Underlying simplicity

A mentor of mine from the old days — to whom I owe my development into the brilliant consultant that I am today — once told me:

You don’t have to be an expert on a subject.
You just need to ask the right questions when interrogating a client.

Nick and GabbyD consistently ask the right questions here and here. Though the two obviously need a bit of help in understanding the concept of underlying simplicity, the quality of their questions was such that my response to them, yet again, warranted an entire blog post.

[This was all just supposed to be in a comment field, Nick. Honest! :D ]

That’s the burden of people who possess insight and a mind that roams free from the shackles of “expert” “thinking”. We just simply don’t run out of ideas to write, right leytenian?

So here we go. Underlying Simplicity. What a complex topic!

Or so we think.

I don’t know how many people here were lucid enough in the 1970′s to remember that the Manny Pacquiao of the time was a guy named Eugene Torre. Back then, the star international sporting hero of our little islands nation earned his stripes using brains.

Times have definitely changed, as the organ of choice for today’s “heroes” has obviously moved downward since those days [someday we're gonna go low enough so that my use of the term "flaccid" (with a double "C", Dean) becomes more, shall we say, tangible ;) ]. My point is that I think most of us here are familiar enough with the Sport of Kings (or is that Polo?) to relate with this latest koan of mine:

The game of chess is governed by simple rules, but a chess game can be complex.

In the case of The Ultimate Poverty Framework™, GabbyD, it provides a simple framework to describe the interrelated mechanisms that determine one’s prospects for gaining or losing wealth or, in the case of the Philippines, remaining chronically mired in down-to-the-atoms-that-make-up-the-dirt poverty.

In the case of the Financial Crisis, Nick, the underlying principle that makes it simple is this little koan that I keep repeating:

We locked ourselves into commitments beyond any inherent ability in us to honour them.

The way the above koan is worded is just a legacy of my previously using it in a blog post describing our Pinoy-style regard for poverty in really REALLY simple terms. With a few changes, we can make it a bit more generic:

Our inherent ability to honour commitments we are locked into determines our fortunes.

[Let's call the above Principle X to conserve a bit of FV bandwidth. I don't want to be accused of being pompously verbose here...]

To further compound the perceived complexity (but enhance the actual simplicity) of the matter, there is another principle that I brilliantly articulate in my previous blog post:

Our monetary system (and the financial system built around it) is an imperfect mechanism for quantifying wealth and keeping score of who has it, and who doesn’t.

[Let's call the above Principle Y to conserve even more FV bandwidth.]

The above tends to be the principle that dazzlingly be-credentialled “experts” in the “science” of economics tend to forget and the one they lose sight of as they imprison their minds with textbook jargon (such as the way they do here for example).

Note now, GabbyD and Nick, that what I describe — my TUPF and Principle X, in particular — are all scalalable in a Mandelbrotian sense. That is, they apply (and their structures hold) both at the micro and macro levels. And that’s where the elegant simplicity of the way great minds dissect issues lie. You need to be able to intuitively be aware of whether you are:

:D Discussing the game of chess;

- or -

:D Discussing a chess game.

So Nick, the Financial Crisis is simple if you understand it at the rules level — where they were fudamentally abused. As I describe the following to you, take note how many times the following come to mind:

;) Principle X
;) Elements of The Ultimate Poverty Framework™
;) Principle Y

(I might help you out about it along the way by adding a few italicised notes in brackets).

Here goes:

What the Ordinary Schmoe wants

Most people want to own their own homes. For most people, the only way to own a home is to borrow money to be able to buy one. Lenders, made comfy by a stretch of prosperous times, developed loan products designed for borrowers who could not afford to take on debt marketed via more conventional loan products. These new loan products were marketed aggressively to people who in more prudent times would otherwise have been excluded from the homeloan market. These people succumbed to clever marketing and by their own free will entered into the commitments stipulated in the small print of these products — most notable of which were the parts stating that you will need to pay back what you borrow [Principle X violation Number One].

What the banks tried to pull off

By definition, an asset is something that generates recurring income for its owner. So for banks, money lent is considered to be an asset, (because of the interest paid to it by those to which it lends money to). Some bright boys (“experts” like a few people here) hit upon the idea of chopping up these assets into smaller units that were smaller than their original unit of regard [in this case the original "unit of regard" is the loan account itself]. They then sold these pieces of assets in the market as securities — supposedly made “secure” by their “underlying” debt assets (the original loan accounts) held in banks that, in turn, were “secured” by the real estate that served as collateral. The tangible asset here, ultimately, is this real estate which had a one-to-one correspondence with (i.e., it was mortgaged against) the loan account. Unfortunately the value of the asset was no more than a perception (kind of like how a few roses on the front yard can jack up the price of a property by a few thousand dollars). [Pinciple Y at work, gentlemen]

The assumptions that made ASSes out of everyone.

Within the “mortgage belt” of most societies (particularly in that high-risk sector of society that these new products had been sold to), defaults on loans are pretty frequent to begin with. What made the planets align in this instance that triggered the chain reaction of implosion could have been a combination of already-inflated perceptions of the value of real property in those areas, and the additional (but still at the time unknown or mis-represented) risk to the system introduced by take up of the new debt products by a low-quality market. The stage had been set a long time ago as the accountants’ “expert” quantification of risk (an example of which is as what is stated in that little line item on the Liabilities side of most business’s balance sheets usually called “Provision for bad debt“) progressively became understated. While the risk of loan defaults increased, the assumed or estimated value in the Provision for Bad Debts thingy remained the same or was not increased proportionately.

Kung baga, if you are gonna lend to losers, you better assume that either (a) you won’t be paid back, or (b) you will be paid back only a portion of what you lent.

The “experts” apparently did not see it that way. Either that or they were too limp-dicked (as accountants and “economists” tend to be) to tell their bosses and the Alpha-male hotshots that sell these products what the real score really was.

Add to that the moronic notion (also propagated by “experts”) that the perceived value of real property will keep going up or at least hold stidi. In other words mortageees in The Belt assumed that, if you can’t pay your loan, all you need to do is (1) re-finance, or (2) sell your property and re-pay the loan in full.

So the possibility that the value of your property would actually contract below the amount of money you owed the bank did not become real until, well, the start of when things started to become interesting a year or two back.

———
Hmmm, maybe I’ll stop here for now and see if any further right questions will be asked.

Here are a few clues as to what the rest of the story is all about (decicated to the clueless amongst us):

:D Meanwhile, East and West of the U.S. Heartland, in those citadels of finance in San Francisco and New York, CEO’s and other Alpha-males borrowed even more money using mortgaged backed-securities as collateral to finance even more deals (adding to the height of the provebial House of Cards) …

:D Back in The Belt, defaults started to escalate as sub-quality mortgagees (a) failed to re-finance (banks woudn’t lend more than 100% of the value of the rapidly disappearing collateral) and (b) couldn’t sell at a high enough price to re-pay their existing loans …

:D Foreclosed property are, themsevles, put on the market by their new owners — the Banks — in attempts to liquidate that started to become even more desperate than the distressed mortgagees themselves …

:D Distrust spread as the quality of collateral and security became generally suspect amongst businesses. Banks stopped lending to one another, and money supply dropped within the financial system. Banks even withheld their cash from their client businesses, many of which used debt to fund working capital (inventory and receivables) — apologies for the jargon that creeped into the picture there. ;) …

:D Distressed businesses that ran out of cash (deprived of access to bridging loans, for example) downsized or failed altogether — putting, you guessed it, Ordinary Schmoes on the streets …

:D (Let’s get a bit macro here). The economy of the biggest manufacturer of useless trinkets in the world — China — depends on people addicted to useless tinkets for business. Useless trinkets start to get lower in the list of priorities when one suddenly finds himself unemployed. Go figure the rest …

:D The biggest suppliers of coal in the world (the fuel of choice for The Big Red One’s trinket manufacturing industries) then starts to get worried as well …

Which brings the story back to Yours Truly. What can I say. It’s all about me folks (with apologies to KG) and my self-serving agenda (right, Patricio?). ;)

As a result of this “worry” amongst countries pockmarked by coal mines, ordinary Australian schmoes get a bit of money from the government to the tune of about 10 billion dollars of our tax money doled out this Christmas to Aussie households with encouragement to us lucky sods to “go out and spend!”. If you consider that we are a country of only 20 million (with an even smaller number of households) Christmas here will be MERRY indeed — that is, of course, if you overlook the reality that such dimwitted measures such as doling out stuff tend to offer merely temporary solutions.

Sorry Mr. Rudd (and tough luck to the once “clever” marketers). But I’m keeping the cash for a rainy day. Nobody knows yet how far this “crisis” is yet to unfold.

It’s simple, really™ ;)

Nick and GabbyD, going back to the lesson underpinning all this — “experts” can tell you really complicated and, worse, convoluted stories (mostly narrative fallacies to explain stuff). But when you — the consumer of the dubious expertise that tends to proliferate amongst small minds — apply a bit of thinking, you improve your chances of finding the golden nuggets of underlying simplicity behind the noise.

And for those cluey enough to finish the the rest of the story in their heads, well, I’ll leave it up to you guys to figure out whether to spoil the ending (and stop moi from posting Episode II of this saga) by publishing their thoughts or hold back and wait for moi to articulate them for you with that elegantly brilliant simplicity that my fans have come to expect of me.

Merry Christmas!!

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