Friday, 6 February 2009

Money is Time

"Loads of dough!"

Iced tea imported from England,
Lifeguards imported from Spain,
Towels imported from Turkey,
Turkey imported from Maine,

How come there was so much cash available from 1999 onwards AFTER so many dotcom and related businesses had collapsed? How could the Banking and Finance sector boast so much "liquidity" when the USA and United Kingdom economies were producing so little and shifting their factories to China, Indonesia, Brazil and other countries that were offering cheap labour?
As explained on my previous blog the Western World has been in recession since 1999. The misdemeanours of ENRON are amateurish compared with what banks did and were allowed to do. This is the story explaining how for almost 2 decades banks have been literally having one's cake AND eating it too. Worse, they have been eating the cake before it is properly cooked, taking it out of the oven after being there for 5 minutes instead of 60... and what happens if you do that, you greedy child? You end up with a "sore tummy"!

Basic Mistake n. 2 or "money does not need time"

We all have heard about gravity and rocket science and scientists. The formulas used are very precise so much so that when the first LEM arrived on the moon it was about 10 metres out of target. That's good, very good to have such trustworthy technology allied with immutable formulae firstly thought by Isaac Newton in... 1687! But what if the formula was slightly wrong, not even the formula but the Gravitational constant G? What if instead of its value of 6.67300 × 10-11 m3 kg-1 s-2 it was 6.663 or 6.21 or 5.77? Most say that the universe would fall apart, that this and other constants follow the Goldilock's Principle, that these figures are not too hot or too cold, just right. For practical purposes if the world had not fallen apart the LEM would have landed 2 miles away from the projected spot. However, with a "bent" G a trip to Mars or further away would be impossible and all our science fiction dreams could not even exist.
The world of Finance has always aspired to be "scientific" to be more than SUM0, more than moving "crates of oranges from one corner of the warehouse to the other" a technique used until exhaustion by Enron. The equivalent to Isaac Newton's gravity formula surfaced in the Finance world in the mid 70s. It is the Black-Scholes Option pricing formula and do you know what... it is wrong! All scientific formulas express a reality and try to explain it. Gravity confirms that "what goes up must come down". In Finance there is also an expression "your investment could go up or down depending on market circumstances". The Black-Scholes formula might be lovely but is an optimistic one! No one will use it to price a future asset to be worth less than the original price. An example: do you remember Dick's 50 Microsoft shares valued at $24 each? He wants to cash today but have an option on it for 5 years. If the Black-Scholes (BS) formula would arrive to a price of $2 per share in 5 years he would never use it, never apply the option, pay for the derivative. He would prefer to take the risk himself minute by minute. However the formula will always give a price of around $50 dollars so, for a premium, he just makes the deal and uses the money straight away does not need to bother for Harry to buy his shares. The BS formula is always used for optimistic purposes creating Silly Money. Always prices up, never prices down.
Here resides the main failure of the last 10 years. With the BS formula bankers forgot that most financial products need time to complete, to stay within a SUM0 environment. 50 years ago financial products always achieved maturity. For example a $100,000 mortgage for 20 years at 6% would generate a total profit to the bank AFTER 20 years of $71,943.45. The bank could cash in the interest every month bit by bit, slowly. However with the BS formula that profit ($71,943.45) can enter the books and be sold to someone else on the next day the mortgage has been agreed. The same applies to almost everything from life assurance to funds. Within this environment there was this frenzy in the past 10 years to sell long term financial products. The banks and brokers were awash with cash, artificially transferred to the stock markets to make more BS deals, artificially giving the impression of growth even when all the indicators of industrial output were close to despair. Bankers forgot that although time is money, you need time to make the money. Everyone was happy, but only the ones inside the financial loop, people that had enough money to invest, people that were working on investments, governments gullible enough to buy this scenario as they were also cashing in on taxes (corporation, revenue) and stock exchange (stamp duty!). And the more the merrier. How many uninvited phone calls did you get in the recent past from your bank (or others) trying to sell you insurance, loans, remortgages? And car dealers trying to sell loans? They would almost cry if you were paying cash! Everyone was trying to sell long term investments because they would get (high) commissions. These operations were even more validated as with this Silly Money generation, deal rooms were having blue fireworks on their screens every second. Why? The icing on the cake albeit half-baked? On maturity, after the BS being applied, there was another "profit" on top i.e. the asset was worth more than the original BS price! So everybody was thinking... "BS works! we are (al)right!"
There was "loads of dough" as my friend on the photo is showing, but only his is a creative one, one that leaves a lovely taste in your mouth.
Until the next basic mistake...

Basic Mistake n. 3 or "safe as houses"

Why are houses safe? How come the prices rise all the time? If you buy a car, even as expensive as a house it will loose its value through time. It gets old, needs repairing, gets outdated. The same happens to houses, however their prices never depreciate. Market "forces", advertising, policy from governments closely knitted with financial institutions and increasing population, all tend to make house prices increase constantly.
Why this "brainwashing" for home ownership in the United Kingdom and United States?
  • Long term financial commitment from individuals implies job security accepting conditions that other countries, mostly in Continental Europe would never accept.
  • Financial "stability" from taxes through house purchasing, IRS or PAYE, steady income from interest, additional corporate tax from financial institutions. Ah and in the end... inheritance tax. Win, win, win,win situation.
  • Psychological effect on work force committed and in debt for most of their working life.
  • Selling the dream of ownership as the ultimate goal and the illusion of a "solid" investment. The expression "real" estate says it all.
It should not be like this. Home ownership is lower in countries like France, Germany, Netherlands. Actually if you check the data it is certain that countries with high home ownership are the most vulnerable and the ones that are suffering the present recession the most. By the way, do you know the rate of home ownership in Iceland? Above 90%!!! Top Banana! Top Crash also! Oh dear!
Then we enter the mortgage process. In SUM0 only the buying of a new property is a creationist one. Anything else enters the evolutionist model buying from someone else or remortgaging. Houses also generate Silly Money although the time frame of the loan could dilute it. But if you ally the process with derivatives and the BS formula then you will crash. How can a model survive when its main component increases its price by 100% in less than five years? When you play Monopoly and add the rule that property prices and the GO fee starts going up by 25% per lap after the 3rd lap you know what happens? Bank of Monopoly runs out of cash! I have seen this somewhere! What a nice couple they were, Fannie Mae and Freddie Mac.

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