Saturday, September 27, 2008

The Crisis, Reexplained

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?


$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.

Do you hear that? No way out except for people to lose a lot of money. Money that they never had in the first place. People are going to have to go out and earn a living by doing something productive.


Anonymous said...

Pretty Lady

Would that all the members of Congress get this message. But what good would that do when they all seem to have side bets with the books. I have it! Vote them all out – every last one of them (up for re-election). The remnant would be left to regale the newcomers with lurid tales of that horrible (election) night in ought eight. I believe that such would have the effect of capturing the attention, clearing the mind, and narrowing the focus of future legislators of whatever persuasion.

David said...

Thank you PL. That is really clear. Everything else is gambling. Apropos that one of the lead stories today in the Times is about McCain's ties to the gambling industry, and his love of gambling.

Anonymous said...

I only have a little money, so I have to be careful.....
But I would like to take a chance and bet $1 that Joe actually never places the bet.
Thank you. Let me know who won.

Anonymous said...

Whoops...I misread the first line.
Is it too late to withdraw the bet?
I think Mega Millions plays tonite.
I could better invest my money in that.
Investing can be complicated. NOw I understand why the CEOs need to paid so much.

a christian said...

Great analysis. Thanks (for the link).

If you haven't heard it, This American Life had a great analysis on the "HOUSING CRISIS!"