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Complexification: Artificially making a simple Wall Street bailout into something seemingly complicated 2008 September 29 © 2008, Libertiny Financial LLC
Many years ago I coined the term “Complexification” to describe a person or group of people who make a simple problem artificially complicated. They do so by using a variety of tactics including industry jargon and catch phrases such as: 1) It’s technical 2) It’s exotic 3) It’s obscure 4) It’s too complicated to understand by the average person
The reasons for the creation of Complexification can vary from the creation of job security and an inability to understand the actual underlying simplicity of a problem to embarrassment because a person had a direct or indirect hand in creating the problem in the first place.
The failure of high-paid and allegedly intelligent management on Wall Street to understand the basic risks of leveraging your money and the fundamental lack of soundness of the collateral that is used to secure loans is the root cause of the present request for a bailout by Wall Street financial firms. The United States government is aiding these firms in the classic Complexification fashion by claiming that the underlying cause is too complicated to understand and that we, the tax payers, ought to just take their word for it and accept a rushed deal without ample time to review it.
Enough is enough.
Main Street does in fact understand the basics of what has happened. It’s the elitists in Manhattan and Washington D.C. who are naïve.
Here’s an example of what has happened: Say there are three large banks: 1) The Bank of Hank 2) The Bank of Ben 3) The Bank of George.
The Bank of Hank decides that it needs to make more money. But they don’t have any more money to lend. So instead of doing the hard work of obtaining new clients through better service and focusing on lending them money for mortgages at a reasonable rate, they take the easy route: They group together the mortgages that they do hold and borrow money against the underlying assets (the home mortgages) from the Bank of Ben. Complexification: The Bank of Hank calls this “financial leverage.” Simple Truth: You and I call this “gambling.”
The Bank of Ben makes money by charging interest to the Bank of Hank. And the Bank of Hank makes money by charging an even higher interest rate to its new mortgage clients than it’s paying to the Bank of Ben.
The problem for the Bank of Hank is that less people need the money. So the Bank of Hank decides to lower their lending standards and lend to people who are less likely to repay their mortgages.
A few years pass and as the economy slows, as it normally does in cycles, the Bank of Hank finds that its newer mortgage payers are unable to pay their loans back because they never had the income from jobs to support the higher mortgages. The Bank of Hank also didn’t know much about the ability of people to pay their mortgages. Complexification: The Bank of Hank calls this “a lack of due diligence.” Simple truth: You and I call this “not asking any questions.”
The Bank of Hank begins to lose money due to people not paying back their mortgages. They lose more money to the point that they can’t pay their bills: Interest on their customer’s savings accounts, loan payments to the Bank of Ben, and wages to their employees.
Instead of making the difficult decision of cutting costs and obtaining new clients, the Bank of Hank decides to borrow even more money, this time from the Bank of George. The mangers at the Bank of Hank just need “a little more time to get through this problem.” We’ve all heard this statement before. Complexification: The Bank of Hank calls this “a liquidity crisis.” Simple truth: You and I call this “not having enough money to pay our bills.”
The Bank of George agrees to lend the Bank of Hank money for 6 months. They’ve known the people at the Bank of Hank for a long time and don’t bother to do much up-to-date background research on the Bank of Hank’s ability to pay back this short-term loan.
Unfortunately, the Bank of George doesn’t have enough money for the Bank of Hank, but they don’t want to miss this opportunity to make “easy money”, so they arrange to borrow short-term money from the Bank of Ben. They charge the Bank of Hank more to lend the money to them than they pay the Bank of Ben and if all goes well, will make a profit on the difference. Complexification: The Bank of George calls this the “spread between LIBOR and LIBID” Simple truth: You and I call this “tying to make a profit by gambling.”
The Lending Pyramid Falls—Reverse Leveraging This is where it gets very simple. The Bank of Hank continues to have difficulty collecting on their risky mortgages and passes the Bank of George’s loan deadline of 6 months.
The Bank of George now wants its money back but the Bank of Hank is unable to pay.
The Bank of Ben wants its money back from the Bank of George because they start hearing about the money problems at the Bank of George--it’s a small world in the banking industry.
But the Bank of George can’t pay the Bank of Ben because they don’t have enough money due to the fact that they leant money that they didn’t have to the Bank of Hank. And as we already know, the Bank of Hank can’t pay the Bank of George because the risky loans that they made to consumers are not being paid back on time or at all.
It’s an inverted financial pyramid (see diagram on this page) that is falling over due to the inability of people to pay their mortgages. It’s falling fast due to the banks using leverage on their questionable mortgages. Complexification: Banks call this “reverse leverage” Simple truth: You and I realize that this is just a normal result from a lever, that by definition, can work in both directions.”
What Should Happen: As with any other company in a capitalistic society, the Bank of Hank needs to go bankrupt. Their managers screwed up and the outcome for any company under these circumstances is to go out of business.
The Bank of Hank still has value via its mortgages and these will be sold at a discount either to another party or to one of the other banks in this scenario.
Say the Bank of George buys the assets (mortgages and buildings) of the Bank of Hank. It takes a mid-term loss because the assets don’t fully cover the loans that it made to the Bank of Hank. But if the Bank of George is able to weather this loss, it will survive and could make some of the money back over the long-term by: 1) Making money over the long-term on the remaining mortgages 2) Selling the homes of people who can’t pay their mortgages at a significant discount. 3) Expanding to serve the Bank of Hank’s customers. 4) Selling the Bank of Hank’s buildings at a significant discount.
The Bank of Ben continues to demand that the Bank of George pay its loan back in full. The Bank of Ben will likely not get all of their money back so they cut a deal with the Bank of George and receive some of their money back today with a promise of future payments based on the Bank of George’s ability to pay. The Bank of Ben also sees a loss.
Lessons learned by the banks: 1) If you’re going to gamble, study the risks and have sufficient reserves to cover your losses. 2) Don’t gamble what you can’t afford to lose. 3) Study the present ability of the people you lend money to in order to determine if they can actually pay you back.
What the US Government is Trying to Make Happen: The government does exactly what the Bank of George did with the Bank of Hank: They lend even more money to the Bank of Hank. After all, the Bank of Hank just needs “a little more time to get through this problem.” We’ve all heard this before.
Lesson learned by the banks: 1) Take risks and the easy way out because the government will use tax payer’s money to bail you out.
Bottom Line: Main Street understands the above scenario inherently because we all have family and friends who have tried to borrow money from us when they need “a little more time to get through this problem.” Some of us make the mistake of loaning money under these circumstances. Some of us just give the money with the knowledge that we’ll never see a dime of it in return. It’s our choice.
In the case of the ongoing bailout of Wall Street during 2008, the US government has given us no choice. After all it’s easy to play with other people’s money when you don’t have any money in the game yourself.
The underlying reasons for the Wall Street failure are not complex. Unfortunately, Wall Street is hiding behind a wall of Complexification in order to obscure a simple reality: Their managers screwed up and they want us to pay for it. |
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