
AIG Implodes: The Two Cows Version - brk
http://clusterstock.alleyinsider.com/2009/2/aig-implodes-the-two-cows-version
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patio11
This is not accurate, though. AIG's problem is not owning cows, it is
insurance. Let me try.

Bob has two cows, each worth $100.

Jane buys one cow from Bob, paying him no money down and borrowing $100 from
the bank. She says she'll pay the bank back with milk money, or refinance when
the cow becomes worth $120 in two years. The bank, sensibly, is worried about
the cow dying, so they take out a life insurance policy on the cow.

Now as it turns out, the cow is sickly so ordinarily a life insurance policy
would cost a lot of money. So rather than insuring one cow, the bank buys
insurance on an entire herd of cows at the same time. They're all sickly cows.
Oh well, no worries. If the cows are insured by a healthy company there is no
way the bank can lose.

Then the bank gets a bright idea: rather than holding the deed to the cow on
their book, they securitize the loan revenues from the entire herd, which are
contingent on the milk flowing from still living cows BUT insured by a
reputable insurance company. So even though these cows are two steps from
death's door why, the security is fairly safe. To make it totally safe, they
divide it up into different tranches.

There is an AA tranch, which is the best sickly cows. Then a BB tranch, which
is the second best cows. Then another tranch, which is cows who are laying
down and leaking polychromatic pus. And they're all insured.

But selling that last tranch is pretty difficult, so the bank gathers up
several copies of that tranch from multiple herds, makes a synthetic herd out
of it, and then among the almost-dying sickly cows there are most-healthy-but-
still-almost dying "AA"s again. Yay! Sales. This lets them lend out more money
to more people to buy sickly cows, the rights to whose loans they securitize
and sell, etc. They make tons of money doing this.

Now why on earth is AIG selling insurance to this bank?! Because they look at
their death rates for cows table, which is for the usual mix of QUITE HEALTHY
COWS and sickly cows (not herds of sickly cows, and not synthetic herds of the
sickest of sickly cows), and decided "cows don't die much, so selling
insurance on them is pretty much a can't lose proposition". So they set their
rates on cow insurance very freaking low: $1 to insure $100 of cow for a year,
no problem!

Then somebody comes up to AIG and says "Hey, you're selling the bank insurance
on cows they don't even really own, since they're selling the cow loans off".
AIG says "Yep, pretty much." Customer says "So you're essentially taking bets
that cows don't die." Yep, pretty much. "I don't own a cow, but I'd like to
bet that that there cow dies anyhow. Will you take me up on it?"

 _And AIG does_.

Then people start buying and selling these bets on the life of cows TOTALLY
UNCONNECTED TO THE COWS THEMSELVES, because they make oodles of money on
transactions. There are notional trillions involved in cow-death bets, because
every time they are sold rather than being transferred there is generated one
"that cow lives" and "that cow dies" contract. It gets really complicated, but
it is all safe, because all the cows are ultimately insured by AIG, and AIG is
safe because cows don't die.

Cows die. And then all the people in the system who bet on cows dying go to
AIG and say "Hey, I paid you $1 insurance premiums to insure $100 worth of
cow. Approximately one billion dollars worth of cow just died. OK, fair's
fair: pay me $100 billion."

BOOM. AIG threatens to topple. And then all the people who owned loans-on-
dying-but-safe-because-they-are-insured cows now suddenly only loans-on-dying-
cows. Whoops, make that loans-on-dead-cows.

1) Hard to milk a dead cow.

2) Hard to sell a dead diseased cow in this market since there is a whole lot
of dead cow meat suddenly available (and much of it doesn't have polychromatic
pus).

3) You've sold the notional rights to the repayment on the dead cow loan so
many times you're not even sure who has standing to repo the actual dead,
rotting carcass. Meanwhile it decays more every day, further losing notional
value. You have to come clean and say "The dead carcass which I can't even
identify as mine is worthless" but if you do your firm will probably collapse
because you own an awful lot of loans-on-dead-cow because they looked like
something of a deal at the time.

BOOM. Financial crisis.

------
Eliezer
Complicated things are hard to explain in a readily accessible fashion; I've
seen that ability called "genius".

What most nongenius explainers do is make up a different and less complicated
story, which is not actually true, and explain that instead.

Decoherence is too complicated? Make up some other story about "quantum
physics" and explain that instead.

Nonstandard models of Peano Arithmetic are too complicated? Make up some other
story about Godel's Theorem and explain that instead.

The best one-line explanation of the financial crisis that I ever heard was as
follows: "Mere stupidity is never enough; people have to pile stupidity on
stupidity on stupidity."

Reality is a lot more complicated than this.

------
johnrob
What's worth noting is that if the bank did nothing with its cows, its net
worth would have still moved from 200 down to 4. To some degree, we are all to
blame because our society is what allowed cows to become so expensive.
Everyone who bought a cow wanted to believe (and profit from) the myth.

[edit] In real life terms: anyone who promoted the idea that renting is a
waste of money is an accomplice to this bubble.

~~~
tptacek
Isn't renting still a waste of money? I thought only a small minority of
people are literally under water on their mortgages.

Housing certainly seems like a bad _investment_ , but so is a car, and leasing
is still a ripoff.

~~~
thwarted
"Waste of money" is a loaded term, especially when considered in the context
of necessities. If you reword it as "quality of investment" and "could your
money have been put to better use spent on something else (or saved and not
spent at all)", then it's a little easier to discuss and compare.

The assumption with buying vs renting is that your money isn't "working" for
you when you rent. When you buy, your mortgage payments are going to build
equity, and the logic used is that it is a "forced savings plan" compared to
renting, where once you pay your rent, you'll never see that money again. The
inverse, which is implied, is that you will actually see the money you pay for
the mortgage at some time in the future. As everyone found out, that's not
necessarily the case.

In my case, I lost money on the sale of my house, for various reasons
(economy, improvements, agent fees, taxes, buying to live in it vs buying it
as an investment, some of which were under my control, some of which were
not), such that I would have been better off renting the whole time. I,
personally, lost about $10k. Had I rented in the neighborhood instead, the
savings would have been even more drastic because I wouldn't have needed to
spend so much, per month, on housing, despite being able to live in the same
area and have the same amenities.

The real value in buying a house though was that I learned exactly what it
means to own a house and exactly what is important to you (in my case,
location is much more important than size), which I don't think you can learn
any other way. There really needs to be a perfect storm of positive variables,
in the last few years especially, to make money on owning a house. My home
buying years have not, and will not, be marked by such an increase in demand
and rise in prices that the sale price offsets all the other, financial and
emotional, costs.

I joke about setting a personal requirement of 80% down on the next home I
purchase, if I ever purchase another.

~~~
ericb
Owning a home long-term after the adjustment will be a great investment in the
US, I imagine. The US is a debtor nation. The debt can be paid off by printing
currency (perhaps gradually). This will cause inflation as more dollars chase
the same amount of goods and services. Your mortgage debt dollar amount
remains the same, but gets paid off with new, cheaper bills.

------
jhancock
The problem with this analogy is that the world of finance does not map
directly to physical goods or how a person would handle a real world asset
they own (as opposed to abusing other people's assets).

Let walk through the first couple of sentences:

>> "John Paulson borrows one cow so he can sell it for $100. He gives you $10
as collateral."

No one in their right mind lets someone walk away with a $100 cow for a $10
deposit. If you are a car rental company, you don't force the borrower to
deposit the full price of the car, but you make up for this risk in volume
across many car deposits and you have insurance and the backup of public crime
fighting organizations. If you have a single page contract for "you borrow my
cow and give it back later, here's a $10 deposit" you have none of this.

Second is the use of the term "borrow". If I loan you a cow and you return a
different cow, this may not be acceptable to the lender. This is not
"borrowing".

>> "You buy your neighbors cow for $100, which you finance by taking out a $90
loan from the bank and use John's $10 to make up the rest."

ok, full stop!!! No bank operating correctly will give you a loan against a
cow that you have already loaned to someone else. This is the root of why
people use the term "ponzi scam" in reference to such transactions.

>> "You brag to everyone about your financial health. You have assets--two
cows you own, plus one Paulson owes you--worth $300, and liabilities of just
$100."

Sorry, there are still only two cows in this story. This is not software where
you can magically copy a cow.

And so goes the problems with analogies like this.

Don't get me wrong. The blog author writes it well and gives a peak at the
absurdity of the financial system. Unfortunately, the financial system is so
absurd that there are no useful metaphor against real world goods.

~~~
pilif
> Sorry, there are still only two cows in this story.

> This is not software where you can magically copy a cow.

huh? Aren't there three? I had two, lent one and borrowed another from my
neighbor.

You actually quoted that.

------
vaksel
is it me, or is the cows example more confusing than what really happened?

------
bstadil
There is no mystery here. If your asset base consist of two cows worth around
$200 and the price fall to $4, your are in bad shape regardless of how you
structured it.

~~~
kragen
There's a substantial difference between having a net worth of $4 and having a
net worth of ($84).

