Nov. 27th, 2007

peterbirks: (Default)
"Virgin will pay back £11bn immediately". "Failure to qualify could cost UK economy £1.25bn".

These headlines are thrown around with gay abandon by journalists, non-financial and financial alike. Also, you can guarantee that in any single morning on the Today programme, at least one politician will mention a sum in excess of one billion pounds (they love the sound that the 'b' makes -- it gives the whole thing a sense of importance).

But actually ask them what these numbers mean, and you suddenly get an Emperor's New Clothes syndrome. Because, once you head into the territory of a billion quid-plus, it's like we were seven-year-olds again.

When we were that age, money was thought of in terms of very small purchases -- a packet of crisps, for example. At the age of seven, the "long term" was saving up your pocket money for a month.

"Big" money deals, like new clothes or, say, redecorating, or a holiday, or a new car, involved sums of money quite beyond our comprehension. That our parents had to choose purchase A over purchase B, when the sums involved were for more than a year's pocket money. Well, it just didn't make sense. It was like trying to understand the size of the universe. It was just so big, that you didn't even bother.

That's what these billion-pound-plus sums are to most of us today. We hear the numbers, but we can't equate to it in terms of impact.

So, let's try a bit of this, shall we?

A few months ago Bernanke said that $100bn might make it a systemic event. Today, word on the street is that it might be three times as much. Once again, $300bn, $100bn. Hell, it's just, well, BIG, right?

Let's suppose that $300bn has gone down the tubes. First, one might ask, where the fuck has it gone?

Well, basically, it's gone to give people a few years in a home that they wouldn't have had otherwise. Although the TV programmes feature interviews with Shaquille Templar of southern St Louis (or wherever), with four kids, and threatened with eviction from the home that she bought with a subprime mortgage three years ago, as some kind of tragedy, the sad fact is, she's the winner on the deal. She's had three years in a home that she couldn't have dreamed of living in under proper loan principles. The "value" of that loan in rental terms might be put at $500 a month, or $18,000 in total.

Now, multiply that by 10 million or so, and that's where we get $180bn of it. That money has, quite literally, gone, although it won't cheer up Ms Templar of St Louis, who will now be sent back to wherever she was before this largesse began. Other winners from all this were the salesmen selling these mortgages. They had a few years of good commissions. Their bosses earnt several hundred thousand dollars a year running companies that are now worth jackshit. That money came from investors in subprime securitisations. That money is gone. Maybe all of that adds another $20bn.

In other places, the whole system was a scam. Borrowers didn't exist, houses didn't exist. The money was channelled into the pockets of bent salesmen, bent lawyers, bent appraisers, bent lenders. That funded a nice standard of living for these people. Although some of them may end up in jail, that money is gone. They've spent it.

OK, so, a big number has gone. But what does it mean?

Well, if we take it that $300bn has been spent in the past few years which other people thought was safely invested (but wasn't), then those people have lost their investment. This is where we get companies mentioning "hits" of $600m, $1.2bn, and so on. That money will come from a variety of places. Where the companies are listed, then the investors will lose out. If those investors are pension funds, then the ultimate owners, the final pension schemes, will lose out. Generally speaking, the more savings that you have in volatile products, the more you will lose out.

Let's divide that $300bn by every adult in the developed world. That brings us to about $2,000 a head. That's a nice start point. If you are average, you are probably $2,000 worse off today than you thought you were.

Wow, I can imagine the fun that the Daily Mail would have with that.

But, in the grand scheme of things, it's no big deal. Because we are like kids when it comes to things like this, most adults think of that £1,000 as "extra" -- money that appears and disappears out of discretionary income. But discretionary income is, for most people, only a small part of their overall finances. Add in mortgage payments, savings for retirement, monthly income in and out for a typical household of 1.3 adults (or whatever) and you get a different picture. That grand is less than half the turnover of the household. If a household has a reasonable return on equity (savings that go into pension funds, paying off the mortgage, etc) then it's probably little more than a single month's household "profit". And that money won't come out of discretionary spending. It will come out of 'profit' over the lifetime of the company -- in the case of an earning household, at least 30 years.

In other words, the average household will have to take a profit markdown of 10% this year.

Now, in one sense, that isn't bad. But, in another sense, if the papers said that all listed companies would see their profits impacted by 10% this year, you'd get a fairly serious hit on market prices. And, as with the "average" household, the impact will not be equally distributed.


Looking at these numbers, they feel about right to me. About a 10% hit on the year to your personal RoE, and about a 10% average hit to annual profits for companies. In both cases, there will be a wide spread that will be distinctly Non Bell-Curve shaped in terms of distribution.

So, what does that mean. Well, we know you've lost a grand. We know that this will not directly impact your pocket. We know that there will be losers and non-losers (and a very few winners). And we know that the money has gone and where it's gone. We can live with it. Just call it a single bad downswing in poker terms -- say, for a month. For some companies, with bad bankroll management, it will be goodnight. Others, with better bankroll management, will feel the pain, but will survive. The guys with excellent bankroll management (step forward Warren Buffett) will make lots of money from this.

August 2023

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