Dark Star

Here's how some of our friends on the Left are looking at the current crisis. Notice how the responsibility in this analogy lands squarely on Wall Street investors (or Capitalists):Open Left:: The Economic Crisis Explained - Really

Analogies are never perfect, but here's one using horse racing. Don't expect a perfect correspondence to the banking situation, but I think it is close enough for government work.

Joe goes to the track and bets $2 on a horse.

Two guys standing nearby get into a discussion and Fred says to Sam, "I'll bet you $5 that Joe wins his bet."

Next to them are Bill and Bob. Bill says: "I'll bet you $10 that Fred welshes on his bet if he loses."

Next to them is Sally. Sally says: "For $3 I'll guarantee to Bill that if Bob fails to pay off, I'll make good on the bet."

Sally then goes to Mary and borrows the $7 needed in case she has to ever pay off and promises to pay back $8. She doesn't expect to every have to pay since she believes Bob will always make good. So she expects to net $2 no matter what happens to Joe.

A quick calculation indicates that there is now 2+5+10+3+7 = $27 riding on the outcome of the horse race.

Question how much has been "invested" in the horse race?

Answer:

$50,000 by the owner of the horse who is expecting to recoup his investment from the winnings of the horse and other future deals. Everyone else is gambling, not investing.

(Notice that the track owner gets his cut of the original $2 no matter what else happens.)

The issue with the home market is that the only "investor" was the person who bought the home. All those engaged in the meaningless derivatives spun off from this are gambling. You can see how quickly the face value of all these side bets can exceed the underlying investment. Who is holding these side bets - not the homeowner? It is the people at the failing investment banks, hedge funds and similar enterprises. Notice that the bailout is being directed at them not the homeowners.

The real world is, of course, even more complicated. Over the last 30 years people have been allowed to place bets on everything starting with the value of stock averages. They might as well bet on the temperature in Newark at 8:00 AM.

So when you hear everybody saying this is a crisis caused by the housing collapse, be skeptical. We are in the midst of a classic pyramid or Ponzi scheme and there is no way out except for people to lose a lot of money. All that is different this time is that it is the taxpayers who are being asked for the cash.

The problem with this analogy is that it characterizes - or completely leaves out the role of Fannie Mae and Freddie Mac.

Let's add to this analogy. The Horse is the homeowner, the Owner of the horse is the mortgage issuing bank.

Now, you have a guy who buys a nice healthy horse. There is a Federal Government-backed institution (a GSE) who buys horses from horse-owners in bulk. There are requirements for the horses in question. Requirements such as, the horse has to be a certain breed, certain, weight, and has been proven to be a healthy animal.

Now let's say that institution seriously relaxed its standards, and would take horses in far worse shape than before. And what's worse, when they put them up for races (so that folks could bet on them) they couldn't speak to the health of the horse. Individuals who buy horses (lending banks) start buying horses left and right - no matter their health - because they can off-load them to the GSE. Matter of fact, the GSE encourages them to do just that.

As for the gamblers, they know that this GSE takes buys only healthy horses, and if something happens to the horse, the GSE will cover a certain percentage of the loss, which isn't true, but the gamblers think it is, which cause them to bet a lot more than they would under normal circumstances.

Now, a high percentage of the horses owned by the GSE start to go down in the races, from broken legs. And all these horses have to be put down. And the gamblers start looking to the GSE to cover a percentage of the bet. The GSE doesn't.

Now nobody wants to bet on horses from the GSE but the GSE owns over 50% of all racing horses and there's still no way to tell if horses in their stable are healthy or not, and you can't bet on a single horse, you have to bet on a whole package of their horses and they are all mixed in together.

So the gamblers, start leaving the track, and the individual horse-owners stop buying horses.

That's not perfect, but it's at least in the ballpark - or racetrack as it were.

The problem is the quasi-private status of Fannie Mae and Freddie Mac and the CRA.

See this video I posted earlier.