AIG Implodes: The Two Cows Version

What most nongenius explainers do is make up a different and less complicated story, which is not actually true, and explain that instead.

Decoherence is too complicated? Make up some other story about "quantum physics" and explain that instead.

Nonstandard models of Peano Arithmetic are too complicated? Make up some other story about Godel's Theorem and explain that instead.

The best one-line explanation of the financial crisis that I ever heard was as follows: "Mere stupidity is never enough; people have to pile stupidity on stupidity on stupidity."

Reality is a lot more complicated than this.

[edit] In real life terms: anyone who promoted the idea that renting is a waste of money is an accomplice to this bubble.

Let walk through the first couple of sentences:

>> "John Paulson borrows one cow so he can sell it for $100. He gives you $10 as collateral."

No one in their right mind lets someone walk away with a $100 cow for a $10 deposit. If you are a car rental company, you don't force the borrower to deposit the full price of the car, but you make up for this risk in volume across many car deposits and you have insurance and the backup of public crime fighting organizations. If you have a single page contract for "you borrow my cow and give it back later, here's a $10 deposit" you have none of this.

Second is the use of the term "borrow". If I loan you a cow and you return a different cow, this may not be acceptable to the lender. This is not "borrowing".

>> "You buy your neighbors cow for $100, which you finance by taking out a $90 loan from the bank and use John's $10 to make up the rest."

ok, full stop!!! No bank operating correctly will give you a loan against a cow that you have already loaned to someone else. This is the root of why people use the term "ponzi scam" in reference to such transactions.

>> "You brag to everyone about your financial health. You have assets--two cows you own, plus one Paulson owes you--worth $300, and liabilities of just $100."

Sorry, there are still only two cows in this story. This is not software where you can magically copy a cow.

And so goes the problems with analogies like this.

Don't get me wrong. The blog author writes it well and gives a peak at the absurdity of the financial system. Unfortunately, the financial system is so absurd that there are no useful metaphor against real world goods.

Bob has two cows, each worth $100.

Jane buys one cow from Bob, paying him no money down and borrowing $100 from the bank. She says she'll pay the bank back with milk money, or refinance when the cow becomes worth $120 in two years. The bank, sensibly, is worried about the cow dying, so they take out a life insurance policy on the cow.

Now as it turns out, the cow is sickly so ordinarily a life insurance policy would cost a lot of money. So rather than insuring one cow, the bank buys insurance on an entire herd of cows at the same time. They're all sickly cows. Oh well, no worries. If the cows are insured by a healthy company there is no way the bank can lose.

Then the bank gets a bright idea: rather than holding the deed to the cow on their book, they securitize the loan revenues from the entire herd, which are contingent on the milk flowing from still living cows BUT insured by a reputable insurance company. So even though these cows are two steps from death's door why, the security is fairly safe. To make it totally safe, they divide it up into different tranches.

There is an AA tranch, which is the best sickly cows. Then a BB tranch, which is the second best cows. Then another tranch, which is cows who are laying down and leaking polychromatic pus. And they're all insured.

But selling that last tranch is pretty difficult, so the bank gathers up several copies of that tranch from multiple herds, makes a synthetic herd out of it, and then among the almost-dying sickly cows there are most-healthy-but-still-almost dying "AA"s again. Yay! Sales. This lets them lend out more money to more people to buy sickly cows, the rights to whose loans they securitize and sell, etc. They make tons of money doing this.

Now why on earth is AIG selling insurance to this bank?! Because they look at their death rates for cows table, which is for the usual mix of QUITE HEALTHY COWS and sickly cows (not herds of sickly cows, and not synthetic herds of the sickest of sickly cows), and decided "cows don't die much, so selling insurance on them is pretty much a can't lose proposition". So they set their rates on cow insurance very freaking low: $1 to insure $100 of cow for a year, no problem!

Then somebody comes up to AIG and says "Hey, you're selling the bank insurance on cows they don't even really own, since they're selling the cow loans off". AIG says "Yep, pretty much." Customer says "So you're essentially taking bets that cows don't die." Yep, pretty much. "I don't own a cow, but I'd like to bet that that there cow dies anyhow. Will you take me up on it?"

And AIG does.

Then people start buying and selling these bets on the life of cows TOTALLY UNCONNECTED TO THE COWS THEMSELVES, because they make oodles of money on transactions. There are notional trillions involved in cow-death bets, because every time they are sold rather than being transferred there is generated one "that cow lives" and "that cow dies" contract. It gets really complicated, but it is all safe, because all the cows are ultimately insured by AIG, and AIG is safe because cows don't die.

Cows die. And then all the people in the system who bet on cows dying go to AIG and say "Hey, I paid you $1 insurance premiums to insure $100 worth of cow. Approximately one billion dollars worth of cow just died. OK, fair's fair: pay me $100 billion."

BOOM. AIG threatens to topple. And then all the people who owned loans-on-dying-but-safe-because-they-are-insured cows now suddenly only loans-on-dying-cows. Whoops, make that loans-on-dead-cows.

1) Hard to milk a dead cow.

2) Hard to sell a dead diseased cow in this market since there is a whole lot of dead cow meat suddenly available (and much of it doesn't have polychromatic pus).

3) You've sold the notional rights to the repayment on the dead cow loan so many times you're not even sure who has standing to repo the actual dead, rotting carcass. Meanwhile it decays more every day, further losing notional value. You have to come clean and say "The dead carcass which I can't even identify as mine is worthless" but if you do your firm will probably collapse because you own an awful lot of loans-on-dead-cow because they looked like something of a deal at the time.

BOOM. Financial crisis.