![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
Safe Investing
Dec. 15th, 2008 11:08 amEvery weekend the newspapers print their personal money sections, detailing, usually sensibly but occasionally insanely, how not to set fire to all of your money.
Meanwhile, through no fault of your own, people who have a legal right to take your money, promptly set fire to it in ways that no-one could make up.
I say that, but I note that Little Dorrit, which came to an end on BBC last week, made it up with uncannny prescience (well, not so much prescience from Dickens, as from the BBC in showing it when they did). For, in the last episode, Mr Merdle, the "man of the age", commits suicide when it becomes clear that his entiire financial operation was nothing more than a Ponzi scheme.
And, that very day, the Madoff $50bn empire was revealed to be exactly the same. Toujours la change...
This is going to be another case of "where has the money gone?" questions from the financially innocent, and statements such as "It's gone to money heaven" from the financially glib. But I don't think anyone will actually say where the money HAS gone.
IN a sense it heads down the old line of "what is wealth?" It's actually a philosophical question that few people in the economic world ever really ask.
In the case of Madoff, some very stupid people (including the Royal Bank of Scotland, which has lost $600m, and I have about a 30-millionth share in a 58% stake in RBS, so I make my loss on this deal to be about ten bucks) gave Madoff lots of money in return for a steady return of 10% interest. They counted the interest in cash (because it was) and they counted their investment as cash (even though it wasn't). In the first case (the interest) the cash was in their pocket. In the other (the investment), they simply had faith that it could be in their pocket if only they bothered to ask. You don't need to be a genius to know that there is a fundamental difference between that which you have and that which you have been promised, but that is a hard thing to put down in accountancy terms.
You can't count your invested cash as "nil", because, if you did, nothing would ever happen. Similarly, you can't count it at 100% because, if it is not in your pocket, there is a statistical chance that you won't get it back when you want it. So, being a good accountant and having studied all the latest Value-At-Risk models, you value it at, say, 95%.
The problem arises when it turns out that you were wrong. Indeed, when you value something at 95%, you MUST be wrong. It's either going to be 100% or 0% (this isn't precisely true, because of the complexities of recovery rates, but in terms of default, it's true. Either a company defaults, or it doesn't.)
So, in answer to the question, "where has the money gone?" you need to explain to the financially unsophisticated that "money" is not as simple a thing as they previously thought. In effect, RBS thought that it had $600m, but it turned out that it didn't have it at all. It had spent that $600m itself in the previous 10 years, when it was getting $60m a year in interest. It had thought that Madoff was paying it interest on its investment, whereas, in effect, it was giving RBS its own capital back. So, while RBS thought that it had $600m + $60m = $660m (and it wrote it so in its books), in fact it had $600m minus $60m plus $60m = $600m. Each successive year, as it booked its investment as safe and its interest as cash, it was writing false accounts.
That, in essence, is where the money went. In 2002 the profit booked (and the dividends paid) were based on a fiction. Shareholders in RBS who received those dividends should pay them back. Bonuses paid to bosses based on fictional profits should be paid back. And that's how we could get the money back.
Except, of course, that isn't how the system works.
Our entire system is based on this kind of 'faith', and even those deploying the "matress fund" technique are equal subscribers. You can't eat money. And, although you can burn it, it isn't a very efficient fuel (with the exception of hyper-inflation Germany in the 1920s, when money got to be so worthless that it actually was more efficient to use as fuel). Money won't stop you getting wet when it rains. "Wealth", in that sense, is a very basic commodity. Clothes (perhaps the compulsive shoppers aren't as stupid as we thought). Tinned food, a generator, fuel to run it (that would power a freezer and a fridge -- great wealth). A stock of painkillers. Candles. A musical instrument. Some books. Maybe some board games.
All that is fairly basic and depressing stuff. A "life" considered something beyond living a hovel-like subsistence existence in effect requires faith - faith that the cash in your pocket will be accepted by someone else for goods. Then, on a more sophisticated level, a faith that cash you have lent to someone else (such as, a bank) will be obtainable when you need it (and that, when you get it, you will be able to exchange it for goods that you need).
When the likes of Merdle (and Madoff) show that this faith can be misplaced, it chips away at the confidence in the whole edifice. The collapse of the interbank wholesale lending market was, in a way, an example of me going to Tesco and suddenly finding that the cash I had in the mattress wasn't any good any more. Many of us, in that sense, don't have a three-month or one-year 'cushion' at all. It's probably little more than week.
______________________
Meanwhile, through no fault of your own, people who have a legal right to take your money, promptly set fire to it in ways that no-one could make up.
I say that, but I note that Little Dorrit, which came to an end on BBC last week, made it up with uncannny prescience (well, not so much prescience from Dickens, as from the BBC in showing it when they did). For, in the last episode, Mr Merdle, the "man of the age", commits suicide when it becomes clear that his entiire financial operation was nothing more than a Ponzi scheme.
And, that very day, the Madoff $50bn empire was revealed to be exactly the same. Toujours la change...
This is going to be another case of "where has the money gone?" questions from the financially innocent, and statements such as "It's gone to money heaven" from the financially glib. But I don't think anyone will actually say where the money HAS gone.
IN a sense it heads down the old line of "what is wealth?" It's actually a philosophical question that few people in the economic world ever really ask.
In the case of Madoff, some very stupid people (including the Royal Bank of Scotland, which has lost $600m, and I have about a 30-millionth share in a 58% stake in RBS, so I make my loss on this deal to be about ten bucks) gave Madoff lots of money in return for a steady return of 10% interest. They counted the interest in cash (because it was) and they counted their investment as cash (even though it wasn't). In the first case (the interest) the cash was in their pocket. In the other (the investment), they simply had faith that it could be in their pocket if only they bothered to ask. You don't need to be a genius to know that there is a fundamental difference between that which you have and that which you have been promised, but that is a hard thing to put down in accountancy terms.
You can't count your invested cash as "nil", because, if you did, nothing would ever happen. Similarly, you can't count it at 100% because, if it is not in your pocket, there is a statistical chance that you won't get it back when you want it. So, being a good accountant and having studied all the latest Value-At-Risk models, you value it at, say, 95%.
The problem arises when it turns out that you were wrong. Indeed, when you value something at 95%, you MUST be wrong. It's either going to be 100% or 0% (this isn't precisely true, because of the complexities of recovery rates, but in terms of default, it's true. Either a company defaults, or it doesn't.)
So, in answer to the question, "where has the money gone?" you need to explain to the financially unsophisticated that "money" is not as simple a thing as they previously thought. In effect, RBS thought that it had $600m, but it turned out that it didn't have it at all. It had spent that $600m itself in the previous 10 years, when it was getting $60m a year in interest. It had thought that Madoff was paying it interest on its investment, whereas, in effect, it was giving RBS its own capital back. So, while RBS thought that it had $600m + $60m = $660m (and it wrote it so in its books), in fact it had $600m minus $60m plus $60m = $600m. Each successive year, as it booked its investment as safe and its interest as cash, it was writing false accounts.
That, in essence, is where the money went. In 2002 the profit booked (and the dividends paid) were based on a fiction. Shareholders in RBS who received those dividends should pay them back. Bonuses paid to bosses based on fictional profits should be paid back. And that's how we could get the money back.
Except, of course, that isn't how the system works.
Our entire system is based on this kind of 'faith', and even those deploying the "matress fund" technique are equal subscribers. You can't eat money. And, although you can burn it, it isn't a very efficient fuel (with the exception of hyper-inflation Germany in the 1920s, when money got to be so worthless that it actually was more efficient to use as fuel). Money won't stop you getting wet when it rains. "Wealth", in that sense, is a very basic commodity. Clothes (perhaps the compulsive shoppers aren't as stupid as we thought). Tinned food, a generator, fuel to run it (that would power a freezer and a fridge -- great wealth). A stock of painkillers. Candles. A musical instrument. Some books. Maybe some board games.
All that is fairly basic and depressing stuff. A "life" considered something beyond living a hovel-like subsistence existence in effect requires faith - faith that the cash in your pocket will be accepted by someone else for goods. Then, on a more sophisticated level, a faith that cash you have lent to someone else (such as, a bank) will be obtainable when you need it (and that, when you get it, you will be able to exchange it for goods that you need).
When the likes of Merdle (and Madoff) show that this faith can be misplaced, it chips away at the confidence in the whole edifice. The collapse of the interbank wholesale lending market was, in a way, an example of me going to Tesco and suddenly finding that the cash I had in the mattress wasn't any good any more. Many of us, in that sense, don't have a three-month or one-year 'cushion' at all. It's probably little more than week.
______________________
