Wednesday, October 22, 2008

Bankers, Beanie Babies, Leverage and Liars

Q: How do you know when a banker is lying?

A: He publishes his quarterly financial statements.

The Institute For Economic Reality, a think tank based in Poulsbo, Washington, has been watching the "credit crisis" unfold for a few years, and has concluded that bankers are dumber and more dishonest than airline executives - a feat that was previously thought to be unassailable.

Many have asked me if there is any way for the banks to be able to "hold" their assets and survive by getting relief from being forced to mark their assets to market. In other words, can the banks just agree to all lie on a grand scale, and pretend all is well?

No. In fact, it will make the matters worse. If they stay this course, we will have a systemic failure of the entire world-wide banking system.

Why? Because the entire credit economy is based upon this little thing called "trust."

Trust is the basis of credit, which is the basis of our monetary system. The dollars, francs, yen, rubles, euros, kroner, pesos, and rupees you hold are all based upon the belief that people will execute contracts faithfully and will transmit truthful statements when negotiating those contracts. Should people lose faith in their counter party to perform on their contracts, money will cease to flow. The less faith, the more the markets will freeze.

If you go to a farmer's market, and a farmer had several bags of produce for sale, but you couldn't examine the produce, you would need to trust that farmer in order to buy what he was selling. If the farmer tells you that there are two kilos of fresh apples in the bag, and you buy them, you expect to get two kilos of fresh apples. Should you open the bag and find two kilos of rotten, worm infested apples, are you going to buy more apples from this farmer?

Only if you are Fannie Mae or Freddie Mac.

If most of the farmers conduct their business in this manner, how much money will flow at the farmer's market? Money will flow proportionately to the amount of trust, which in this situation is zero.

What happens to the farmers that actually have fresh produce, but still sell them in the opaque bags that all the dishonest farmers use? They fail too.

You can see the problem; our politicians can not. It is costing you trillions of dollars, and it is about to cost you even more.

So, what does this have to do with mortgages, and why do the banks want to continue to lie? Because their alternative is to die, and their executives will probably get the Ken Lay treatment.

The reason the banks can't tell the truth is because of the leverage they have used to get them into this Gordian Knot. Banks like to keep things complex, because they believe we can't figure out what they are doing if they use complicated terminology and talk about really large, spooky figures. However, as we have already stated, bankers are the sleaziest animals in the business community, so they like to masquerade as High Priests of a goofy, New Age religion in hopes that we just leave our tithes and hope the God of High Finance smiles upon us.

Banking is actually pretty simple. Bankers go out into the community to borrow money from people with more money than debt at a low interest rate, repackage it, mark it up, and sell it to people with more debt than money. They pocket the difference (aka "spread"), pay their bills, and call the remainder profit. That's it. That is what they do.

So, if it is so easy, why are they in such trouble? Greed + lack of vision = bankruptcy.

Let's look at another example that we can understand without having to break out our Banking Rosetta Stone.

Back in the early days of "Operation Enduring Bubble," we had lots of speculative playthings. Yes, housing was moving right along, but the real action was in esoteric tech and Internet stocks, Pokemon cards, and Beanie Babies. Americans were simply enamoured with colored socks that were half filled with plastic beads and given a cute name. With the advent of eBay, we had people that made a living buying Beanie Babies at a high price, marking them up, and selling them to a love-starved population at an even higher price.

One such such enterprise that consulted with The Institute For Economic Reality was named "DRECK's: Purveyors of fine American schlock." Dreck's came to the IER with quite a story, and they have agreed to share their story so others don't make the same mistake, or at least if they do, they will feel really bad about it.

Dreck's started out on a limited budget and had a sales volume of $1000/yr in Beanie Babies. They would buy about $800 worth of BBs and sell them for $1000, netting themselves a sweet 25% profit. Then, as the Beanie Baby craze hit its stride, the owner of Dreck's got a bright idea. He could borrow money, expand his business, and really rake in the dough. The interest rate was fixed, Beanies were cute and would "always go up" in price, so this was a "no lose" situation. In fact, the only way to lose was not to be fully leveraged to the never ending Beanie Baby craze.

Dreck's went to a friend and borrowed $9000, combined it with his own $1000 and now had $10,000 worth of half-filled colored socks in his mother's basement. Dreck's friend, the lender of the $9000, made the loan without collateral, as he trusted Dreck's to make good on the loan.

The risk paid off, and paid off big. Beanies were up 30% in that period, which brought the entire gross sales amount to $13,000. Dreck's paid back the $9000, plus $50 in interest, got his original $1000 back, and still had $2950 left over. His return on investment (ROI) was 295%!


Now, Dreck's was a real business. The owner went out and took his sweetie to a monster truck rally, and got a lift kit for his Toyota 4x4. He also bought shares in in late 1999.

Dreck's did it again. He took $1000, and borrowed $19,000, because he calculated that he would get a 50% return on the sales, and he could then move out of his mother's basement and get real office space. He placed an order for $20,000 worth of adorable bean bags. The lender was happy with the previous investment, so he thought it would be prudent to extend the credit line.

Bubbles have a funny way of popping when the maximum damage will occur, and this would be no exception. Rather than appreciating 50%, the Beanies were now deflating 15%. Dreck's couldn't move his Beanies at the prices he used to justify the loan, and was afraid to put them on eBay at a lower price, for fear the lender would see and call his loan.

That $20,000 order now had a market value of $17,000 and the trend was for it to continue to decline even more.

Dreck's original $1000 was gone, and $2000 of the lender's money was also gone. This is where it gets bad. Dreck's decided to pay the interest and "roll" his loan. He cooked up some false financial statements stating that his Beanie Baby inventory was worth $25,000, rather than the $30,000 he had anticipated, but he was still solvent at $25,000. The lender didn't think otherwise. After all, the lender trusted Dreck's.

The petty cash at Dreck's was drained to pay the $100 interest payment and then the next thing was to find new investors to keep the money coming. Occasionally, some Beanies would be sold to fund the interest payment, but they would be done discreetly, as not to alert the lenders to the crashing market.

No other investors could be found, so the owner of Dreck's hit up his mom for a loan, and she blithely obliged the request.

Eventually, the lender called up Dreck's and asked about the market for Beanie Babies. Dreck's was in debt to his mother, was behind in his UPS bills, and still had a mountain of half-stuffed socks that he couldn't move. He needed to wait until the market recovered, or he was ruined. If the existing inventory was marked-to-market, he would be instantly out of business, and so would his lender, as he couldn't take a 10% hit.

They all agreed that they would lie and say that the Beanies were priced high enough to keep them from being shut down, and hopefully, they would attract other lenders to extract their money from this brier patch.

The other lenders asked to see their books, and when Dreck's said their Beanies were at the theoretical value, the lenders looked at the market and decided that Dreck's could not be trusted, so they refused to invest.

Every Beanie Baby that was sold went to pay off the loan, and Dreck's owner realized that he could never sell enough to get out from under the debt. His stake was completely gone. What money he had to operate came from his mother that was taking Beanies as collateral against the money she loaned.

Now, the mother's rainy day money is gone, and all she has is worthless Beanie Babies. The hair salon doesn't take Beanies as payment, nor does the piano teacher or soccer coach.

No matter what happens, Dreck's can't recover his money. His investors are also in trouble, as their loan was unsecured. Nobody else wants to invest, because they don't trust the numbers that Dreck's uses. Holding the assets won't help, unless another frenzy develops that takes prices higher than what they were before, but with all the Beanies on the market, coupled with the reluctance for people to speculate in bean bags, the price outlook is grim.

Meanwhile, interest payments and overhead need to be paid.

This is why the banks can't just "wait it out." Their leverage killed them, and by lying about their assets, they have guaranteed they will not get the funding to continue. If Dreck's had marked their inventory to market, they would have been bankrupted, but their Beanies would have been sold to "Second Hand Sam's" at auction, and Sam would have marked his new assets at market, gone out for a loan, and sold them for a profit. The lenders would have been paid back with interest, and the cycle would repeat. The lenders are not afraid of Sam, as they know his assets are marked at a true value. Sam cycles loan after loan, and moves Hula Hoops, Tickle Me Elmo, Pet Rocks, Rubik's Cubes, Pokemon, Beanie Babies, and parachute pants at market prices.

The denial is killing us. Lying is for poker, not for banking. This is a multi-trillion dollar bluff that will be called.


Jillayne Schlicke said...

Hi Eleua,

A couple of questions.

The government continues to support more and more bailouts.

Instead of letting the untrustworthy banks just fail, we are keeping the system alive a little while longer by continuing to pump money into the dying banks.

What would happen if a new administration comes along and says ENOUGH. "Let the banks fail."

Whatever that is, it seems to be what the politicians are trying to avoid.

Like you, I'd rather see us go down hard so we can start to rebuild instead of continuing to push taxpayer dollars into a dying beanie baby business.

Next question: Obama or McCain?

I'm still undecided.

Which administration will stop the insanity or is it worse than that....neither?

Eleua said...


Thanks for stopping by.

Regarding your question about what would happen if the .gov just let the bad banks fail...

I think the economic situation would spike down, and then ultimately stabilize, but would rebuild upon a system of having proper risk/reward built into the business model. This is absolutely key, as it is has been missing from the present generation of banks. The .gov would have to get out of the business of "democratizing" credit, and allow the private sector to send credit wherever it was most prudent.

This would cause many to declare bankruptcy. Believe it or not, this is a good thing. People that bit off more than they could chew would be denied credit for 7 years, while they think about their foolishness, but most importantly, both the assets and individuals become unencumbered by debt, thus allowing them to be put back out into the market to generate a new cycle of wealth.

Those that saved their money would buy up these assets and be rewarded for thier prudence, thus reinforcing prudent fiscal behavior.

The present course of bailouts seeks the exact opposite. People and assets remain encumbered, the wrong behavior is reinforced, and banks get rewarded for mispricing risk.

There is no situation where we avoid the next depression, however, we can decide what kind of business environment we establish, after it is over. The widespread bankruptcies are coming, so let's just get it over with before our children come of age.

Regarding "McCain or Obama..."

Both men will seek their guidance from the same source (Wall Street insiders), so both will react the same way. They both believe .gov is the solution and can prevent economic catastrophe. As far as the credit situation is concerned, they are a wash, as evidenced by their votes on the TARP.

Regarding the economy as a whole...

Normally, we are treated to two choices: a maniacally insane Leftist that wants to drive the ship of state into the ditch, and the Neocon that says he will only drive it into the ditch at 2/3 the speed, in the interest of 'small government.'

We still have the "Dem x 2/3" characteristic in McCain, but with Obamassiah, His Most Merciful, he wants to drive it into the ditch at 200% the normal speed. The spending priorities of His Most Merciful will certainly crash the bond market, thus rendering void any hope of a .gov sponsored correction of the economy. Obamassiah, His Most Merciful will also continue to support "democratizing" credit, thus making it virtually impossible for banks to get on their feet.

I'm not voting for The Obamassiah, but I still haven't made up my mind about McCain. I have not liked McCain for well over a decade.

I see the rise of Obamassiah, His Most Merciful as an ominous development, and will be the subject of a new blog in the next few days.


Everything thats happened over the last five years is just one bad nightmare.