Discussion of the current financial crisis is often shrouded in a bunch of pseudo-technical jargon. People, especially intelligent and highly educated people, are often hesitant to ask basic questions. But as Socrates tells us, the beginning of wisdom is a definition of terms.
Imagine you live in a cave in hunter-gatherer society. Og is going to spend the day hunting. You have previously harvested some berries, lived frugally, and now have an extra handful of berries you can give Og to eat while he hunts all day. You and Og make a deal. When he returns from the hunt, he will give you two handfuls of meat. That’s debt. If instead of promising you a fixed amount of meat, you agreed that he would give you a fixed share – say half – of what he brings back to the cave, that’s equity. As an example calculation, if Og takes one handful of berries under such a debt contract and a second handful under such an equity contract, and if he comes back into the cave with, say, 10 handfuls of meat, then he has to give 2 handfuls to the debt holder and 5 handfuls (half of 10) to the equity holder. He is left with 10 – 2 – 5 = 3 handfuls of meat for his dinner. This combination of debt and equity is called his capital structure.
The debt gets paid first; then Og and the equity holders split what’s left, if anything. If Og comes back with less than two handfuls of meat, and hasn’t saved any for a rainy day, then he can’t pay his debt and has defaulted. Note that as Og gets more and more confident about how well his hunting will go that day, the more berries he wants to take in the form of debt rather than equity.
Suppose that Og gives you an IOU for your debt (call this a bond) or for your equity (call this a share of stock). We could refer to the stocks and bonds as, collectively, securities. Suppose your friend in the cave has given a handful of berries to his cousin Ug in return for a promise for some of the meat that Ug brings back to the cave. You might agree to a deal in which you and your friend give each other a half-interest in each other’s securities. Why would you each agree to this? Because there’s a lot of uncertainty in how any one person’s hunt might go on any one particular day, and therefore you’re each more likely to have at least some meat to eat for dinner this way. This is called hedging, and it is one of the primary means by which financial transactions can create value. If you do hedge, you’d be wise to make sure that Og and Ug tend to hunt in different fields and for different animals, so that if one has a bad day, the other is more likely to have a good day. That is, you want to hedge with uncorrelated securities.
As time proceeds some smart people in the cave invent things to make all of this easier. Physical storage and exchange of berries and meat is replaced by money, which is really a kind of general-purpose IOU produced by trusted third-parties. Governments (a.k.a., groups of big guys who like to be charge and have spears) arise to adjudicate and enforce contracts, and eventually monopolize the creation of money. Banks are launched so that you have a safe place to store money, and can pay somebody else to do the work of deciding whether Og or Ug is a better risk for your loans of berries. A corner of the cave is set aside as a securities market for people to trade stocks and bonds under defined rules. One important type of transaction that this securities market permits is “shorting” a stock. This is a deal in which I pay you some money today in return for your promise that I can make you buy a share of Og’s stock from me 90 days from now at today’s price. Therefore, if the price of this stock is lower then than it is now, I can expect to make money and you can expect to lose money, since I should be able to go into the market and buy it at the then-current price and make you buy it from me at today’s higher price. All this financial infrastructure may seem parasitical to the “real” work of hunting animals and gathering berries, but it helps this cave become very wealthy because it serves to make sure that berries are allocated to the best hunters at the right times, and therefore increases the aggregate production of meat.
While this is happening a couple of sharp operators might sit together in a dark corner of the cave, and make a wager about whether Og will default on his bond. In plain English, we would call this a side bet. Though if you wanted to sell this idea to a fairly gullible person who holds Og’s bond, you might make it sound kind of gee-whiz by calling it a Credit Default Swap. If I hold one of Og’s bonds and I take a bet that pays out if Og defaults, then I’ve just hedged my risk.
The bookie who offers me the swap keeps some money on hand, but like all bookies what he really needs is a book of bets that cancel one another out, so that he makes money no matter who wins or loses. The bookie develops a variety of hedging approaches to do this. An illustrative approach is to have his associate quietly go over to the securities exchange and short Og’s stock. Since Og’s stock will tend to fall massively if he is believed to be likely to fail to pay his debts, the bookie will make lots of money on the short sale that he can then use to pay off the swaps. He, in effect, sits on both sides of the bet. Bookies will tend to hire lots of very smart caveman PhDs to develop sophisticated mathematical models to structure these off-setting bets in a way that makes them the most money.
Now, consider the dynamics that might occur in this cave if you had a string of very good hunting seasons.
Hunters start to borrow more and more berries and enjoy much nicer meals while hunting. The hunters shift their capital structures to increasing amounts of debt versus equity. Less adept hunters see that they can succeed, and begin to hunt instead of gathering berries. Smart bankers observe that lending is very profitable, and compete to provide more and more loans to hunters, with terms that are more and more favorable to the hunters. This enables the banks to make more money, and they can use this to offer higher interest rates to depositors. Banks who think this is too risky and don’t make bigger and bigger loans will have less profits to use to pay higher interest rates to attract deposits, and will therefore tend to shrink. Bankers also realize that the odds of every depositor showing up on one day to demand their money is almost zero, so they can hold a lower and lower proportion of deposits actually on hand, which enables them to make more loans which enables them to offer higher interest rates and attract more deposits. They see that this is risky, but like making more loans, if they don’t do this, they will not have the profits to pay competitive interest rates to prospective depositors, so very few people will deposit with them, and therefore they will lose business.
Of course, there is a great solution to all this risk the banks are taking on: They can buy swaps to hedge this risk. They and the bookies who provide these swaps call it “credit insurance” because this makes everybody feel better. The business of providing swaps is very lucrative, because the hunting is so good that they almost never have to pay off. Like the banks, the bookies begin to be forced by competition to take larger and larger risks, which require ever more sophisticated models. Large banks and other financial institutions begin offer swaps because they are so profitable, and because the detailed hedging strategies embedded in them are so hard to understand that the banks that buy them rely on the brand name of the provider to feel safe.
What happens if we then get a string of bad hunting seasons because the weather changes? The worst hunters can’t bring in any meat, and many good hunters have borrowed so much that they can’t make their debt payments. Lots of bank hedging strategies start to fail because previously uncorrelated hunting performance across different fields and animal types suddenly become correlated – the weather gets worse everywhere at once. Defaults start to rise substantially across all portfolios, but the banks aren’t worried at first, since they have “insured” the debt.
But when the providers of swaps are called upon to pay off, they realize they have a huge problem. Lots of the other people over at the securities exchange are also shorting the same equities at the same time for the same reasons, because so much debt has been insured in this way. They know that they all will have to sell. This would drive down the price of the offsetting equities too rapidly to be able to execute the short-selling strategy that they rely upon to be able to pay the bank.
An invisible crisis becomes visible when a major swaps provider projects that it won’t be able to meet its contracts, and threatens to declare bankruptcy (let’s call them, oh, AIG). Suddenly all the bankers confront a horrible realization: Their credit insurance was an illusion. If more than a tiny fraction of market participants rely on it, then as soon as it is needed, it isn’t there. Banks all simultaneously foresee that if even one large provider of swaps goes bankrupt, it could create a chain reaction. Banks that were depending on that provider’s swaps will not have sufficient funds to pay depositors, and will go bankrupt. Other banks that have lent money to this bank will suddenly be short on money. Since nobody has clarity on how exposed various banks are to swaps or similar instruments – either directly, or because they have more standard loans out to banks that are exposed to them – depositors of even highly conservative banks begin to withdraw money. No bank holds enough money to make good on all depositors’ claims at once. Realizing this, depositors scramble to get their money out before their bank goes under. A series of bank runs start. Banks begin to stop making normal business operating loans to hunters in order to conserve capital and protect themselves against runs. More hunters can’t get berries to eat while hunting, so they hunt less, and defaults increase further. This leads to more defaults by providers of swaps, which in turn leads to more bank runs and more constriction of lending, and so on. In short, financial contagion ensues, leading to an enormous economic contraction.
Unfortunately, all of us in the developed world appear to be living in a cave that is teetering on the edge of such a catastrophe right now.