CHARLIE: How about our money, George? Where’s our money?

GEORGE: Now, come on, now, please! Now, wait a minute, now! Listen to me! Now, you’re thinking of this place all wrong. Your money’s not here!

CROWD: (ad-libs) What?

GEORGE: Wait a minute, now, let me tell you. Let me tell you. Your money’s in people’s houses! In the Kennedy house, and the MacClaren house, and in your house, and a hundred others. Now, what are you going to do? Foreclose on them?

From “It’s A Wonderful Life”

You’ve probably read somewhere about the Global Financial Crisis. And you’ve probably heard how it was caused by a collapse in the housing bubble. Some of you may even have read how it was a program initiated by the Democrats of helping “poor people” – you know, the sort who really don’t deserve a place of their own – to buy their own homes.

It sent the world into recession – but not Australia (so all that money Kevin Rudd borrowed was just wasted) – and threatened the worst crisis since the Great Depression.

Of course, one wonders how something as simple as a reduction in house prices could lead to such potential devastation. Particularly when everyone seems to agree that houses were over-priced. Surely, that should have been just part of the capitalist “boom and bust” cycle we know and love. I mean, the total In 2007, the total value of home sales was less than two trillion, which is only about five percent of the value of shares traded on the US stock exchange that year.

To understand why this happened, you need to first gain an understanding of leveraging, and before you do that, you first need to understand money.

The online dictionary lists seven different meanings for money, so it’s a word that means different things in different contexts but for simplicity let’s look at the Wikipedia (thank you, Greg Hunt) explanation.

“Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given socio-economic context or country. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past, a standard of deferred payment. Any kind of object or secure verifiable record that fulfills (sic) these functions can be considered money.”

and

“The largest part of the world’s money exists only as accounting numbers which are transferred between financial computers. Various plastic cards and other devices give individual consumers the power to electronically transfer such money to and from their bank accounts, without the use of currency.”

Money is a concept. Money is an agreement. Some of you will even argue that money is a fiction.

But basically most money, these days, is simply an entry in a bank’s computer system. As most of you are probably aware, actual cash is just a fraction of this. And a few billion dollars off the price of houses, should have had no more effect on the rest of the system than you dropping your wallet with $1,000 in cash off a bridge.

So, why couldn’t the system withstand a drop in the price of houses in the US?

Because of the way the assets were being used to back up the Potemkin village that the financial system had become.

Someone once suggested that to make drivers drive more safely, instead of installing airbags and seat belts, we should have a large spike in the steering wheel, pointing at their chest. Who wants to brake suddenly in those circumstances? Prior to the GFC, banks and other financial institutions were running around with the belief that they not only had airbags and seat belts, but they were encased in a hardy shell. The large spike in the steering will was simply ignored.

Part of the trouble was the way in which the whole system is interconnected. In order to provide protection against defaults, financial institutions rely on Credit Default Swaps*. which in simple terms work like a form of insurance.

Now the idea of insurance is that it should reduce your risk. So why didn’t this work in the GFC? Quite simply, there were too many risky bonds and investments which had “insured” with agencies that had a high credit rating. When the defaults started to happen, the agencies with the high credit ratings were either downgraded, or ran the risk of being downgraded, unless they could offload their riskier bonds. So, suddenly, you have large numbers trying to sell off their “assets”, causing a need for more “assets” to be sold because this sell-off was leading to a drop in value. And this drop in value of the riskier items flowed through to all assets.

And, of course, some firms found themselves downgraded anyway. Which meant that they found it impossible or, at the very least, more expensive to borrow.

Ideally, firms should have the sort of balance that enables them to balance potential losses against potential gains. Sort of like going to the roulette wheel and betting on all the numbers because you’re being given odds of 40 to 1. Because there are less than forty numbers on the wheel, you’ll make a profit every time. The problem arises when you suddenly discover that a handful of the numbers don’t pay out at all. This wouldn’t be a problem, except you’ve lent out some of your potential wins to others, so that they can bet on other roulette wheels at the same casino. And while you try to grab as much back as you can, you’re discovering that with each passing spin, more of the numbers are being declared duds.

Each downgrade leads to more downgrades, which in turn makes everyone reluctant to lend. As credit dries up, firms go to the wall, which leads to more downgrades. And then the heavyweights start to falter. Some even go under. The Butterfly Effect!

The USA falls into recession.

This could be bigger than the Great Depression, we’re told.

But then governments start to bail out the private sector. Some argue that this shouldn’t happen, but most don’t feel like it’s the time for debate.

The ship is steadied. We continue on our way. We’ve learned our lesson.

But it’s unclear what the lesson is.

Is it that sometimes only Government intervention can help?

Or is it that some of the regulations that were there from the 1930’s until recently, actually worked?

Or is it that maybe financial markets are too inter-related?

Or is it that we should take away the safety bags and make financial institutions drive with a large spike pointing straight at their heart?

Whatever, I’m sure we’ve learned our lesson and it’ll never happen again.

*Wikipedia on Credit Default Swaps.

“A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by Blythe Masters from JP Morgan in 1994.

In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.[1] However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called “naked” CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan.”