The Economic Crisis Explained - Really

by: robertdfeinman

Sat Sep 27, 2008 at 18:46

(A helpful little model and stimulus for discussion. - promoted by Paul Rosenberg)

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.

robertdfeinman :: The Economic Crisis Explained - Really
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?


$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.

(Notice that the track owner gets his cut of the original $2 no matter what else happens.)

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.

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Why would a horse be worth $50,000? (0.00 / 0)
Except that people bet on the horse, and bet on the result of the bet, etc.

The $50,000 disappears if the gamblers go away, and the "investor" probably doesn't even like horses, and wouldn't own one but for the gambling.  The distinction between "investors" and "gamblers" is entirely false, in the example and in the real world.  Just because the system is complex, doesn't make it a ponzi scheme.

Like Richard Said (4.00 / 2)
Analogies aren't perfect.

The difference between the analogy and the reality is folks actually live in their houses--they have to live somewhere, don't forget--and while there's been considerable housing price inflation, and now deflation, most folks simply kept living where they were living throughout it all.  

In contrast, we don't really know how many people would raise racehorses without the bettors, but we do know they'd cost dramatically less.  Still, even if it were only $5,000 or $500, Robert's basic point would remain, even if the price were dramatically lower.

You are correct in one thing:

Just because the system is complex, doesn't make it a ponzi scheme.

It's not the complexity that makes it similar to a ponzi scheme.  It's the reliance on a greater fool coming along to cover your bets.  And just because it's not formally identical to a ponzi scheme doesn't mean it's not similarly vulnerable to catastrophic collapse.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3

[ Parent ]
but wouldn't the people who lent the horseracer (0.00 / 0)
or homeowner be investors?  They expected 6% a year (or whatever.)

New Jersey politics at Blue Jersey.

[ Parent ]
Let Me Be Clear (0.00 / 0)
I'm not one of those who thinks all finance is the same.  The problem is not finance capital per se, it's the switch-over between finance facilitating investment and trade and finance spinning off into it's own little world.  I know that there's no hard-and-fast line between the two, but you can damn sure tell when you've gone way over the line, and that took place a long, long time ago.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3

[ Parent ]
The problem: (0.00 / 0)
as long as the system is free of fraud and misinformation, it doesn't matter how complex the system is, how many bets are placed, etc., or who owns the asset and who owns the paper.  Economists will tell us that the system will be rock solid, because markets process information efficiently.

The more players and layers of investment, the more money in the system available to make renters into homeowners.  This is a good thing.

The problem arises when links in the chain are infected by fraud.  Regulation could have addressed the new financing schemes, both at the mortgage broker level and the securities level.

[ Parent ]
A horse is worth big money not only because of horse racing and gambling (0.00 / 0)
but also because of breeding and progeny. Horse racing gambling has been going on forever, ever since there were animals to be raced against each other. But organized gambling is a very different thing and has driven the horse prices up, caused them to stop racing them when they win big races in order to breed them and make huge profits that way for years and years. More than they get for racing them. The race is just to prove their worth against the field for future breeding. No breeder wants to race them even one more time after they have won a big one in case something bad would happen to them.

[ Parent ]
i think the attempted difference is (0.00 / 0)
between productive capital and finance capital.

[ Parent ]
The investment is the key... (4.00 / 1)
whether it is a horse, a house, a stock, or an acorn doesn't matter.  The fact is, people invest their assets in order to gain value.  Ponzi scheme?  Gambling?  Who cares?  The bottom line is ALL of us invest our money so that we appreciate value, even if it is invested in a simple CD.

The bailout is NOT as simple as many of you are asserting.  In fact, I doubt ANY of you have ALL the facts about his bailout.  In truth, you seem to be insisting that we citizens ignore any advice or information from any source EXCEPT you.  Such nonsense.  

Yes, I have been banned... and I will continue to post despite your attempts to ban me.  My earlier handle was cabresch, and I was banned for disagreeing with Matt and Chris.  My disagreement was given respectfully, but my banning was done anonymously...  Interesting how that works.

I am now posting as cjabresch.  If I am banned on this handle I will post on another handle, and I will continue to find ways to point out the hypocrisy of the moderators of this forum.  (Just for the record: for those who have read my posts, they know I am both a supporter of progressive ideals--though I am no zealot!--and I actively support the democratic ticket).  I continue to insist that my original account, cabresch, be opened so I can continue to post.  Progressive, indeed--your actions to stunt discourse are regressive!

[ Parent ]
I don't trust those delivering the message of necessity (4.00 / 1)
Institutional Washington is not on our side.  A few of the folks here who are inclined to be on our side -- folks like Pete Stark and Marcy Kaptur and Dennis Kucinich and Donna Edwards -- are skeptical about the definition of the problem/crisis and the solution being offered.

The Bush Admin, GOP leaders on the Hill, Pelosi, Reid, Frank Hoyer...all of them -- they will not let anything upset the established order of things in DC.  No matter how many people suffer or die out here or in Iraq or wherever, they will not allow anything to threaten the institutional power that they defend.  They didn't want to impeach Reagan, Weinberger, et al over Iran-Contra; they didn't want to stop funding the Iraq War; they didn't want to impeach Bush; they failed on the MCA and FISA and bankruptcy reform; they don't want to go to the mat over $700,000,000,000 being sent to Wall Street.

Now, I'm no economist.  Maybe they're right that it's necessary, and in my interests.  But I'm quite certain that it's being in my interests, if it is, is purely coincidence.  They have no concern for my interests.  They're worried about Wall Street.  So I find their protestations totally unconvincing.

In short, I don't trust them and they don't lead me.  And from the polls showing vast disapproval on Congress and anger about this plan, they don't lead much of anyone else outside the Forbidden City, either.

[ Parent ]
No disagreement there... (0.00 / 0)
I don't trust them either.  But neither do I trust the the simple idea of resisting anything they may offer to the political discourse of ANY issue.  To think that resistance is a solution is FAR too simple an idea for me.  I simply do not accept the idea; nor do I agree with anyone who suggest that doing nothing will produce something meaningful.  That is pure nonsense, just as it is nonsense to think that politicians have OUR best interest at heart.

My beef is not that there is something wrong with resisting the notion of spending my children's future on Wall Street.  My beef is with folks here who HAVE NOTHING TO OFFER except resisting doing something to address the problem.  It is almost as if folks here think there isn't a problem.  HELL, all I have to do is look at my retirement portfolio and measure the results over the past 8 years.  HELL YES there is a problem!

I don't give a hoot about Wall Street brokers, CEOs or broker firms or anyone else who have been bilking the regular guy/gal over these past 8-20 years.  In fact, I don't give a f**k about them.  What I do care about is what I have worked for, and what my children and grandchildren are going to inherit.

You want to NOT invest?  Then give me a REAL reason.  NOT some made up crap that has no depth.  [Mind you, I'm speaking rhetorically--not to you, but to the gist of the argument that has been put forth by the bloggers on THIS site--a site that I have been frequenting for quite some time, because I do find some affinity, yet still find ground that must be argued!---even when the bloggers here BAN me!]

[ Parent ]
That really strikes me as a strawman (0.00 / 0)
Sirota has a front-page post up right now detailing alternatives, and lots of left-leaning economists have been proposing all kinds of alternative set-ups all week.  Hell, Bernie Sanders put his proposal up last weekend, or maybe on Monday.  There have been tons and tons of suggestions about how else to spend $700,000,000,000 from the public kitty to help people survive whatever it is exactly that this economy has to throw at us.

So if your beef is with folks who have NOTHING TO OFFER, then I think your beef is largely with people who don't post here, particularly frontpagers (I can't speak for every commenter, b/c I haven't read every comment).  And frankly, if your replies to people making constructive criticisms and alternative suggestions is to ALL CAP your strawman argument, then, while I disagree with admin bannings in nearly every case, it would make perfect sense to me if you got troll-rated into oblivion.

[ Parent ]
You need to make a real argument (0.00 / 0)
All you have done is to parrot what has been said.  I do not propose banning you, why would you propose banning opposing viewpoints, such as mine?  

As far as the 'strawman' argument better look up what that means.  It simply does not apply here.

[ Parent ]
I am making an argument (0.00 / 0)
I'm arguing that (a) you're fantasizing the existence of people who HAVE NOTHING TO OFFER and loudly denouncing these non-existent people, rather than actually reading the alternative proposals described on this site and others and critiquing them; and that (b) such behavior is detrimental to productive conversation and certainly worthy of troll-rating on a comment-by-comment basis.

And back on the topic -- I'm arguing, as I assume you're intelligent enough to tell, that the vast majority of office-holders in DC are utterly untrustworthy, that the few office-holders who have seemed somewhat sympathetic over the years oppose the compromise, and that many independent economists oppose the plan, as well.  And that each of those groups in opposition has proposed alternative approaches that should form the basis of the Democratic majority's response to the trouble/crisis on Wall Street.

[ Parent ]
Close enough for government work. (0.00 / 0)
I say that all the time to my staff.  

Close enough for corporate work! (4.00 / 1)
Their bureaucracies are very often worse than government ones. Especially compared to social security which is one of the most efficient large bureaucracies around.  

Jeff Wegerson

I can understand these derivatives as I sort of started to play with those ideas myself (0.00 / 0)
And that's how they started. You have a bunch of mortgages backed by real estate and some are more solid than others. So you play with the idea of merging them in one pot and diversifying the risk. All it takes is some statistical sophistication and some mortgages to ferment the idea. What if........... and away we go.

The boomers who did this in many cases were schooled in the new math and had a far different grasp of math than other adults before them. Their unbounded creativity found an outlet here in these financial instruments. Can't you just see someone in line at the track who has read this email doing the same thing the email suggests in fun.

I think it started out as creative work/play and then was copied because greed took over. Like making interesting recipes and getting addicted to really good food and then getting fat. It was a damned good idea to spread the risk. Sort of like using puts and calls for your underlying stock that you own as insurance. Then the gambling starts with puts and calls by people who have no underlying stock. They are just gambling and the odds are much better than Vegas.

Not perfect (0.00 / 0)
But close.  I think the initial bank loan to buy a house qualifies as an investment on the part of the bank.  But it does start spiraling into gambling pretty quickly.  In particular, you can "short", which is pure gambling and I have no idea why it is even legal.  Betting for success while your bet is actually used to pay for that success and improves the odds of success is all good stuff.  Everything else is crap.

Bad, bad example (0.00 / 0)
The buyers of the CDOs and MBS securities were basically the ones that ultimately lent to the people taking the mortgages.

There was no Ponzi scheme here. Are you sure you understand what a Ponzi scheme is?

The CORE problem behind all of this is the bursting of the real estate bubble. It's not clear how we could have stopped that and nothing I have seen proposed, including greater regulation, is a surefire way to stop a bubble forming.

Couldn't the Fed have stopped the housing bubble (0.00 / 0)
by not dropping interests rates to 0% (compared to inflation)?

[ Parent ]
Not sure (0.00 / 0)
The Fed controls short-term interest rates, not long term ones. The Fed really has no direct control over mortgage rates.

They could have imposed some type of lending limits to make it more difficult to buy a house. But it's not that easy to detect a bubble until after it bursts, unfortunately.

[ Parent ]
Bubble (4.00 / 1)
The bubble was quite obvious to everyone.  There were only a few who believed the rising prices were permanent.  But lenders could cash in anyway while money was to be made.  Here's a chart I've seen versions of many times and just googled up:

The bubble's kind of obvious, eh?  The chart is from April, 2007.

[ Parent ]
It's obvious now (0.00 / 0)
But there were all kinds of rationalizations at the time. Do you think the people at Lehman purposefully decided to destroy their bank and lose their life savings (most employees got bonuses in stock)? Of course not.

[ Parent ]
Individuals (0.00 / 0)
Individuals don't care if the company goes under.  They care they get their own bonuses.  Name one person at Lehman who did worse individually because of this mess.  I don't think the person exists.

You are correct about the rationalizations, of course.  There certainly was a lot of self deception.  But the system is set up so self deception was beneficial.  All the major players make money by the short term transaction, not the long term.  

[ Parent ]
Are you asking (0.00 / 0)
if Lehman employees lost money as a consequence of all of this?

If so the answer is an unequivocal YES!

Most employees had large holdings of the company stock which turned out to be worthless.

Let me give you another example. On April or May 2007, when  the first indicators of the crisis began but it had not yet exploded, CDS spreads rose and several bond insurers claimed it was a good thing because now they could charge more for their product. Of course, a few months later most of the bond insurers would be out of business and most of their employees laid off and their stock holdings worth almost nothing. Do you think they did that on purpose? Not at all. Even they, who had the most to lose, did not see the magnitude of what was happening.

[ Parent ]
"It's not easy to detect a bubble until after it bursts" (4.00 / 1)
People knew this was a housing bubble.  Maybe not the moment it started, but years ago it was clear that housing prices were skyrocketing for no legitimate reason (e.g., mass housing shortage, spiking population).

You don't have a t.v. show called "Flip My House!!" if there's no housing bubble.

[ Parent ]
By the time it was clear to all it was a bubble (0.00 / 0)
it was too late. That's the problem.

Remember, we had a huge internet bubble. You'd think people would learn. Yet only a few years later we had a huge real estate bubble.

[ Parent ]
I'm not an economist (0.00 / 0)
or an expert on finance.  But I own a house, and I distinctly remember realizing literally for 2 or 3 years that housing prices were ridiculously inflated.  Now, some of that inflation in high-end markets like the Bay Area and NYC was due to accelerated income concentrations among the wealthy, but I can't believe experts genuinely thought that housing was suddenly worth so much more year after year when most people's actual take-home earnings was stagnant at best.

People knew it was a bubble -- they just figured they would get the good end of it and leave some other sucker holding the bag.  If you think your smarter than everybody else, you think you'll get away with it.

[ Parent ]
Housing bubble (4.00 / 1)
But the housing bubble itself was cause by many of these Ponzi schemes.  They let people borrow money to buy houses they had no business buying.  They encouraged people to buy well beyond their means.  Because prices were going up, it was ok if they defaulted.  Hell, banks wanted defaults at first, because they then got to sell the house at a higher price.  This, in turn, raised the prices of real estate even further.

So Wall Street investing schemes directly effected the housing market.  The bubble was generated because cheep financing (often in the form of arms the lender didn't really understand) pushed prices higher.

The problem is the bubble itself is very real.  Comparing home values with rentals and one can see just how artificially high the cost of homes became.  There is very little anyone can do about that.  The trick is to minimize the damage to the economy given that reality.

[ Parent ]
That's not a Ponzi scheme (0.00 / 0)
That's simply bad analysis. Lots of people were convinced that housing prices could only go up or, at worst, just stall.

Don't forget that even in the subprime market most loans today are being paid back (I think defaults are around 25%). So that's millions and millions of people that own a home today they wouldn't if we had imposed stricter lending controls.

My point is that this is a complicated story based on one huge mistake (not realizing this was a bubble) so talk of schemes and betting completely misses the point.

[ Parent ]
Ponzi (4.00 / 1)
Duh, everyone knows Ponzi is the genetic hybrid of Potsie and Fonzi.  Happy Days for all!

But seriously, Ponzi is close enough for a reasonably accurate description.  From the wiki:

A Ponzi scheme is a fraudulent investment operation that involves promising or paying abnormally high returns ("profits") to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business.

Since rising home prices only rise because some future buyer is expected to pay more for the same home, yea, close enough.  You can afford to pay a little more because some day it will be worth even more than that.  Don't worry about the variable Arm, interest rates will be low forever.  If not, you can just sell the home for a profit!

[ Parent ]
It's Not A Ponzi Scheme, BUT (0.00 / 0)
it's similar in that it depended on an impossible endless chain of new "investors".

A classic ponzi scheme simply takes the money from new investors and gives it to old investors under the guise of "returns" to show what a sound investment it is, and thus lure even more investors, without ever investing in anything or creating any new value.

That is clearly not what was happening here.  But it's dangerously close, and Robert's analogy helps explain why: there was a booming aftermarket that absorbed "investments" that didn't go into creating any real wealth on which everything else ultimately depends.

"You know what they say -- those of us who fail history... doomed to repeat it in summer school." -- Buffy The Vampire Slayer, Season 6, Episode 3

[ Parent ]

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