An utterly basic question about losing money

[GlennB]

Please be gentle.

If I bet £10 on a golfer - and he fails in his quest - I have lost £10. The bookie has my 10 quid.

If I sit down to play poker with some friends and end the evening up £50 then someone (or ones) has lost £50. I have the 50 quid.

If AIG "lose" $62 billion, who has the $62 billion?

;)

[drkitten]

If I bet £10 on a golfer - and he fails in his quest - I have lost £10. The bookie has my 10 quid.

If I sit down to play poker with some friends and end the evening up £50 then someone (or ones) has lost £50. I have the 50 quid.

If AIG "lose" $62 billion, who has the $62 billion?

No one. "Lose" is ambiguous that way; to an economist, you didn't "lose" ten quid, you simply paid it to your bookie.

But if your house, valued at a hundred thousand quid, suddenly burns down, then you definitely "lost" the value of your house.

Or even if your house drops in value, because your neighbor's house burned down and no one wants to live next to a burned out wreck.

[Blackadder]

Is it true that I can buy houses for $5000 or even less in Detroit these days?

[Random]

Please be gentle.

If I bet £10 on a golfer - and he fails in his quest - I have lost £10. The bookie has my 10 quid.

If I sit down to play poker with some friends and end the evening up £50 then someone (or ones) has lost £50. I have the 50 quid.

If AIG "lose" $62 billion, who has the $62 billion?

;)

They didn’t “lose” $62 billion. They bet $62 billion that housing prices would go up and lost, then realized they didn’t have the money to cover their losses. That’s why they have to go begging for cash from Uncle Sam.

It’s like you have a hundred dollars in cash, call a bookie and place a thousand dollar bet on a “sure thing” which invariably loses. You haven’t actually lost a thousand dollars, since you didn’t have it in the first place. This logic will not appeal to the large man named Vinnie who is currently pounding on your door.

Insurance companies are basically casinos. They figure out what the cost of something bad happening is, divide that by the odds of that thing happening, then add a house edge, or “premium”. If they have calculated the odds right, then they will make money over the long term. If there is a 5% chance of a Collateralized Debt Obligation (CDO) failing, charge 5.2% for the insurance and get twenty CDOs to sign up. The insurance company gets the equivalent of 104% of a CDO in income, one of the twenty fails and the insurance company pays out, leaving 4% for the insurance company.

Unfortunately, AIG radically underestimated the risk of the CDOs. They really should have known better, since they were getting risk shoveled onto them and anyone with a brain should have realized that the entire subprime market was based on the untenable idea that the housing bubble would last forever. But they were stupid and the AIG casino put wrong odds on all their games.

AIG suddenly finds defunct CDO operators showing up at their doorstep with contracts saying that they are owed hundreds of billions by AIG, which AIG does not have.

[tkingdoll]

Please be gentle.

If I bet £10 on a golfer - and he fails in his quest - I have lost £10. The bookie has my 10 quid.

If I sit down to play poker with some friends and end the evening up £50 then someone (or ones) has lost £50. I have the 50 quid.

If AIG "lose" $62 billion, who has the $62 billion?

;)

You assume that $62billion existed as actual cash. That is not the case. Your £10 was money in your hand, not a number assigned to a concept. No-one actually had the $62billion, it's more that XYZ that used to be valued at that level is now valued at a lower level, or the concepts it was based on are no longer valid.

[drkitten]

Is it true that I can buy houses for $5000 or even less in Detroit these days?

I believe so, but in this instance as in so many others, Google is your friend.

It's also almost certainly true that you don't want to buy the house that is available for $5000; it's likely not to be inhabitable. If nothing else, by the time a house drops to that level, it's very likely that the vultures will have been by and stripped it of everything that can be sold on the secondary market, including pipes, wiring, floorboards,....

[drkitten]

They didn’t “lose” $62 billion. They bet $62 billion that housing prices would go up and lost, then realized they didn’t have the money to cover their losses.

Not quite. A lot of the money was quite real, but it was in the form of investments that went south. The CDO's, for example, are typically backed by real assets in the form of houses; if you bought a CDO worth $500 million, then there was $500 million in real estate behind it.

And now you're in exactly the same position as the person who watched his neighbor's house burn down and cost him half the equity in his home.

A better analogy would be that you had $500 in stock, and you went to the bookie and bet $250 on a "sure thing." Normally, even if you lost the bet, you wouldn't be hurting because you could still sell your stock to cover yourself.

But in the time it took to settle your (losing) bet, the stock dropped $400 in value.

NOW you're in trouble.

[Random]

Not quite. A lot of the money was quite real, but it was in the form of investments that went south. The CDO's, for example, are typically backed by real assets in the form of houses; if you bought a CDO worth $500 million, then there was $500 million in real estate behind it.

AIG was not buying or selling CDOs however, they were in the business of insuring them against losses. The increasing value of the property was only important to AIG in the sense that it would keep the CDO profitable so AIG would not have to pay out. This means that AIG could be on the hook for more money than they ever actually saw.

A CDO decides it wants to buy $100 in insurance, and calls AIG. AIG says the chances of a CDO failing are 5%, so they charge the insurance company 6% or $6. They get nineteen other CDOs to make the same deal, $100 dollars of insurance for $6. So 20 CDOs give AIG a total of $120. AIG figures one will go under, AIG will pay out $100 and then pocket the remaining $20.

Then half of them CDOs fail. Ten guys call up AIG each asking for their $100. AIG is on the hook for a thousand dollars, but it only has $120 in the bank. AIG needs $880 in a hurry, and the only one who can bail them out is the Uncle Sam. Uncle Sam doesn’t want to bail out AIG since they were stupid ****s, but if they don’t then the CDOs won’t get their insurance money, and instead of one big failed institution, you will have one big failed institution and ten smaller failed institutions.

AIG has screwed up so big Uncle Sam has to help.

[GlennB]

AIG was not buying or selling CDOs however, they were in the business of insuring them against losses......

A CDO decides it wants to buy $100 in insurance, and calls AIG. AIG says the chances of a CDO failing are 5%, so they charge the insurance company 6% or $6. They get nineteen other CDOs to make the same deal, $100 dollars of insurance for $6. So 20 CDOs give AIG a total of $120. AIG figures one will go under, AIG will pay out $100 and then pocket the remaining $20.

Then half of them CDOs fail. Ten guys call up AIG each asking for their $100. AIG is on the hook for a thousand dollars, but it only has $120 in the bank. AIG needs $880 in a hurry ....

Thanks for all the replies. Now, to continue the betting analogy:

Would it be fair to say, then, that here AIG have effectively been acting as the bookie? That they have been offering odds of 6-1 about an event when the true odds were more like evens, and the punters have bet heavily at 6-1 and watched their "horse" romp home ?

[LTC8K6]

$5,900; 1 ba 1,422 sqft Single-Family Home

http://thumbs.trulia.com/pictures/thumbs_3/ps/8/0/a/6/picture-uh=cbd73f3bce7418ed6021ca34d5acbfe2-ps=80a6e842514f63d53c4820642ad99585--Alter-Rd-Detroit-MI-48215.jpg

$10,000; 3 br 2 ba 1,131 sqft Single-Family Home

http://thumbs.trulia.com/pictures/thumbs_3/ps.2/7/1/2/1/picture-uh=a995cd8cc279bb52fc0393af34ef2e2-ps=712107cd73de06e6297d664f8e23cc9-20521-Pelkey-St-Detroit-MI-48205.jpg

$10,000; 3 br 1.5 ba Single-Family Home

http://thumbs.trulia.com/pictures/thumbs_3/ps/7/7/9/c/picture-uh=9192a9554248daeb38446a9d977784e2-ps=779cfe3d1fb413bc12da583fc248d1-12606-Longview-St-Detroit-MI-48213.jpg

[a_unique_person]

I believe so, but in this instance as in so many others, Google is your friend.

It's also almost certainly true that you don't want to buy the house that is available for $5000; it's likely not to be inhabitable. If nothing else, by the time a house drops to that level, it's very likely that the vultures will have been by and stripped it of everything that can be sold on the secondary market, including pipes, wiring, floorboards,....

"Four Corners" had a story on this two yeas ago, when the Sub Prime was only just taking off. They were at an auction of a perfectly good house that could not be sold. It was worthless because the area was losing value, and it would be stripped of anything of any value in no time.

Transcript http://www.abc.net.au/4corners/content/2007/s2035637.htm

Web video
http://www.abc.net.au/4corners/content/2008/20081013_debt/interviews.htm


MARK SEIFFERT, HOUSING ACTIVIST, CLEVELAND OHIO: It’s devastating. I mean, you know we’ve had, in Cleveland there's supposedly about 80,000 property units, buildings. Ten thousand of those are vacant as of today. And we’re seeing foreclosures increasing by more than 300 per cent over the last couple of years.
.................
PAUL BARRY: If anywhere is ground zero in this terrible mortgage meltdown it’s America’s Midwest.
Cleveland Ohio is one of the cities that made America the greatest industrial power this world has ever seen. Its steel mills and machine tool factories once worked round the clock to help Ford and General Motors knock out cars by the million.
Now it’s known as the rust belt. Its factories are closing, its jobs are going, its inner city is emptying as whites flee to the suburbs.
In Cleveland one in 20 homes are now in foreclosure.
BARBARA ANDERSON, HOMEOWNER, CLEVELAND, OHIO (showing Paul Barry around the neighbourhood): What we have here is at the very end of this street is you have three houses - one, two, three - that are vacant and been vandalised over the course of the last 12 years actually ...
PAUL BARRY: It’s no longer just black Americans like Barbara Anderson who are suffering.
BARBARA ANDERSON, HOMEOWNER, CLEVELAND, OHIO: This devastation has creeped from Cleveland, from the inner city all the way out into our suburbs, both the inner and outer ring suburbs and now people are paying a little more attention simply because of now who it’s hurting.
PAUL BARRY: Barbara Anderson has lived on Cleveland’s East Side for the last 27 years and she's seen the neighbourhood fall apart around her, with a great deal of help recently from what is known as predatory lending.
BARBARA ANDERSON, HOMEOWNER, CLEVELAND, OHIO: What has happened is that our street has gone from a street that once was full of children laughing and talking and playing, to a street where half of it has been wiped out. The houses are boarded up, they’re empty, vacant, vandalised and they offer a real threat to our community.

[Francesca R]

Would it be fair to say, then, that here AIG have effectively been acting as the bookie?Yes--that's what an insurer does. Except that the "odds" are not based on other bets placed but on probabilities derived from risk assessments which failed. Pooling of risks--which is insurance--is OK as long as you don't miss a common factor that sends them all the same (wrong) way in correlated fashion. Most of AIG's mainstream business was not affected by such, but the credit default swaps it wrote (not CDOs) were.

[oggiesnr]

Would it be fair to say, then, that here AIG have effectively been acting as the bookie? That they have been offering odds of 6-1 about an event when the true odds were more like evens, and the punters have bet heavily at 6-1 and watched their "horse" romp home ?

More to the point a bookie adjusts his odds so that over the whole range of runners he should make a profit on each race no matter who wins. Won't always happen and if too many favourites win on any day he may make a loss but he will always carry enough cash to settle his bets.

The difference with AIG is that they had no way of evening out all the bets and exceeded their reserves big style.

Steve

[Francesca R]

The difference with AIG is that they had no way of evening out all the bets and exceeded their reserves big style.The spread of a CDS evens out the bets--there will always be as much money buying protection as there is selling it, and AIG (or anyone) could probably have made its book default-neutral. It decided not to.

Note--there is a big difference between a credit default swap and a collateralised debt obligation. The former is purely a contract for differences on a credit event, the latter is a (well--should have been a) real asset (except the real value has createred for many of them).

[GlennB]

So, AIG cannot pay out on the insurance.

Presumably (ultimately) various financial institutions that provided mortgages on overvalued properties are left with the properties that are now worth less than the mortgage provided. And their insurance can't make up the difference. Would that be a fair assessment?

If so, would it also be fair to say that the original vendors of those properties (whether individuals or institutions) have shown a total 'profit' equal to the 'loss' now being suffered by the mortgage providers*? That is, no money has gone missing (as it were), just that the money has become diffuse rather than concentrated in the hands of major institutions. Expressing it in terms of a really big poker game, there have been many small winners but a few gigantic losers?

* I use this term loosely, realising that these debts have been bundled, traded and who knows what-all.

[Puppycow]

Yes--that's what an insurer does. Except that the "odds" are not based on other bets placed but on probabilities derived from risk assessments which failed. Pooling of risks--which is insurance--is OK as long as you don't miss a common factor that sends them all the same (wrong) way in correlated fashion. Most of AIG's mainstream business was not affected by such, but the credit default swaps it wrote (not CDOs) were.

Yep. Their risk assessments didn't account for black swans.

[Francesca R]

So, AIG cannot pay out on the insurance.No it can--but only because it has been bailed out by the Federal Reserve. That was the point--to rescue AIG so that the spoke-and-wheel arrangements of AIGs guarantees against other bonds defaulting did not shatter. This was judged too pervasive (through the global payments system) to be permitted to break down. Now it might not have been--recall that the (first) bailout happened about three days after Lehman Brothers was not rescued. And Lehmans had been broker-dealer to a huge amount of CDS insurance itself, and there was a huge amount of CDS insurance bought/sold on Lehman's own debt too. And those CDSs mostly settled fine, actually. But the bankruptcy of Lehman Brothers exacerbated the broader credit crisis in other ways.

Presumably (ultimately) various financial institutions that provided mortgages on overvalued properties are left with the properties that are now worth less than the mortgage provided. And their insurance can't make up the difference. Would that be a fair assessment?Sort of *hesistates to attempt more convoluted explanation*

If so, would it also be fair to say that the original vendors of those properties (whether individuals or institutions) have shown a total 'profit' equal to the 'loss' now being suffered by the mortgage providers*? That is, no money has gone missing (as it were), just that the money has become diffuse rather than concentrated in the hands of major institutions.Not really, no. There was a net destruction of value.

[Francesca R]

Yep. Their risk assessments didn't account for black swans.This is correct, but strictly you can use "failure to account for black swans" to declare everyone responsible for what happens to them. For example, if Sid the builder has to stop trading because of a crappy economy and the withdrawal of working capital from the bank to pay his lads, you can say that his risk assessments didn't account for black swans like a global credit crisis and the worst recession for decades.

[Puppycow]

So, AIG cannot pay out on the insurance.

Presumably (ultimately) various financial institutions that provided mortgages on overvalued properties are left with the properties that are now worth less than the mortgage provided. And their insurance can't make up the difference. Would that be a fair assessment?

If so, would it also be fair to say that the original vendors of those properties (whether individuals or institutions) have shown a total 'profit' equal to the 'loss' now being suffered by the mortgage providers*? That is, no money has gone missing (as it were), just that the money has become diffuse rather than concentrated in the hands of major institutions. Expressing it in terms of a really big poker game, there have been many small winners but a few gigantic losers?

* I use this term loosely, realising that these debts have been bundled, traded and who knows what-all.

Only in a few cases. If someone sold their house at the peak of the bubble and didn't immediately buy another house, they made a profit, but those cases are few and far between. Most homeowners actually have equity in their house and that has simply disappeared. When assets lose market value, nobody gets the difference. It just evaporates into thin air.

[Random]

If so, would it also be fair to say that the original vendors of those properties (whether individuals or institutions) have shown a total 'profit' equal to the 'loss' now being suffered by the mortgage providers*? That is, no money has gone missing (as it were), just that the money has become diffuse rather than concentrated in the hands of major institutions. Expressing it in terms of a really big poker game, there have been many small winners but a few gigantic losers?


Sort of. As usually happens in speculative bubbles, a lot of the "missing" money is in the hands of those lucky individuals who were the last ones out before the (housing) bubble burst. They did ok, some of them quite well. Everyone else got hosed.

A lot more of the money never really existed in the first place. If you own a hundred homes and everyone offers you $250k for a home, you can say you have $25 million in assets, since the homes are "worth" $250k, even if you don’t have $25 million in cash.

But if suddenly people are only offering $100k for a house, your pile of houses is only "worth" $10 million. You have suddenly "lost" $15 million, even if you don’t sell a single home at the reduced price.

[oggiesnr]

A lot more of the money never really existed in the first place. If you own a hundred homes and everyone offers you $250k for a home, you can say you have $25 million in assets, since the homes are "worth" $250k, even if you don’t have $25 million in cash.

But if suddenly people are only offering $100k for a house, your pile of houses is only "worth" $10 million. You have suddenly "lost" $15 million, even if you don’t sell a single home at the reduced price.



And if you've put that $25million on your balance sheet as assets it (correct me if I'm wrong) probably means you've inflated your profits so it balances (or even paid out bonuses based on it). You then have to cope with the loss in value when the asset drops and suddenly your profits for that year take a big hit.

There is a lot to be said for a policy of conservative asset valuation but it doesn't tend to keep shareholders happy (until something like this happens) or managers in big bonuses.

Steve

[Francesca R]

And if you've put that $25million on your balance sheet as assetsAssets are recorded at book value or aquisition cost under GAAP and IFRS in most juristictions. So that would mean that a company would only record 100 houses with a value (before depreciation) of $25mio if it actually paid that much for them.

it (correct me if I'm wrong) probably means you've inflated your profits so it balances (or even paid out bonuses based on it).This would be wrong--fixed assets don't impact profits unless they are sold, and even then they are recorded as extraordinary items (or some equivalent of this) so that they don't skew operating earnings.

You then have to cope with the loss in value when the asset drops and suddenly your profits for that year take a big hit.Accounting rules are deliberately constructed as above so that this doesn't happen (if they are followed).

There is a lot to be said for a policy of conservative asset valuation but it doesn't tend to keep shareholders happy (until something like this happens) or managers in big bonuses.There is a lot to be said for it yes--which is why it is adopted. I think you have the wrong end of some or other stick.

[Random]

Assets are recorded at book value or aquisition cost under GAAP and IFRS in most juristictions. So that would mean that a company would only record 100 houses with a value (before depreciation) of $25mio if it actually paid that much for them.

Of course, if you paid $25 million for the 100 houses, and suddenly identical houses in the same area are selling for $100k, you know that those 100 houses will not sell for $25 million. If you sell the houses for the $10 million they are probably worth, you take a $15 million loss on your books.

If you keep the houses however, you can keep the $25 million in assets on you books. So you sit on the houses, effectively locking up those assets while you wait for the situation to improve so you don’t take a $15 million dollar loss. And this is how you become a zombie institution…

[Francesca R]

If you keep the houses however, you can keep the $25 million in assets on you books. So you sit on the houses, effectively locking up those assets while you wait for the situation to improve so you don’t take a $15 million dollar loss.That's how it should work though. Your share price will probably get marked down, because to a minor extent share prices (and share analysts) discount break-up value, but to a more important extent houses are capital goods and they generate positive cash flows (rental yields). Assuming rents fall, in a slump of 60% in house prices, then that's how your profits and your market valuation fall. But there is no reason why your balance sheet should be written down

And this is how you become a zombie institution…You've overpaid for a large acquisition, but that happens frequently without threatening the going concern abilities of companies.

[Random]

That's how it should work though. Your share price will probably get marked down, because to a minor extent share prices (and share analysts) discount break-up value, but to a more important extent houses are capital goods and they generate positive cash flows (rental yields). Assuming rents fall, in a slump of 60% in house prices, then that's how your profits and your market valuation fall. But there is no reason why your balance sheet should be written down

You've overpaid for a large acquisition, but that happens frequently without threatening the going concern abilities of companies.

Yeah, I should have clarified zombie institutions more. They are… odd.

Do you think CitiBank and Bank of America are zombies right now?

[oggiesnr]

There is a lot to be said for it yes--which is why it is adopted. I think you have the wrong end of some or other stick.



Thanks for the corrections. I note however that one reason for the big HBOS loss is that Lloyds went through the loan book and revalued a lot of it using a more conservative valuation.

Steve

[Francesca R]

Yes the accounting standards and guidance for loans is different from the accounting for fixed assets. Loans normally have fixed maturities, unlike real estate (although obsolesence and capital leakage occur with the latter--but these are accounted for with depreciation and capex)

http://www.hmrc.gov.uk/manuals/cfmmanual/cfm4050.htm

[GlennB]

Only in a few cases. If someone sold their house at the peak of the bubble and didn't immediately buy another house, they made a profit, but those cases are few and far between. Most homeowners actually have equity in their house and that has simply disappeared. When assets lose market value, nobody gets the difference. It just evaporates into thin air.

My bolding.

Would it be equally true to say that "when assets gain market value the difference has appeared out of thin air" ?

p.s. it might appear that I'm being provocative. I'm not. Financial affairs at this level are a total mystery to most ordinary folks, I suspect. My only (probably forlorn) hope of understanding them is to translate into a simpler language. Hence the betting analogies.

[Francesca R]

Would it be equally true to say that "when assets gain market value the difference has appeared out of thin air" ?Sort of. But not in the sense that it is nothing more than ethereal "confidence" in what others will pay. The ability of an asset to generate "hard" cash flows may have "genuinely" increased.

[GlennB]

Sort of. But not in the sense that it is nothing more than ethereal "confidence" in what others will pay. The ability of an asset to generate "hard" cash flows may have "genuinely" increased.

Thanks for the various replies by the way. EC1 eh? I have memories of working down that way that would be happy except for the evil commutes:)

However ... at what part in the process does value become "hard" to the point of becoming "genuine", such that actual value can be lost in a crash(as per your post above)? I can only guess that this would be where the worst possible sale price of (in this case) a house - even in a massive house price downturn - exceeds the outstanding debt. Otherwise it appears there is always the possibility of loss. Even then, the mortgage provider now owns a repossessed asset that could gain in value in the future.

Bring in the actuaries?

[Francesca R]

EC1 eh? I have memories of working down that way that would be happy except for the evil commutes:)(Gobbing distance of Sadlers Wells. And it avoids commutes.)

However ... at what part in the process does value become "hard" to the point of becoming "genuine"When it's cash in the bank. Other than that, the fat bloke never sings.

[oggiesnr]

When it's cash in the bank. Other than that, the fat bloke never sings.

Or when HMG bails you out and turns your "paper cash" into taxpayers' cash in (preferably) an offshore tax haven. :)

Steve

[GlennB]

My bolding.


However ... at what part in the process does value become "hard" to the point of becoming "genuine"

When it's cash in the bank. Other than that, the fat bloke never sings.

And yet in post #17 , the discussion went :

If so, would it also be fair to say that the original vendors of those properties (whether individuals or institutions) have shown a total 'profit' equal to the 'loss' now being suffered by the mortgage providers*? That is, no money has gone missing (as it were), just that the money has become diffuse rather than concentrated in the hands of major institutions.

Not really, no. There was a net destruction of value.


These two statements of yours appear to suggest that because of the "destruction of value" there must be less "cash in the bank", i.e. the system has lost actual money rather than potential money. The sum total of all the bank balances in the world has declined??

[Blackadder]

$5,900; 1 ba 1,422 sqft Single-Family Home



$10,000; 3 br 2 ba 1,131 sqft Single-Family Home


$10,000; 3 br 1.5 ba Single-Family Home
]

cool, thanks for the pics. I am almost tempted to buy one, just so that I can say:" I am a house owner in the USA. " And spend a few holidays there.

but I guess the neighbourhood won't be very tourist friendly, and you cannot fix the house, because it will be stripped again as soon as you leave it.

[Francesca R]

These two statements of yours appear to suggest that because of the "destruction of value" there must be less "cash in the bank", i.e. the system has lost actual money rather than potential money. The sum total of all the bank balances in the world has declined??Maybe it is not useful to distinguish between "paper" gains/losses and "crystallised" ones. The market value of a $500K home dropping to $400K is the same as a $100K home burning down in economic terms. It's just that a market recovery won't bring the burned on back up in value later.

[Just thinking]

cool, thanks for the pics. I am almost tempted to buy one, just so that I can say:" I am a house owner in the USA. " And spend a few holidays there.

but I guess the neighbourhood won't be very tourist friendly, and you cannot fix the house, because it will be stripped again as soon as you leave it.

Just buy it, insure it for $75,000, then wait for it to burn down. You may not even have to wait until your first mortgage payment.

[Just thinking]

Maybe it is not useful to distinguish between "paper" gains/losses and "crystallised" ones. The market value of a $500K home dropping to $400K is the same as a $100K home burning down in economic terms. It's just that a market recovery won't bring the burned on back up in value later.

I was making almost that exact same argument to someone last week. I told him that if you have a $500K mortgage, of which you owe more than that, gets reduced to to say, $400K --- and you pay that new mortgage properly with no delinquency --- the original mortgage still never gets paid back in full.

Now ... multiply that by 2 million.

It's things like this that make me feel this is more than just another "recession" ... maybe not a depression, but something else. (The only thing that comes to mind is major contraction.)

[soylent]

If AIG "lose" $62 billion, who has the $62 billion?

Holders of Credit Default Swaps written by AIG on junk bonds.