May 7, 2009

Where has all the money gone

I entered into an interesting twitter exchange recently, to whit:

BrendanWenzel: A lot of people have "lost" money, but who is gaining it all? Wealth is never destroyed, but transfered. Who is it being transfered to?
kurt_cagle:Actually, in this case, "wealth" is just being destroyed, because assets are being repriced downward.
kurt_cagle:Most real wealth was made 2004-2006 by people in top 1%; we're just now discovering the fact that we've been robbed.
BrendanWenzel: So you are saying that these worthless assets never had value and were just a tool to steal wealth?
kurt_cagle: ... a tool to steal wealth? Um ... yup, pretty much. Did any investment banker really produce $30 million worth of value? No.

The numbers vary - from $2 trillion dollars to more than $40 trillion dollars depending upon how measure it, but in any case, a lot of "wealth" has seemingly gone up in smoke in the last year. Retirement, pension and college funds have been cut by 50% or more, municipal bonds have turned to dust, treasuries at the local, state and national level are bare. The world has, seemingly overnight, gone from being hyperfrenetic with activity to being, well broke ... and broken.

The question that Brendan brought up is a sensible one - where did all that money go? Is there someone out there who's now sitting on a pile of everyone else's money? No ... and yes.

People, including bankers who should know better, tend to look upon money as being, well, solid. You work every day, you get a paycheck for your efforts that represents a contract with your employer. That contract is usually slanted toward the employer - you provide the labor, and at the end of two weeks or one month or some other milestone, the employer gives you a piece of paper transferring a certain amount of value from the companies earnings to you. You take this to the bank, the bank deposits it, and from there you can "spend" this value.

Suppose, however, that the company has not made this money in earnings yet. Instead, they went to a bank and said "give us a line of credit, here is our plan to make value in the future". The bank evaluates the plan and the individuals involved, and if it feels like the plan will return a reasonable amount of earnings within a reasonable time, it will give the company that line of credit - a form of a loan, along with a fee to be added in order to compensate the bank for the risk that the company won't in fact make these earnings over the stated time.

This means that the money that you are making is not based upon existing value, but upon future value production. In essence, the company is in turn taking a risk that you will produce, though it is usually a pretty safe one. If you don't, then you will no longer receive that compensation, and someone else will be hired.

Yet, say after a couple of years, the company is not making enough money - the guess that was made concerning the profitability of the venture was off. The company's already sunk money into infrastructure, into salaries for the people, into energy costs, and into intangibles - marketing efforts. The company can go back to the bank and ask for an additional loan, but the bank at some point needs to determine whether the ongoing effort will ever prove profitable - otherwise, it is simply throwing bad money after good. The bank decides that "no, we're not going to give you the loan" and assuming the company doesn't find other investors (typically with more stringent requirements because of increased risk) it will close its doors, and everyone will be out of a job.

Now in this particular venture, you may have made money - though much of that money went into paying off necessities - housing, transportation, energy, food, information access and so forth - so you may have actually just broken even or even fallen behind. However, when the company fails, it can't turn around and ask for that money back. It's been spent. The money that the bank has also loaned has been lost - the loan becomes non-performing, because it no longer generates revenue, and the bank also took a loss.

If the bank charges fees on the establishment of the loan, these fees are things that can be assessed early - at the time the loan is made. At some point, the bank manager might realize that taking the fees are less risky than waiting for the loan to mature. They sell the loan as a "security". Now, this security is still potentially valuable, because it represents a steady stream of income in interest, and an investor can buy the security as a long term performing vehicle - so long as the person or company who took out the loan can continue to make payments.

Now the bank, at this point, has been lobbying the government to let them sell these securities, and a particularly business friendly administration gives the go-ahead. All of a sudden, a bank can make a loan, pocket the fees for that origination, then sell the loan as a security taking additional fees. What this means is that the bank no longer has any real incentive to insure that the person or company taking the loan can actually pay it back, because by the time it becomes an issue, it will be someone else's problem. The bank has essentially siphoned off a fairly significant amount of money in the transaction without actually creating significant value.

What this means is that they will be encouraged to make many more loans, because there is no moral hazard if a loan goes bad. If the loan is a mortgage or a lease, the bank may also encourage the ones acting as brokers in the sales of these properties to try to get top dollar, because it increases the fees that they can take off the transaction. The mortgage broker sees no problems in that - he too gets a percentage off the top, so the more valuable the property, the more he makes. The county assessors that determine the baseline price will try to increase the property price as well, because that increases revenues in the tax coffer, and if tax revenues go up, well, its good for the city or county.

Now, normally, this breaks down if interest rates are high - because the person who actually commits to the purchase has to pay the interest on top of the agreed upon price and fees. However, if interest rates are kept generationally low, then even though the house may cost more, the individual payments may be smaller, especially if they can be spread out over a longer period of time. Then of course, you also have speculators who buy up properties with no intention of paying the long term price - they simply become brokers themselves, selling to someone else at a higher price in three or six month, because real estate prices always go up. The buyer may also simply not have the financial resources to purchase the property in the first place under normal circumstances, but with a bit of "creative accounting" they are encouraged to buy.

Now this chain goes all the way up and down - ratings agencies are encouraged to rate securities higher than they should be, corporate raiders use risky securities (junk bonds) to effectively purchase companies, replacing actual earnings with debits against future earnings. Stock brokers use this debt to leverage purchase of stock with very little actual money committed, and so forth.

All of this activity involves replacing existing earnings - real work - with promised earnings - credit, and because there is comparatively little oversite, the actual obligation on the part of the wage earners and company earnings climbs and climbs and climbs, until you get a situation where a person would have to work continuously, 24 hours a day, for century or more to produce the real work that's been obligated on her, usually without her direct consent. That's clearly unfeasible, and the system ultimately collapses as each company or person fails.

Debts that the banks and shadow banks hold have to be written off, rather than being treated like assets. This reduces the amount of money that the banks can commit to writing loans, and also instills a sense of hyperconservatism in extending new loans, because they can no longer service the old ones. This causes credit availability to collapse, which means that companies can no longer pay their workers (as the paychecks were paid from the loan which was to be repaid by earnings).

As workers lose their jobs, they cut back on their spending, which causes other companies to go out of business, which only exacerbates the situation. Companies are forced to lower their prices in order to move any product, and a deflationary spiral sets in. Everything loses value as the availability of money dries up and markets plummet.

Eventually, demand for goods reasserts itself, as things wear out, as population grows, or as people become less fearful about the future. However, the damage has been done - the negotatiated value of things have dropped dramatically, whether that's the cost of a new car or the cost of a stock, and people who purchased the stocks thinking that it was a safe investment now discover that they're holding worthless paper - the company has either gone out of business or, if it survived, now has a much smaller cash position and it will take time for it to get back to its earning potential, significantly reducing the long term return on investment.

So, given that, chances are pretty good that there's not one person out there who is now sitting on everyone else's money. The money never really existed, save in potentia. What disappeared was the expected potential of that future labor.

However, that doesn't mean there aren't scoundrels. Companies who buy and sell these securities have profited immensely by the transaction fees and bonuses, which also came from future earnings. It would be much like you being paid for the next thirty years of your wage earning time up front. If the business fails, it makes no difference to you - you've already been paid handsomely, and can turn around and spend that money any way you choose.

Yet that money has to come from earnings at some point, and it does. It comes from pension funds that fail, leaving people who have invested with nothing. It comes from reduced pay elsewhere in the industry, as credit has been compromised. It comes from tax revenues, which decline dramatically in a recession because people don't have the wherewithall to pay. In other words, the thirty million dollar "bonus" that the hedge fund manager or bank CEO takes home comes directly or indirectly from the earnings of others, who now have to work longer just to get back to where they are.

So, yes, it was a ponzi scheme, a bubble with a skim, caused by the greed of "financial professionals" and political officials, aided by tax cuts that were highly favorable to these same people, and a war that made it possible to hide similar fraud elsewhere. It is still going on, and it has bankrupted this country for years to come.Where has all the money gone

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