thought I would also share what I learned. If you find mistakes, please forgive, part of it is ignorance and part of it is bacause I tried to simplify the explanation.)
To over-simplify things, er, life is very simple! You use money(assets) to make more money(assets). For example, if you have some money, you can buy some machines, produce something, sell it and make more money. Then some smart people figured out that if you dont have money, you can borrow from your friend. You can tell the friend that I will earn money in the future, so I can repay you. Then use that to buy machines, produce something, sell it, make profit, use part of that to repay your friend, and keep the rest. This is called “business” and borrowing money like this is “credit”.
Some smarter people figured out that if you have money, you can just lend it out to someone who does work, then go to sleep, wake up in the evening and collect interest. This is called ‘banking’.
Another example. I just got a new job, so I dont earn enough to buy that cool mobile phone. But the problem with growing up in the city is that when I want something, I cant wait and I want it now. So I tell my bank, l will earn money in the future, so give me some credit. I buy my mobile phone using my “future money”.
We have so far learned four lessons-
Lesson 1) If you have money (or assets), you can make more money (or assets). This is “business”. Note that you can buy assets if you have money and you can get money if you sell assets. So, asset is the same as money, well almost. In fact they are the same only if everybody else believe they are the same.
Lesson 2) If you dont have money now, you can borrow money to make more money. This is credit and that is what banks sell.
Lesson 3) To get credit, you need some asset. “Future money” is also an asset.
Lesson 4) In the city these days, all people and all businesses depend on credit. (Of course, if I want to be more racist and less accurate, I could use certain place names instead of “city”.)
We need to learn a few more lessons before the story can begin.
Lesson 5) The bankers are lazy and would like to sleep all day without doing any work.
But bankers are more greedy than they are lazy. So they lose all their sleep trying to figure out who got “future money” so that they will get back all the money they lend. But this was too much work. So they asked some of the dumber bankers to do that while the smarter ones slept, or vacationed in Hawaii. Thus “credit rating” was born. Now, these people may be dumb, but they are also bankers and dont forget Lesson 5.
Lesson 6) “Credit rating” is telling the banks whether the borrower is likely to repay.
You might already have started thinking, “Hey, that’s not fair. Why should bankers have all the fun?” This is exactly what the businessmen thought. “I own this company with so many machines (assets). Can I convert them to money now?” So they wrote down on a piece of paper, “I am selling you all the machines I have”, put their signatures underneath, took thousand copies of it, kept 500 of those with him, and sold the remaining to 500 others. These papers are called “securities” and the process of converting assets into pieces for sale is called “securitisation”. In the case of a company, we call these pieces as “shares”. Just about anyone can buy and sell these securities.
Lesson 7) If you have an asset and you want to sell, say, half of it, you can cut it into small pieces by “securitisation”.
If you thought that was neat, where do you think they got the idea from? Of course, from the bankers. In fact these are the smartest (and wickedest) of the lot and are called “Investment Bankers”. They are a very small group of people who are over-paid for not doing any real work.
Lesson 8.) “Investment Bankers” help businessmen cut their assets to pieces and sell parts of it to others. Investment Bankers charge a 2% fees for that!
Now the stage is set, and the story can begin
(To be continued…)
The clearest explanation of business and money that I have come across.Will comment in more detail as the story develops.
C.Padmakumar
October 20, 2008 at 6:38 am
A nice beginning
N BHASKARAN
October 20, 2008 at 10:11 am
A very good introduction to a glossary of terms which most people assume they understand, but really don’t! A good way to begin telling the story. I look forward to following the story as it unfolds.
Balagopal
October 21, 2008 at 10:51 am
Anand, good work. You’ve explained the stuff quite well I think. But you forgot who caused all this. No, its not the bankers.
Some thoughts:
Money is not the same as assets. I tend not to agree with “money (or assets)” usages throughout. Though we use them interchangeably in our conversation they are very very different. A stock is an asset. A gold bar isn’t – its money. An asset has counter party risk, money doesn’t. Lehman Brothers had plenty of assets. So has AIG. What they didn’t have was liquidity (money).
“Lesson 5) The bankers are lazy and would like to sleep all day without doing any work ” , this is a common feeling among everyone now.
I think banking is an essential element in any economy. So a person who works and saves 1$ puts that money in the bank. The banker keeps the money and gives him an interest. Then he turns around and lends 10$ to entrepreneurs at a higher interest. Seems like an easy and greedy job. But a banker is a person who really sticks his neck out. He’s taking the risk of his loans not being paid back. He could go out of business based on a rumor (if all the people who has deposited money in SBI comes asking for their money back now, SBI goes out of business now)
The problem comes when the leverage goes up. ie. instead of lending 10$ for very 1$ deposit that a banker has with him, if he starts lending 30$ or 100$ he’s taking a huge risk. Add to that, that the money wasn’t lent to entrepreneurs but to consumers who blew it up on “stuff”.
Then why do bankers do that? Well, there are two human emotions that make capitalism work – fear and greed. You want to make money but then you also don’t want to lose what you already have. So there is a balance. People take risks they can afford, else they go broke. Now, what happened now is that the fear factor in this was taken out – by the GOVERNMENT. When you bailout a insurance firm, or a bank or an auto maker, then you are telling them and others “go ahead and take all the risk you can. don’t worry about failing. if you take too much risk that you will bring down others also with you if you fail, we will see to it that you won’t fail”. Refer to LTCM
This created greedy bankers. Don’t blame investment bankers for this. Blame the government who took fear out of the equation. If there is no fear that we’ll lose money, you and I will make the same bets. It’s human nature. And the most beautiful part of the story is that not many people see through this. So the government can place the blame squarely on the “greedy bankers” and everyone will swallow it.
This is just another example of governments screwing up and sticking the bill on the common public. It’s not the first time and definitely not the last. This is what politicians do. And most people don’t care enough or are too stupid to realize this. They think the government stands for them. Poor souls !
Xavier
November 1, 2008 at 12:34 pm
Anand,
Very nice
and
Good attempt.
All the Best.
Nice and Regards.
Sam Chandran
November 5, 2008 at 8:50 pm
Excellent.This information is explained in such a manner that any layman can understand.Anand you have done great.
Dr Hari Menon
November 14, 2008 at 4:38 pm