I’m not entirely sure what to make of Yvette Kantrow’s column today. On the one hand, I’m the only person she’s remotely nice about (I’ve "done a decent job," she says) in her review of the way the credit crunch has been covered by the financial press. But on the other hand what she really seems to want is someone to ride in with a clear-cut heroes-and-villains story which will "how these complex markets and products fit together and why anyone should care about them". And that’s clearly not going to happen. But maybe I can help a little, by talking about hamsters.
Kantrow does have something of a point. If you look at the coverage of the credit crunch, the overwhelming majority of it is written by financial sophisticates for financial sophisticates. This, for instance, appeared today not on some credit wire but in the New York Times:
Pay-as-you-go swaps do not involve a one-time payment to cover a default on a corporate bond, a pool of mortgages or some other debt instrument. Instead, they involve the payment of ongoing obligations on debt instruments that, because of their terms, may not be subject to a clear default trigger.
One can argue about how clear or how helpful this is. But there’s no doubt it’s utter gobbledegook to the overwhelming majority of the NYT’s readers. And there are lots of Market Movers posts, too, which would be similarly incomprehensible to most readers of any general-interest newspaper. (This is where having a blog comes in handy: you can have more of a niche readership.)
So why has the press been so bad at giving people the view from 30,000 feet? I think it’s mainly because although people use credit all the time, almost nobody outside the finance industry thinks of it as a product. If I loan you ten bucks till Tuesday, I don’t think of myself as owning a receivable worth (more or less) $10. Well, maybe I would, ‘cos I’m weird that way. But you wouldn’t, and most newspaper readers wouldn’t. And similarly, when someone spends money on a credit card or gets a car loan or takes out a mortgage, they just think they’re borrowing money: they generally don’t think of themselves as buying a financial product which has real value to the lender.
On the flip side of the coin, how many people consider their checking account to be a low interest or interest-free loan to their local bank? Precious few: if they borrow $100 from the bank, that’s now their $100 and they can do what they want with it. But if they
lend $100 to the bank deposit $100 into their checking account, that’s still their $100.
Anybody coming in contact with the banking industry has a weird moment of cognitive disconnect somewhere at the very beginning: from a bank’s point of view, loans are assets, while deposits are liabilities. It’s a point of view which takes a bit of getting used to, and until you internalize the idea of loans-as-assets (and most people never will), you’ll never really understand what on earth is going on with the credit crunch.
If you do understand the idea of loans as assets, however, I think I can give you a big-picture view of what the credit crunch is and why it matters. Consider a product you consume unthinkingly every day: let’s take bandwidth as an example. Now, let’s assume that bandwidth is created by having a whole bunch of high-tech hamsters spinning in a whole bunch of high-tech wheels. Over time, the technology going into those hamsters gets more and more sophisticated, which means that a whole multi-billion-dollar industry of bandwidth-dependent products springs up, from YouTube to video on demand. And now imagine that, one day, the high-tech hamsters simply break. There are still a few low-tech hamsters still going, but they’ve mostly been replaced, and now they’re massively overburdened because the high-tech hamsters aren’t doing their jobs. The entire bandwidth-dependent economy simply grinds to a halt: no more YouTube, no more video on demand, no more Rhapsody.
You see where I’m going with this. Credit, in the US and indeed global economy, has become a taken-for-granted commodity, and the amount of it has been growing very fast, thanks to all manner of clever financial innovation. But those high-tech financial inventions (the RMBSs and CDOs and CDSs and monoline insurers and SIVs and auction-rate securities and on and on ad nauseam) have broken. There are still a few old-fashioned banks around, but all too many of them jumped onto the high-tech bandwagon so they’re as hurt as everybody else. There just isn’t enough credit to go round any more, which means the whole economy – and all advanced economies are built on credit – is going to, well, crunch.
I don’t know whether Kantrow’s Aunt Mary will be happy with this explanation, but it’s the best I can do. And now we’ll return to our regularly-scheduled programming of counterparty risk arbitrage opportunities.