On Not Learning The Lessons Of Long-Term Capital's Failure

[mheslep]

It's a tangible asset. There's some inherent value of the land and house, and it is more than zero. A derivative is simply a sidebet on the outcome of some other financial event; without any direct involvement with the financial event being wagered on.

Alright a side bet, instead of the main bet.

 

[Al68]

I'm sorry Al68, but despite my best efforts, apparently at the moment I don't have the skills to explain this fairly simple thing to you with any more clarity.

Well, I have a fairly good idea about your beliefs, but I don't want to be presumptuous and jump to conclusions.

Bottom line is, the only thing I have a problem with is people using force against other people to obtain ownership of wealth. If someone just doesn't recognize private property rights, but also doesn't want to use force against anyone else to claim ownership of their property, that's just as good in my book.

 

[russ_watters]

Sorry if I'm missing something here, I haven't been following the thread much, but this one jumped out at me:

It seems inevitable that prices will rise faster than the income of the mass of consumers. So, the standard of living for most people is, inevitably, being steadily eroded.

Where do you get that from? It has never been anywhere close to true for the US over the long term or for any income bracket.

Not only is it not true as an overall principle/average, it is even worse when applied to individuals. The fact that average incomes rise through history means odds are better than 50/50 that at age 40 you'll be better off than your parents were at age 40, at age 50 you'll be better off than your parents at age 50, etc. But due to learning and experience, it is almsot never true that a person is better off at age 40 than they will be at age 50.

There is a third level to the issue, an additional reason why what you said is wrong: we use a sliding scale to measure standard of living. Based on the scale we used, people say that the poverty level hasn't dropped much since the 1980s (for example), but the fact of the matter is that people living on on any point in the demographc curve (say, at the median point) have better houses, better cars, more toys, more money for entertainment, etc. than people who lived on the same point in the curve previously. Now 3a would be that average family size is decreasing, so in addition to being able to buy a bigger house than a median income earner did years ago, for example, you also fill it with fewer people today.

 

[russ_watters]

Alright a side bet, instead of the main bet.

There's still a big difference in risk, though, since one bet has a very real chance of losing all of the principle and the other doesn't have any chance whatsoever of losing all the principle (for all practical purposes).

Lumping all "bets" together is a major fallacy by which people misunderstand investing and even just risk in general. Packaged equities based directly on mortgages are not bets like a lottery ticket or 00 on the roulette wheel. They are fixed-income and extremely low risk - exactly what you want to base a stable, constantly in use retirement fund (for example) on. Short of an asteroid taking out half the country, it isn't possible for them to lose even a small fraction of their principle, even in the short term*.

The stock market is similar, though not as low risk (or limited return). Once companies are big and stable enough to be listed on an index, the odds of losing all of your principle are extrordinarily low and your investments should be structured in such a way that absorbing a short term 40% loss shouldn't be that big of a deal (ie, if you are two years into retirement, you shouldn't have much money in the stock market anymore)

Derivatives, on the other hand, are much more like a plain/ordinary casino gamble, easily possible to lose everything you put into it. [edit] Actually, it is more like a casino where they give you credit. It is actually possible to lose more than you put into it, via credit.

*Let me quantify that: the median home price in the US is down something like 15% from its peak (having trouble finding the exact, but here's a link that says 12.4% in 2008, where most of the loss was: http://www.inman.com/news/2009/02/12/median-us-home-price-falls-124 ). That means that a mortage-backed security has a hard asset backing 15% lower than when it was bought. And in order for that theoretical 15% loss to become real, people have to default on their mortgages.

 

[mheslep]

There's still a big difference in risk, though, since one bet has a very real chance of losing all of the principle and the other doesn't have any chance whatsoever of losing all the principle (for all practical purposes).

I agree, my point is there is risk on both, the difference being a matter of degree. I think it is not fair to call one evil and pretend there is no risk in the other.

Lumping all "bets" together is a major fallacy by which people misunderstand investing and even just risk in general. Packaged equities based directly on mortgages are not bets like a lottery ticket or 00 on the roulette wheel.

Well it depends on how many numbers one covers on the wheel - again its a matter of how great a risk you want to assume.

They are fixed-income and extremely low risk - exactly what you want to base a stable, constantly in use retirement fund (for example) on. Short of an asteroid taking out half the country, it isn't possible for them to lose even a small fraction of their principle, even in the short term*.

The stock market is similar, though not as low risk (or limited return). Once companies are big and stable enough to be listed on an index, the odds of losing all of your principle are extrordinarily low and your investments should be structured in such a way that absorbing a short term 40% loss shouldn't be that big of a deal (ie, if you are two years into retirement, you shouldn't have much money in the stock market anymore)

Derivatives, on the other hand, are much more like a plain/ordinary casino gamble, easily possible to lose everything you put into it. [edit] Actually, it is more like a casino where they give you credit. It is actually possible to lose more than you put into it, via credit.

*Let me quantify that: the median home price in the US is down something like 15% from its peak (having trouble finding the exact, but here's a link that says 12.4% in 2008, where most of the loss was: http://www.inman.com/news/2009/02/12/median-us-home-price-falls-124 ). That means that a mortage-backed security has a hard asset backing 15% lower than when it was bought. And in order for that theoretical 15% loss to become real, people have to default on their mortgages.

I believe you're underestimating the risk in MBS's, looking at this from more from a homeowners point of view, not the lender. The decline may be only on paper for the homeowner, and he/she can keep living in the house forever even if the market were to value it at zero. The lender does not have that luxury, the property has no value to the lender whatsoever other than its market value. The lender has to deal with 'mark to market' on a day to day basis when accounting to regulators or when borrowing money overnight. Recognize that the lender is itself borrowing near every dollar it lends from someone else (depositors, etc), and that it has to keep paying some nominal rate on every one of those borrowed dollars. The lending institution does not have the option of saying, in effect, 'we are not doing that bad, we only wiped out 15% of our investors, the rest of you are ok'. The bank itself is in default in such a case.

While the countrywide median home decline may not be that bad, in broad down turns like this property actually in default often declines in value to the lender by more than half. For one thing, the lender is almost certain to have its income stream on the defaulted and about to default properties go to zero for at least many months, and that income is gone forever.

 

[ThomasT]

Where do you get that from? It has never been anywhere close to true for the US over the long term or for any income bracket.

Thanks for the input. I was just guessing. Turns out I was wrong. However, there is a portion of the workforce for which prices do increase faster than income, ie., whose buying power is steadily eroded. I'm not sure where in the income spectrum this begins.

 

[mheslep]

Thanks for the input. I was just guessing. Turns out I was wrong. ...

I'm still curious: where would you say your information comes from that forms the background for that guess?

 

[ThomasT]

I'm still curious: where would you say your information comes from that forms the background for that guess?

I'm still curious too.

As I mentioned in one of my posts, I know very very little about the big economic picture -- just a lot of not fully explored or thought out ideas about things. I was just wondering about the implications of a truly or totally free market economy after the contributions by Brilliant!. These are considerations for another thread in the philosophy or economics forums I suppose, since I'm not sure how to relate it to the OP by Ivan Seeking. On one hand, taking things as they are (ie., we don't have truly free market capitalist economic system -- and it seems to be getting further away from that ideal with time), then regulating or constraining certain possible behaviors of financial sector participants seems to be the only answer to abuses that contribute to problems such as the current one. I was thinking that a significant influsion of currency into the mass, real market, consumer economy coupled with price capping might help things. But of course there are problems associated with that approach. On the other hand, we might, as has been suggested, begin a program of deregulating things to an extent that the current population has never experienced. And of course there are problems associated with that approach also. One of my questions on this was that if the buying power of a certain portion of workers (say, the bottom 10 to 20 per cent on the income spectrum) is inevitably, steadily eroded under the current system, then wouldn't an even larger percentage be similarly adversely affected in a free (or significantly freer) market system.

Regarding your question, I just Googled a lot of different queries about income, and inflation, etc. I'm just learning about the different indicators and indexes involved in macroeconomics. From my rather hasty scans of the databases that I discovered, and from a therefore necessarily shallow and narrow understanding of it all, I got the impression that the buying power of a significant portion of the nation's workforce was, more or less steadily, declining. How this relates to 'standard of living', I don't know exactly. What Russ said made sense to me. People in this country do, after I thought about it some more, generally seem to me to be better off in most ways that I would deem as being relevant to 'standard of living' than they were, say, 40 years ago, or 80 years ago. And, there doesn't seem to be any 'real' poverty of the destitute and hopeless sort that other, especially developing, countries have. If this is true, then I'm curious about whether or not this 'well being' would be as general under a truly free market system as it is (or at least as it seems to me to be) under the hybrid system that has characterized US economics since ... whenever (I don't know if we ever had a truly free market capitalist system, or, if we did, when it first changed toward the mix that it is now.).