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Hallo meine Damen und Herren, willkommen zu einer weiteren Ausgabe der Frugal Samurai…
COUGHS LOUDLY TWICE.
Ah, that’s better.
Apologies – I had my German voice on.
Should be fixed now.
Anyway… Hi guys! How’s everyone doing today?
Ain’t it yucky here in Old Sydney Town – old mate Harry and his missus Meg brought the British weather down under, CRICKEY!
Wait a tick, too much Aussie…
Sorry guys, having trouble finding my inner voice this morning…
Let’s start again shall we?
Of course they would.
After all, it’s been 10 years since the GFC and Lehman Brother’s collapse – what other business topic would generate more eyeballs (as in, views – not physical mutilation).
My prominent dental friend SZ, (aka Mr HotShot) asked me regarding what my thoughts were on this topic.
Flattered SZ, flattered.
But you know, everyone’s obsessed with the GFC, we pay attention whenever those three letters are uttered.
I mean, anyone who’s lived and worked through it – harrowing times indeed.
However, not many of us actually understand the crux of the crisis and how it spread.
I don’t mean the huge run-up in US housing values circa 2002-2006, or the sheer number of sub-prime loans offered then, or how the mortgage holders themselves ran away when they couldn’t pay another day – no, there’s been enough media articles covered on those topics that practically everyone knows what happens there.
But not much is said about the root cause of the contagion, why it went so wrong because of this.
Because of what?
Let’s introduce the words – collateralized debt obligations.
Collateralized what now?
Yeah exactly, WTF CDO’S FFS ASL?
Here’s how the media explains it:
“The last shadow-banking frenzy on Wall Street centred on home loans, which were repackaged into investments used to build collateralised debt obligations, or CDOs.
Banks pooled millions of mortgages — some of them to borrowers with a shaky ability to repay — to create CDOs. They kept some, and the rest they sold off to a slew of other investors: in-house hedge funds, European banks, large US pension plans and more.”
That definition doesn’t even do it justice!
Here’s The Frugal Samurai’s more detailed explanation:
Let’s say in 2002-2006 there was an insatiable demand for peanuts – everyone loved them, everyone wanted them.
People couldn’t stop buying those delicious, roasted, nutty goodness.
So as a local peanut farmer at the town market, you stand to make a killing if you could somehow deliver your peanuts to even broader markets.
Then you have this bright idea to package peanuts in larger bulk sealed and air-tight bags.
In goes the peanuts, all shapes, all sizes, varying levels of quality and ripeness.
Your wholesale customers receive the peanut bags, which they proceed to on-sell to their customers overseas for more money.
The end customer (overseas) proceeds to sell the peanut bags to their customers, who go home engorged in the succulent peanuts.
The price of peanuts increase due to increase in demand – everyone is happy.
Suddenly, one day – Simple Sam down the road advises you that he cannot eat anymore peanuts – he cannot afford them.
Annoying Amy, your wife’s best friend – also advises you that she cannot eat anymore peanuts, she cannot afford them also.
Not to worry you think – I can afford to lose Jim and Mary’s patronage.
Then Slapstick Sally tells you the same, Jumping Jono, Tiny Tim – everyone starts telling you the same thing.
Oh well you say, there’s always the larger, wholesale customers – I’ve always generated bigger profits from them.
The wholesale customers continue buying, but not at such elevated quantities as before given the reduced demand.
But then you hear word that the end customers overseas are unhappy – the peanuts they received are all rotten!
This is because when prices were rocketing, you didn’t implement any quality control measures – just stuff every single peanut in.
A couple of rotten peanuts caused the whole bagful to rot en route.
And because price of peanuts are not rising anymore – suddenly, everyone wants their money back!
This causes peanut prices to crash through the floor.
Up the chain it flows, the overseas customers want money back from the wholesalers, who want money back from you.
You declare bankruptcy. Your wife leaves you for Jumping Jono. Your kids hate you for breaking up the family. You turn to drink and fully-clothed cold showers.
Meanwhile, the wholesalers asks the government to bail them out, who do but not before making an example of one of them.
During this time, the great peanut crash envelops every country who had exposure to peanuts – not just the US.
Which is what made the GFC such a universal problem – it wasn’t the fact that US Housing crashed, it was the sheer number of firms and countries who had exposure to US Housing through CDO’s (bags of peanuts).
What made it worse is that during times of crashes and steep falls – everyone becomes scared.
When everyone is scared no one does anything.
When no one does anything, everything stops.
When everything stops, the world stops.
Hope that made as much sense to you as it did to me…
What’s Next Then?
So what’s this new thing on the horizon?
Well – it’s called CLO’s (instead of CDO’s).
Basically it’s when sub-prime i.e. those with poor credit rating, companies borrow more and more for their own use (e.g. further acquisition or investment).
Now, there’s nothing wrong with borrowing money IF it is used correctly and IF you can afford repayments.
However what’s happening in the market is similar to what happened during the GFC.
That is, as long as the price of assets (peanuts) keep rising, the likes of Simple Sam and Annoying Amy will keep on borrowing money to purchase them.
As long as the repayments come in, there will always be lenders willing to lend – it’s a profit driven industry after all.
And as long as Wall Street exists, there will always be fancy names applied to new, exotic and sexy financial instruments created to make a buck – CLO’s are just the latest.
Will a GFC 2.0 eventuate? No one can answer that.
But I can leave with you with my reply to SZ can’t I?
“…nowadays people are paying more and more for less and less returns because that’s how the industry has become.
Everything has become overvalued to the extent that these purchases are more and more fueled by debt financing.
So inherently you have firms paying too much for overvalued assets using debt, which isn’t where you wanna be.
The contrarian approach whilst everything is artificially rising is to take some cash off the table and wait for when it goes bust. The big question is when will it occur – no one knows”.
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P.S. Peanuts are used as an example only – they may or may not go rotten during long-haul flights. Please do your own due diligence when purchasing peanuts.