30 Nov A Little Less Clueless

On my first day of kindergarten,  the morning rush was more hectic than usual as my parents verified that I had all my school supplies and was properly dressed to exit the house (at the age of five, I still occasionally forgot to put on some crucial article of clothing). After making sure that I was indeed wearing pants, my mother bundled me onto the bus. Since I hadn’t had time to eat, she thrust two quarters into my hand and told me to buy my breakfast in the school cafeteria.

That evening, my mother asked me how everything had gone. Fine, I replied, except I hadn’t been able to eat breakfast. It had cost forty cents. Since I had fifty cents-not the correct amount- I hadn’t tried to buy anything.

Managing to keep a straight face, my mother explained the concept of receiving change. And my worldview shifted slightly…. The financial transactions I’d witnessed up to that point now made sense. I had a number of coins squirreled away, thanks to my allowance of 25 cents a week, but now they meant something different to me. They had solid numbers and values, but flexibility was built in. I’d always assumed I needed the exact amount to buy something, but the system had been demystified. I understood the principles.

A couple of decades later, I felt again like I was missing some crucial piece of information. In 2008, banks were collapsing and bailouts being hastily pushed through, but I had only a vague idea of why all this was happening. I’d studied literature and language in college, and had almost no knowledge of the fundamentals of the finance world.  I wasn’t unaware of the housing bubble — skyrocketing prices in Phoenix, where I was living at the height of the housing frenzy, had kept me in the rental market. I knew, vaguely, that it would have been easy to get a loan (although in principle, I shouldn’t have been able to qualify for one, given my salary). But I had no idea what was driving the market, and certainly never suspected that the zero-money down, adjustable rate mortgage that I would have qualified for would have been such a huge factor in the market implosion three years later.

As economic conditions worsened, I became aware of words that I’d never heard before. Collateralized debt obligations.  Synthetic CDOs. Credit default swaps. Different terms and acronyms were tossed around in the news, but with opaque explanations. Articles assumed a certain baseline of knowledge.  I didn’t understand the logic of the system, but this time none of the people around me seemed to fully understand either. It was like being 5, only I couldn’t sit on my mother’s lap and have her explain the financial intricacies. The rules of the game as they’d been laid out over the last decade were shifting and it turned out that I’d never really understood them in the first place.

Finally, I became tired of being a financial nitwit. My job at the time, like so many others was being directly affected by the crisis, and I wanted to understand what was going on. So I picked up John Lanchester’s book I.O.U. Why Everyone Owes Everyone and No One Can Pay. A journalist who makes no claim to any specific financial background and in fact emphasizes his outsider status, Lanchester provides a lucid description of the factors leading up to the crisis, and explains them in ways even the most financially ignorant person can understand.

For example, his explanation of swapping the risk of default uses a personal finance analogy to clarify:

Say your neighbors the Smiths approach you and ask to borrow some money—say, to pay for a loft conversion. You happen to have a spare $100,000 in cash, which is the amount they want to borrow, and they promise to pay you a good rate of interest, say $1000 a month (just to keep the numbers simple) and then to pay back the principal at the end of the year. So you make the loan, and then you fall to wondering what happens if the Smiths can’t make their loan payments, on which you are relying for handy extra income. At which point you ask your other neighbors, the Joneses, if they are interested in making a little bit of cash on the side. They say yes, and so you swap with them: they take on the risk that the Smiths won’t pay the loan—in other words, if the Smiths default, the Joneses will make up the money—and in return you pay them a fee, say, $50 a month. In effect, what you’ve done is taken out a form of insurance. So the Smiths get their $100,000; you get your $1,000 a month; the Joneses get their $50 a month. If the Smiths stop being able to pay you, you collect from the Joneses instead. Notice that there is one huge benefit from this deal:  you have managed to lend money, at a good rate of interest, at no risk… you’ve just engineered the risk out of existence.

This book, and others like it, changed my perception. Understanding the roots of the crisis wasn’t as complicated as I had feared. One didn’t need to understand the math and science behind the ideas in order to understand the ideas themselves.

What I didn’t, and still don’t really comprehend, is how so many of the experts also didn’t understand. Cupidity? Willful blindness? Or maybe just denial, proving the truth of Upton Sinclair’s maxim: It is difficult to get a man to understand something, when his salary depends on his not understanding.

Emily Seftel Copyright(c) 2012 All Rights Reserved