Lessons in liquidity, insolvency, mark to market accounting, risk management, and the big difference between luck and skill.
Liquidity, Insolvency, and the financial crisis -
By "Executive" Analogy...***
Deep in the heart of Texas:
Your neighbor, George, recently lost his job.
One Saturday morning at nine o'clock, George knocks on your door. "Morning neighbor, he says. Want to watch some of them hunting and fishing shows on ESPN 2?
You say ok, and invite him in. George has been away a while, and besides, he has always been good for a few laughs.
George pulls a can of Schlitz from his pocket, pops the tab, and takes a few big gulps. He narrows his eyes. "Heck, you're one of thos economist fellas, aint ya? " You respond that you are indeed an economist. "Riddle me this, then," he says.
Curious, you take the bait, "I'll try."
"Tell me about this mortgage, financial crisis, subprime..."
"You want me to explain the financial crisis to you?"
You can see he is serious. Well, George, we need to start with a few concepts first."
"Great. I'm a concept guy. Know what I mean?" He smiles; punches you in the arm. "Call me Doubayuh. George is my daddy." He giggles.
You clear your throat. "Ok, uh, Doubayuh. Well, at the most basic level, I think we need to start with liquidity, then maybe insolvency, risk management maybe - then we'll take it from there."
"Sweet." He guzzles his Schlitz.
You take a deep breath. "Ok, well, absent umm government price regulation, the value of any asset is generally set by supply and demand - which basiscally comes down to how many people want it and how bad do they want it."
Your neighbor interrupts - "Right, right... Supply and demand. Heard of it. Go on, Professor."
You continue. "Well, if demand is high, you should be able to convert whatever you are selling into cash rather easily. In other words, you can liquidate your asset for real money. So that is they mean when they talk about liquidity."
Your neighbor smiles at you. Then he squints and nods his head. "That's what who, means, err - I'm afraid you lost me there Professeroooney." He punches your arm playfully.
"You can call me Mike, sir."
Course I can call you Mike. But I like nicknames, if you get me, err, get my drift." He chuckles. "You know, like Brownie."
"Yes, whatever you want George. So, I was talking about the folks who set monetary policy. You asked me who they were."
"Go on, Brownie. Just kidding. Go ahead Mike."
"I was talking about the Secretary of the Treasury, the Fed Chairman, bankers, the guys on CNBC..."
"Treasury. Wait, that rings a bell. That Paulsen guy, right? I call him Goldy, cause he used to work at-"
"Mr. Pre- uh, George. Hank Paulsen isn't the Secretary anymore."
"Really? I had no idea. I really liked that guy. Real strong sense of right and wrong, ya know? Goldy - umm Hank Paulsen - The guy was always talking about how we need to avoid moral hazards. Great family values..."
"Ok. We need to back up a little bit here George. You a football fan?"
"How bout them Cowboys! Course I am. This is Texas. Friday night lights is the best book I ever read. Ok, I didn't read it. Hell of a good movie. Go Panthers!" George pulls a new can of Schlitz out of his other pocket, pops the tab, and pours in a mouthful.
"Great," you say. "Let's try this with a football example. I think you'll have an easier time relating to the concepts."
"Let's say you need to come up with two thousand dollars in 48 hours to pay off your losses from a bad bet on the Dallas Cowboys. Your bookie, let's call her Tipper, has threatened to break your thumbs if you don't pay up. No problem, you think to yourself. You're always telling everyone that your, umm, "stuff", is worth at least ten thousand bucks. You decide to have a yard sale. You put an add in the Dallas Morning News. The next day, your ranch is flooded with potential customers." You with me, George?"
"Ok. Now, let's say you get offers below what you had hoped. You sweat it out, but in the end your proceeds are $2,005."
"My thumb is safe, right?"
"Yes. Your thumb is safe. Anyway, you've just had a liquidity crisis because your assets weren't worth nearly what you thought. But the crisis didn't kill you because you ultimately were able to raise the money you needed, if just barely."
"On the other hand, if you think your stuff is worth ten grand, and you need at least two to pay Tipper, but you raise less than a thousand dollars, then you have a bunch of problems. First of all, you have a liquidity problem that has evolved into an insolvency problem. You have nothing to sell, and not enough money to pay your debt. You are in the hole, sir, and you may need some bankruptcy protection."
"I know. Also, you have some serious accounting issues. You have apparently been inflating the value of your assets by more than 90%."
"Maybe I did it on purpose." He squints again, and cracks up laughing. His shoulders bounce up and down under a denim jacket. "Oh man. No, seriously, how was I supposed to know what the junk was worth? I never tried to sell it before."
"And that is a very good point. You don't know what the stuff is worth until you try to liquidate it. However, you've been strutting around town telling bankers, bookies, and whoever else you know that you have more than ten thousand dollars in liquid assets. The truth is that you have less than one thousand. And that is the problem with thinly traded assets like CDOs."
"Thin CD who?"
"Forget it. That's for another day. The point is that your actual liquidity was less than 10% what you said it was. Translation, you bet on the Cowboys with money you don't have. That, my friend, is bad risk management."
"This is just an illustration, George. You don't need to apologize."
"I know. But role-playing is more fun if you really get into it." He winks.
"Ok. Well then, unfortunately for you, the Philadelphia Eagles crushed the Cowboys. Next comes the painful consequences of your high-risk behavior."
"Yes George, Tipper is gonna come break your thumb."
"Hah - fat chance - She'll never catch me."
"Probably not, sir. Now, here is the really interesting part - for me at least. You could have gotten lucky and won your first bet. Maybe you accidentally bet on the Eagles or something like that. Point is, if you won that first bet, you would not have had any reason to liquidate your stuff. Nobody would know that you overvalued your assets. And nobody would know how poorly you manage risk."
"Now that sounds good to me."
"That's what the banks thought."
"Uh, we'll save that for next time too."
"All right. So maybe you win the first bet, and then go on a nice streak, winning bets for 6 weeks in a row. Even better, let's say you let all the winnings ride each week and keep right on winning. Everyone would be impressed at your obvious skill. You also would have made a small fortune. There's no reason to stop, you think. You are damn good at this football betting. Its easy money. How bout them Cowboys, indeed."
"Professor, this sounds too good to be true."
"I'm impressed, George. Ok. So you know you are taking too many risks. But you do it anyway. You let it all ride on week 7. The game happens to be a a rematch with Philly. The Eagles smoke the Cowboys again. You lose it all. Every penny. Nobody thinks you are so smart anymore. How could you lose so badly. Haven't you heard of hedging your bets? In the end, people correctly judge you as just another risk-taker that had a lucky streak and blew up."
"Wow." George finishes his beer and then checks his watch. "I've got to go Professor. But that was one wild roller coaster ride. Thanks for the lesson on liquidity, insolvency, and gambling. Next time maybe we can talk about the notional value of credit default swaps." He stands, smiles, and winks. "Adios amigo." He says.
By Brett Sherman, The Sherman Law Firm