Monday, October 06, 2008

The Financial Crisis for "Dummies" (a.k.a. me)

Two years ago, before I did my MBA, I would not have understood this financial crisis.  The following is an inner monologue arrogant pretty-boy 2008 "New Toshi" vs. that lovable goof 2006 "Old Toshi".  Enjoy. 

 -- Begin inner-monologue --

New Toshi - Apple stock price tumbled to 128 to 105 in a single day of trading. 

Old Toshi - I never quite understood this.  What the heck is stock price and why does it change? 

New Toshi - That is both a stupid and incredibly complex question.  Think of it this way.  Add up every cent Apple profits over the next 10 years.  That's the profit off of every iPod, iPhone, and computer it sells until 2018.  Well ... that big number ... that's the value of the company - that's how much it's worth.  Divide that by the number of shares and you get the stock price. 

Old Toshi - Wait, so stock price is just the sum total of all of it's future earnings for 10 years?

New Toshi - It's not but trust me ... it's complicated ... so let's pretend, for the sake of argument, otherwise you're head will explode.

Old Toshi - So how do people know what Apple will make in 2018? 

New Toshi - No one knows for sure.  Some persuasive idiots make predictions but for the most part the market makes guesses based on the best information available today.

Old Toshi - So two days ago people thought Apple was doing well.  In one day people think it's going to make 18% less over the next 10 years? 

New Toshi - Well, people think we're heading into a recession.  It's not just Apple that went down.  Almost every stock in the market dropped too.  That means all those other companies are expected to have lower earnings in the future too.  That means less pay for employees, less hiring of new grads, less money for luxuries like the iPhone... 

Old Toshi - it's one big ecosystem?

New Toshi - Exactly. 

Old Toshi - Ok, so why did the market go down?

New Toshi - Long story short.  The financial crisis.  You've heard of sub-prime right?  These 'Toxic Waste' assets?

Old Toshi - Sounds cool.

New Toshi - Well, in 2000 they were really cool.  Banks used to think they'd provide them with a steady stream of income forever.  Today, we knows sub-prime assets aren't worth the paper they're printed on.  Turns out a lot of big investment banks and hedge funds spent a lot of money on sub-prime.  Some more than others.  Lehman and Bear Stearns had toxic waste spewing out their mouths.

Old Toshi - So how do people know who has a lot of sub-prime and who doesn't?

New Toshi - Again, no one knows.  All the bankers are spooked.  No one wants to lend to nobody.

Old Toshi - Why?

New Toshi - Would you lend money to someone who's assets may or may not be 100% toxic, but have no way of finding out?

Old Toshi - So, what that has to do with Apple and the stock market? 

New Toshi - Well, banks operate by lending money to people and companies right?

Old Toshi - Is that supposed to answer my question?

New Toshi - Hear me out.  Where do those banks get the money to lend?  Turns out banks hardly ever use their own money.  A lot of them borrow money from other bigger banks.  Those banks borrow from even bigger banks.  This goes on and on until finally you get the big fish in the money market sea - the pension funds, the governments, and the sovereign wealth funds. 

Old Toshi - So when small banks can't borrow money they can't lend and if they can't lend they ...

New Toshi - ... die.  Banks are failing all along the line.  AIG, Fannie Mae, Freddie Mac, Lehman Brothers, Bear Stearns, Merryl Lynch all went bust from this mess.  Even retail banks like Wachovia and Washington Mutual went down this week. 

Old Toshi - So the banking industry is an ecosystem too. Is that why the US government proposed a $700 Billion bailout plan to buy up the toxic waste? 

New Toshi - Right.  When that didn't pass people rightly assumed we were in for more and more bank failures.  People are getting scared and that's making them more reluctant to lend.  That'll cause more bank failures.  It's a vicious cycle. 

Old Toshi - So, in 2013 when Apple needs to borrow money to come up with the new iPod, they'll pay a higher interest rate?

New Toshi - .... not just Apple, every company, every government, and every person in the world.  Less competition means higher interest rates.  No one knows how long it'll take for the financial system to recover.  For that matter, no one knows IF it'll recover.  It took a hundred years for the markets to create Lehman Brothers.  It took 6 months to make it a memory. 

Old Toshi
- Dude, when is this going to blow over?  Doesn't the economy go through fluctuations like this all the time?

New Toshi - *sigh*  That's the thing.  No one knows.  If the banks were merely dropping, I'd say yes.  But they're dropping dead.  In fact, we haven't had this many corpses since the great depression.  The fear might subside, but that's not going to change the fact there are 7 less banks. 

Old Toshi - Wow.  It's a big shit sandwich....

New Toshi - .... and we're all going to have to take a bite.

 -- End inner-monologue --

On a final note, my British investment banking friend Vaneet was kind enough to look at this blog entry to check its veracity.  Arms crossed in his pinstripe suite, Vaneet read blithely over his spectacles slowly shaking his head in disapproval and told me (in posh Londoner's accent)

"While it's quite evident you've learned nothing in business school, I do say - your fundamental arguments are structurally sound"

which translated into American (a.k.a. "real") English means

"Duuuude, right on !!!  You rock !!!!   Whoooo!!!!  " 

He did however say I should include this funny little accounting concept called mark-to-market.  Happy reading :)


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