If I borrow $5 then I'm immediately in the red. But presumably I'm borrowing that $5 so I can turn a profit of $6 tomorrow. I then pay my $5 off and borrow $6 more. Now I'm $1 richer but still in the red. Rinse & repeat. When the day comes that you can't repeat and you need to unwind, if the resale value of your assets is less than your liabilities, then you go bankrupt. This is literally how the 2008 crisis unfolded, except in a domino fashion. Not because the entire system as a whole couldn't have absorbed the losses (again, both TARP and the Federal Reserve ultimately made a profit, even early on), but because 1) the web of the financing directly or indirectly exposed to mortgage-backed securities reached so far, and 2) unwinding is never instantaneous (it cascades), short-term lending seized up. For various technical reason most large businesses (especially but not exclusively investment banks) rely on short-term lending for liquidity. When the system seized everybody had to begin to unwind at precisely the moment when the immediate resale value of their assets (especially mortgages, and light of the disruption of lending normally used to purchase such assets) was exceptionally low--lower then the (in retrospect) long-term return.
On some level it's all as simple as we intuitively think it is. I think the difficulty is coming to the realization that it's turtles all the way down--there's no magical, true price where book-value perfectly reflects all "real" assets. This dynamic complexity is most apparent when you dig into currency exchange rates, where you very often get very counter-intuitive results when you [literally and figuratively] follow the money. I'm by no means an expert, either in finance, accounting, or math. But I did study international economics in undergraduate, which has helped me to internalize the notion that there's no "true" price to anything except for what others are willing to exchange at any one moment, given all their imperfect information and incentives. And in graduate school I took an economics course with a professor who wrote one of the first studies (commissioned by Toyota) that empirically showed how exchange rates fluctuated in response to current account surpluses and deficits, in turn effecting demand & supply--a phenomenon everybody now takes for granted but which was not widely appreciated at the time even though it's obvious in retrospect. He really only mentioned it in passing one day, but the concept really stuck in my head and has helped me to conceptualize (albeit very imperfectly and at a high level) that valuation is an ongoing process; quantifying it at a fixed point in time is less meaningful than we intuitively believe.
But don't take my word for any of this. One of the most enlightening books I've ever read is "Lords of Finance: The Bankers Who Broke the World", which won the 2010 Pulitzer Prize. I read it in 2010, shortly before I read The Big Short, because of the accolades and because I wanted some context to the economic crisis. It's partly a scholarly work which makes it little dry, but its still very accessible. Basically, everything I said above about the role of the gold standard in the interwar period (WWI to WWII) comes directly from that book. Reading the Big Short explains how the mortgage-backed securities market works. It helps to have some grounding in economics to really maximize your dividends from reading those books.
Thanks from me too, very interesting. I'm also no professional expert, but it looks to me like this can be non-intuitive because borrowing "creates money" only when said borrowing is linked to an asset bubble.
Case in point: if my house appreciates on the market by $100K, I am $100K "richer"; this by itself doesn't increase the circulating money. But if I'm able to borrow $100K by mortgaging the increased value of my house, now I have $100K more to spend. The lender has $100K less in their bank account, but they now have a mortgage-backed security which is worth $100K and that, if there is a liquid market for such securities, can be almost as good as actual dollars for trading. The circulating money has increased.
It gets even worse. If the lender and/or the borrower use even just a part of those $100K to speculate in the housing market, the bubble will accelerate... until, at some point, enough people actually want to use their new riches to buy products that aren't part of the asset bubble, and producers of those products don't accept those inflated securities as payment. Then, the bubble bursts.
And, by the way, this whole mechanism has nothing to do with bad central banks or fiat money. It's perfectly consistent with a perfect free market AFAIK, and the only (not easy at all) way to prevent it is regulation.
Well, the central bank is supposed to watch out for this kind of stuff, and adjust to prevent it. The problem is that several other actors also have levers they can adjust, and they act after the central bank does. This means that the central bank has a very imprecise kind of control.
Thank you sir for explanation that is understandable even to financial layman like me. Posts like these make me read much more comments section on HN compared to actual articles :)
On some level it's all as simple as we intuitively think it is. I think the difficulty is coming to the realization that it's turtles all the way down--there's no magical, true price where book-value perfectly reflects all "real" assets. This dynamic complexity is most apparent when you dig into currency exchange rates, where you very often get very counter-intuitive results when you [literally and figuratively] follow the money. I'm by no means an expert, either in finance, accounting, or math. But I did study international economics in undergraduate, which has helped me to internalize the notion that there's no "true" price to anything except for what others are willing to exchange at any one moment, given all their imperfect information and incentives. And in graduate school I took an economics course with a professor who wrote one of the first studies (commissioned by Toyota) that empirically showed how exchange rates fluctuated in response to current account surpluses and deficits, in turn effecting demand & supply--a phenomenon everybody now takes for granted but which was not widely appreciated at the time even though it's obvious in retrospect. He really only mentioned it in passing one day, but the concept really stuck in my head and has helped me to conceptualize (albeit very imperfectly and at a high level) that valuation is an ongoing process; quantifying it at a fixed point in time is less meaningful than we intuitively believe.
But don't take my word for any of this. One of the most enlightening books I've ever read is "Lords of Finance: The Bankers Who Broke the World", which won the 2010 Pulitzer Prize. I read it in 2010, shortly before I read The Big Short, because of the accolades and because I wanted some context to the economic crisis. It's partly a scholarly work which makes it little dry, but its still very accessible. Basically, everything I said above about the role of the gold standard in the interwar period (WWI to WWII) comes directly from that book. Reading the Big Short explains how the mortgage-backed securities market works. It helps to have some grounding in economics to really maximize your dividends from reading those books.