When E.F. Hutton talks, people listen.
-- Commercial
E.F. Hutton hasn't spoken in twenty years. Have you noticed the silence? No? I didn't think so.
I am about to embark on an analogy. I don't generally do analogies because eventually they all fall apart. But this one has helped me to understand what I see going on, and I think it will help you too. It's an analogy to highschool, and it goes pretty far before it falls apart.
--start of analogy--
In this scenario, we have a highschool full of students. The highschool is the economy and the students represent the investments in that economy. The parents are the owners of those investments and the teachers are the bankers and brokerage firms responsible for watching and grading those investments.
So everybody wants every student to perform in this school, and the teachers are responsible for making sure that they do. So the teachers select a mix of students. Some teachers have advanced classes and high standards others, not so high. In fact Miss Lehman and Mr. Merrill were mixing a lot of subprime students into their classes.
Their argument was clear, and they had a lot of support. Just because these kids are subprime and come from poorer communities doesn't mean they too can't have the American dream, they said. So Miss Lehman said, in fact, I am going to stake my reputation on my ability to keep these subprime students afloat. Both she and Mr. Merrill to the hurrahs of most everyone said that the solution was to give extra credit. So they gave the subprime students extra credit and figured that sooner or later, they would perform.
But the fact of the matter was that when it came to passing their midterms, a lot of these students were flunking. In fact, a lot higher percentage of them were flunking than anybody suspected. The extra credit didn't help. In fact, it made the parents think that their kids were OK, but the parents didn't really look closely at the curriculum. They didn't realize that over time, the easy stuff would end and that because they weren't performing they'd have to go to summer school.
So Mr. Merrill had to flunk some of his students and so did Miss Lehman. In fact, the other parents started to doubt the reputations of Merrill and Lehman, so much so that they started to pull their kids out of their classes and put them in other classes. The problem was that Lehman and Merrill, but especially Lehman did not put their non-performing students in detention. They didn't want to declare them as bad kids, and kept using euphemisms and putting their reputation on the line. All the other teachers knew this - they started clearing their classes of subprime students who were bringing down the curve and threatening the reputation of the entire school. It took several years to reverse the trend. Mr. Stearns was the first teacher who got fired, still Lehman thought she could pull it off.
In the end, Merrill saved his class but now he's lost tenure, he's a substitute and all of his pupils are now going to be taught in the big lecture hall. Lehman has now been let go, and all of her students have to go elsewhere.
How is the school? Well, the good students are still good students and the good teachers are still good teachers. But nobody gets any extra credit any longer, and nobody gets graded on a curve any longer. The small, specialized classes for subprime students are all on the way out, and that's bad news for the OK students too because, well standards are back.
--end of analogy--
Somebody said yesterday that banks take your $1 and loan out $10 and that is how money is made. They literally bank on the chance that you won't demand too much of your $1. Because if you do, they'll have to demand a lot of their $10. Interestingly enough, people are making side bets that those $10 will be good, and when they lose those bets - when the banks say that they can't collect, then more people demand more of that $1. That's why the side bets are always in jeopardy, especially when the banks are not being honest about some fraction of the collectability of the $10.
So how much of the economy is the $1 and how much of the $10 is legitimately OK? That's the real economy, and that real economy is doing fine. How much of that $10 is not particularly legit, and how big are the side bets? That's the less-real economy, and that's the stuff that is in danger. The figure has been between $300 and $600 billion is the less-real economy. Some of that are bad assets, and the most visible part of it is the goodwill in stock valuation of the management capabilities of those bankers, which is what the Dow is pricing out as we speak.
When I watch CNBC, I listen for clues as to changes in that 300-600 billion figure, and I try to figure out by stock price which financial institutions have lost the faith that they can manage their securities. But I understand, which is why I don't panic, that the securities themselves are no more good or bad than they ever were. It's just about how much junk securities we can handle. Subprime mortgages are the people's junk bonds.
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