I just want to thank everyone that has done the following since I started writing:
It’s clichéd, but the support does make it so much more worthwhile.
PS: and for some shameless self-promotion… Carry on – especially with the sharing!
The Businessweek Article:
I mean – how could I resist? It’s a ready-made soapbox to stand up and make a counterargument about counterfeiting. And also, there are the condoms.
About six months ago, I listened to Loretta Napoleoni give a lecture at the LSE* about her book “Maonomics”. And she made the most fascinating observation about China’s fake good industry – it may, or may not, have rocked my world view. I’ve mentioned it before in passing, but with a segue like dodgy durex, it gets a post all of its own.
Have you heard of ACTA?
The Anti-Counterfeiting Trade Agreement is one of those much-campaigned-for international treaties (like the Kyoto Protocol) – and this one is meant to deal with the enforcement of international intellectual property rights. And by “international” what we mean is: the US, Europe and Japan. The rest of the world looks happy to stay in their grey area:
Of course – if we were to redraft that map to emphasize principal targets and offenders, it would be CHINA and SOUTH ASIA with a few small islands representing Nigeria and Latin America. Of course China won’t be signing on – the counterfeit good industry makes up 8% of their GDP by official numbers.
Which may make ACTA a bit moot; but it does make it obvious how absolutely disgusted the West is with this blatant thievery of intellectual property.
Why The Outrage Bores Me
Integrity is expensive – it means that you have to buy the DVD boxset. So let’s talk about DVDs.
Since I was blessed with the means; it somehow felt ungenerous, or unsupportive, not to buy DVDs from an outlet store. In my head, the argument has gone “Well I like the cast, so I don’t want them to stop making the movie/series. And I like being able to visit music stores, so I don’t want them to go out of business. Let me just buy it rather.“
And then I’d get home, and put the dvd into the player, and press play. Immediately, and un-move-past-ably, I’d be bombarded with the PIRACY IS STEALING advert. And the sound would boom across the room at a volume far above the normal setting on my TV (how do they do that?). And it would happen every single time I wanted to watch it.
Then. Then maybe I would try and play the series on my lap top while I was travelling. And it would be rejected out-of-hand by the optical drive with a small little error message about “being set to the wrong region”. Because of that one time that I was in Paris and bought a french movie and clicked “yes” to the change-region notification. AND COULD NEVER CHANGE IT BACK. And was told, by Mitsusomething’s website, that I would have to replace the drive if I wanted to go back to watching Region 2.
Dear DVD makers. I don’t care about your outrage. Because you’re already outrageous. Selling me product that I can’t use, and getting all preachy when I was already converted.
Honestly – thank God for iTunes. It just made everything so much easier.
But I’m not blind – I know that not every counterfeit good is a DVD. Some of them are condoms. And that leads me to Loretta Napoleoni’s awesome point:
Why Counterfeiting is Good for the Original
Here are two articles about two studies:
Let me give you the summarised version. Here is what the lobbyists in favour of ACTA are saying:
I realise that some may read that as me mocking the pro-ACTA argument from the get-go. Oh! How deceived you would be. I paraphrased point 3 a bit – but that was really the extent.
Here are the counterpoints:
Where Counterfeiting is Legitimately a Problem
Counterfeit drugs sound serious. As do counterfeit airplane parts. And counterfeit food items (although, by my understanding, that’s usually just horse).
Oh yes – and counterfeit condoms.
Which brings me neatly back round to the original article. Police in the Fujian province just confiscated more than 2 million “incorrectly-labelled” condoms. The enterprising individuals concerned had purchased condoms from one factory, packaging materials from another, and had appointed themselves as “assemblers” in the supply chain. And, I guess, adders of brand value?
No word on whether the condoms were faulty.
But ultimately, faulty condoms, unlike fake handbags, can have a real impact on a confused consumer: death, disease and/or unexpected offspring.
So regulate those guys. And let the DVD retailers take care of themselves.
*via iTunes U, naturally: the audio lecture link.
**Ermagherd. Lerst sehrles!!
***Could this argument be any more emotionally-manipulative?
In the BBC newsfeed this morning:
“Eurozone recession continues into sixth quarter.“
The headline made me think about how most of us know the words “recession” and “depression” as interchangeable jargon used by the business news anchor. Also: “contraction”.
It’s the kind of language that floats ominously around the TV room while you’re tweeting an instagrammed photo of the cup of hot chocolate that you just made. And maybe I should try it with that vintage filter. And if I just fiddle with this light/dark thingie… Perfect. Looks retro but not like I tried too much. Send. Oh. The business news. Where’s the remote?
And then you flip over to The Good Wife where you watch Diane Lockhart announce that “this economy is about to enter a triple dip recession”… And even as Christine Baranski layers her character’s line with hushed seriousness, you can see her eyes glaze over and the proverbial blank speech bubble popping up on the side of her head.
But before we can get to recessions, depressions, contractions and triple dips, I need to backtrack a bit by asking the fundamental questions. Starting with:
What is an Economy anyway?
This question is a bit like asking “why is water wet?” – we may know what it is empirically; but theoretically, it’s complicated.
If you look at the root of the word “economy”, it derives from the Ancient Greek word for “household management*”. Which gives a great starting point: because any household more or less functions as an semi-independent ecosystem:
And an “economy” – as we understand it – is more of a collective noun for all of the households (micro-economies) contained within a geographical region (the macro-economy).
But even if we know what it is, this leads to an even more difficult question. That is: how do you know if a economy is a good one? Some options (and I’m sticking with the household analogy):
Gross Domestic Product (GDP)
GDP is the least of the measurement evils: we look at how much an economy is producing as an indicator of how well that economy is doing. Of course, there are some problems with it:
But let’s just accept that we can address some of those problems and come up with a reasonably reliable estimate of GDP. At that point, we can start comparing the change of GDP from year to year. And when a country produces more, it’s experiencing economic growth (AKA a boom period); and when it produces less, there is economic decline (AKA a bust period).
But this is all highly relative to time. For example – an economy naturally produces less in January – because people are still getting back from Christmas leave. Would we say that the economy just went through a bust period?
Seems a little extreme…
How Long is a Piece of Bad Time
Economists love to agree on conventions – especially in relation to time. And then, of course, disagree about whether the convention is appropriate.
But that aside – clearly, looking at GDP movements month-on-month is subject to seasonal distortions (like a strong Christmas period in December, followed by a slow month in January). So to smooth out those impacts, economists will talk about quarterly movements in GDP.
When GDP decreases from one quarter to the next, this is known as a “contraction“. But again – this need not necessarily be something dismal. If a country is very agricultural, the harvest Quarter will usually be splendid in GDP terms – followed by a less productive winter Quarter (ie. the economy undergoes a natural contraction).
But if an economy contracts for more than two quarters*****, that’s beginning to look less normal. After two quarters of negative growth, it is generally accepted that the economy is experiencing a “recession“. And in turn, a “depression” is usually declared when an economy has been in recession for longer than two years.
Now obviously, there are some interesting variations (or distortions!) that can take place. Let’s say that you have two really bad quarters (Q2 and Q3), but things recover a bit in Q4 because of Christmas spend and bonuses. But it was just a short term thing, so you go back into two even worse quarters (Q1 and Q2) of the following year. You’re now in a “double dip recession“. And if that cycle repeats itself, you can end up with ever increasing multiples of dips.
But I don’t think I can overemphasize how unusual it is for an economy to contract quarter in and quarter out for quarters on end. We’re not just talking about a “bad time” – because when you’re in a “bad time”, you expect to hit the bottom of the barrel, and then improve relative to the bottom of the barrel. It’s the problem with the phrase “recession” – it implies that you’re just in a funk, lazing around and refusing to get out of your pyjamas.
This headline up top – it’s the Eurozone getting progressively worse as the quarters go by. To extend the metaphor, the lazing around caused bedsores, which then started to smell, which attracted the rats, which drove away your mother, which stopped the chicken soup from being delivered.
If the cycle continues, Europe may end up in a depression. And at that point, the concern is that the atrophy will leave her trapped in the house indefinitely.
That headline is terrifying.
But try not to worry too much.
*goes back to tweeting his support for Angelina and her pre-emptive double mastectomy*
*For those interested in the etymology, the word is “οικονομία” – which is in turn derived from “οíκος” (household) and the verb “νεμω” (I manage).
**It’s why GDP is normally quoted two ways: once in US dollar terms, and once in “Purchasing Power Parity” terms – meaning that the GDP number is adjusted to reflect the fact that you can buy more for $1 in South Africa than in France.
***Most economists just ignore this. Part of the justification might involve: “if too much of a product is produced, then its price will go down, so we’ll get an accurate reflection”. Which is fine, unless you have a government determining the price of holes artificially… And/or you have a population that wants every person to own four houses on the premise that they can rent them out. But, like, to whom?
****Clever people making estimates do a lot of the work. As does the Tax Collection Authority…
*****The quarters:
On my last family holiday, I branched out on easyjet to visit Berlin. Whilst there, I suddenly realised that my camera simply could not do without a tripod – because, obviously, all my tourist photos of the Brandenberg Gate and Alexanderplatz were missing the most important part (me, waving). So I stepped into one of those giant discount electronic stores and searched for the cheapest, lightest, and most fold-down-able tripod available. I managed to find one that cost €4.99* – which delighted me no end, because South African debit card conversions had made for a very budgeted branching-out.
I arrived at the till and presented my debit card. At which point, the much-pierced teller took one look at it, handed it back, and wagged a tattooed finger at me. Turns out, they don’t accept Visa cards in that store. They, ah, only accept American Express.
At which point, I got properly annoyed. Up to that point, in my mind, the whole Visa/Mastercard/AmEx logo on my card was just luck of the draw. The guy issuing the card at the Enquiries desk would just pick one, hand it to me, and that was that. So how dare this German department store reject my purchase on the basis of a decision made by a bank clerk?!
Apparently, Germans don’t take too well to that particular kind of customer complaint. Especially when delivered in loud english. So I changed my face, handed over a €5 euro note, and left rather hurriedly.
But I have now nursed the anti-AmEx grudge. And seeing as the world of business is largely preoccupied with vagaries of Chinese economic data this morning, I thought that it might be a good time to do a bit of research into credit card companies.
What Do Credit Card Companies Actually Do: A History
It’s a good question. Because when you swipe your card (debit or credit), aren’t you just arranging for an EFT into the merchant’s bank account? I guess that’s always been my in-my-head explanation for what’s going on. But really, I had no idea.
So here is the fascinating story of how we suddenly arrived at credit cards:
The point is: Visa and Mastercard became centralised lines of credit. This allowed places that would never normally have sold anything on credit (like restaurants) access to a whole new market of credit-paying customer. And instead of each store doing background checks and collection – this service would be conducted by Visa or Mastercard through its card-issuing members (banks).
In return, the merchant would accept a small discount from the quoted purchase price: ye olde credit card charge**.
Where Does American Express Come In?
AmEx really became famous for inventing the traveller cheque, after AmEx president J. C. Fargo travelled to Europe with traditional letters of credit and got rejected everywhere but the major cities. Before that, AmEx was mostly an express mail service that offered money orders in opposition to the US Postal Service.
In the 1980s, American Express got excited about Investment Banking (it was the thing to be!), and acquired the investment bank Lehman Brothers Kuhn Loeb. Lehman Brothers was eventually spun off into its own entity in 1994, and went on to become famous for being the 2008 Financial Crisis and trying to steal money from nonprofits (see yesterday’s post).
But it was in the late 1980s that AmEx released its first proper credit card. And to gain market share, they went on a spree of offering special discount charge rates (which were pretty close to zero) to retailers that agreed to accept only AmEx credit cards.
Obviously -Visa and Mastercard complained. But they didn’t really need to. Probably because of that policy of zero-charges for exclusive merchants, American Express was forced to charge higher fees to places that weren’t exclusive (4% versus the 1.5%-2% being offered by Visa and Mastercard). So many non-exclusive merchants stopped accepting AmEx cards.
That was no good for a new card – so AmEx was forced to become a little more competitive and lower its fees.
Nevertheless, that perception of American Express bullying the small retailer that can’t afford to be an exclusive AmEx merchant has never really gone away. Which I guess is why more of us still have Visa and Mastercards. And it’s not entirely fair, because AmEx fees are significantly lower than those charged by PayPal (so I’ve read) – and yet we all love Paypal…
FYI though – AmEx charges are generally slightly higher than those of Mastercard and Visa (probably because the AmEx network is smaller, so there is less spreading of costs…).
Here’s a Basic Credit Card Charge Breakdown…
Whenever you swipe your card, or pay for something online, there is a fee charged. Some of that fee gets absorbed by you, some of that fee gets absorbed by the person you’re paying. But in any credit card transaction, there are usually three recipients of that fee:
Either Way, Just Remember
Whenever you’re in a discount electronic store in Germany, you need to pay with American Express.
For everything else, there’s Mastercard.
And Visa.
*And you have to love ze Germans – because I still have it, and it still works!
**Incidentally, realising this now fills me with rage. Once upon a time in my youth, I waitered at The Greek Fisherman in the V&A Waterfront in Cape Town. And every time one of my tables paid via credit card, the restaurant would deduct money from my tips – because of “insurance”. And they’d do it to all the waiters. I mean – could it be more wildly unethical – making the serving staff carry the credit card charge? No one eat there.
Here’s a headline:
“Lehman Reaches Beyond Grave to Grab Millions From Nonprofits“
Spicy. It’s Twilight meets the Zombie Apocalypse meets CNBC’s Squawk on the Street.
The background:
The story summary:
Which all sounds really terrible. But I have significantly less sympathy for non-profits than the journalist writing this article. Maybe I’m jaded (someone is sure to accuse me of that) – but ever since reading the TIME Magazine article about the billing practices of the healthcare industry in the US, I have been a little more circumspect about non-profit organisations.
What Does It Mean To Be Non-Profit?
Being a non-profit organisation does NOT mean that “it doesn’t make any profit”.
What being “a non-profit organisation” actually means is that the organisation/company does not exist with the primary motive of making a profit, nor does it have shareholders and/or owners. Which, in turn, means that any profits made are usually kept in reserve for future use by the organisation/company.
Because of these two characteristics, non-profits generally get special tax status (ie. no tax on any profits they make). Some examples: charities, churches, hospitals, schools, universities…
The Key Point
The real distinction between a for-profit and a non-profit company is entirely how-much-tax-they-should-pay. And if you think about it, that’s a strangely unnecessary distinction to make if a non-profit makes no profit to be taxed in the first place…
In practice, many non-profits are hugely “profitable” (like hospitals), and they’re often the recipients of generous donations (I’m yet to hear of a university that doesn’t send out pleading donation requests to its alumni). So they end up holding massive reserves of funds (what many tax codes like to call “surplus revenues”) that have to be invested and managed until the organisation has need of them in the future.
Sidebar: whenever you hear the word “endowment” used in reference to universities, hospitals and the like – just know that it’s usually referring to the swimming pools of coinage in which non-profit executives are contentedly doing breast-stroke.
In reference to this article, it is that type of non-profit that can engage itself in swap arrangements with big banks like Lehman. We must be serious. No cash-stripped on-the-poverty-line mom-and-pop charity is going to be holding complex swap arrangements with too-big-to-fail banks!
To close: I’d like to point out that there are probably as many non-profits that are owed money by the Lehman estate as owe money to it.
Those poor non-profits will only be getting 18 cents on the dollar…
Are we honestly saying that the winners are the only ones that should lose money?
*There are some definition issues here. Economists define depressions and recessions as different from each other. And depressions can become recessions, which make recessions a deeper form of depression. But neither of these is a contraction, which is normally symptomatic of both a depression and a recession, but need not necessarily… You get the general idea about terminology: all just ways of describing things not being well.
**Unfortunately, this is not a post about swaps and derivatives – which makes this footnote necessary. Swap and derivative contracts are essentially bets, and an “open” contract means one whose outcome either hadn’t been settled (in the case of a derivative), or one whose outcome was indefinite (in the case of a swap). If I was to describe this in metaphorical terms, a derivative would be a hand of Texas Hold’em where the river card is still to be flipped; and a swap would be a multi-roll bet in a game of craps (a game that no one really understands, but that seems to work out in your favour suspiciously often…until it doesn’t…but you’re still not sure why).
I am in my late twenties.
Most of my life is taken up by trying to restart exercising, checking facebook to see if anyone has like my last status update, typing and deleting tweets, agonising over the size of my twitter following, seeing how many more people have read today’s blog post since I last checked ten minutes ago, and panicking about any tax return deadlines that I may have missed.
It is a long and steady flow of small anxieties.
The thing about small things is that they eventually grow into big things. Game-changingly so. I mean – my steady trickle of panic may one day become a coronary. Or a lifelong commitment to an asylum. Or an inability to leave the house without locking the door four times and high-fiving the gutter. All possible.
But.
By this same principle, I can also make small changes, and I can achieve small successes, with similarly grand potentials of outcome. You know the old adage: “a lifetime to build a reputation”?
Financial freedom is no different. It does not arrive with a bonus, or a career opportunity. There is no lotto win, or fortuitous marriage into inheritance. The wealthy, as well as the poor, get stuck in the trap of not enough money*: that moment where the cash coming in does not cover the cash going out. At which point: credit cards are maxed, home loans extended, second mortgage applications submitted, relatives approached, et cetera.
The Solution?
The solution involves two things, really:
From what I have seen (in myself, and in others), the reason we fail on this front is that our default mental math position is addition rather than multiplication. We look at the small sacrifices as an additive process of pain, rather than a multiplicative organic process of future rewards.
The Crisis of Mathematical Conditioning
Our understanding of time and life as addition and subtraction has dramatic ramifications for the way we operate. Relationships built on grand gestures have greater standing than those forged with small but repeated acts of kindness. We shout at a subordinate when we’re having a bad day, because we can tally it up against all those times that we’ve been gracious. We don’t recycle because what’s the point if no one else is doing it.
The trouble is that life and/or reality is an exponential process. Small shifts have multiplier effects. And if you ever have the chance, you should read Alex Bellos’ “Here’s 2 Euclid**” – because in it, he explores the psychology of math.
In the very first chapter, he studies the Munduruku tribe of Brazil, who have no words for numbers beyond “five” (ie. their number system goes 1, 2, 3, 4, 5, many). He runs some experiments to understand their understanding of magnitude,*** and their understanding turns out to be logarithmic. That is, they had a natural understanding of magnitude. He then goes and looks at studies of children. And by a further series of (very clever) experiments, he establishes that before we enter school, our understanding of numbers is also logarithmic. But by the end of our second year of school, our understanding of magnitude has flattened into an additive process.
Let me put this another way: you know the question about placing a 1mm thick coin on one corner of the chessboard, and doubling it on each subsequent square, and asking how high the pile of pennies would be on square 64? That 184 trillion kilometre answer shouldn’t be so surprising: that answer should be intuitive.
As should the answer to this question: “on what square was the pile of coins half as high as the pile on square 64?” For most of us, the tip-of-the-tongue answer is somewhere around square 32. The intuitive (and correct) answer should be “63″ (because the pile doubles on square 64).
Summary: our current mindset places the growth of coins onto a flat arithmetic line, where a logarithmic mind would see a curve.
What this means from an Investment Standpoint
To put this in terms of an example:
The point of this post: you really should start putting some money aside. Even if it seems only a token amount (like R300/$30 every month into a unit trust), it’ll keep busily growing.
And the impact will be so much greater than your mathematical mind can contemplate.
*The wealthy man with the four kids in private schools and the two homes on mortgage and the wife with the retail habit – he too can go into convulsive fits of panic in the week before pay day. In fact – it’s almost worse. Because no one will understand – the wife will leave, the children will hate, and the two homes will empty and transfer into the hands of another beleaguered breadwinner.
**Also called “Alex’s Adventures in Numberland”. There seems to have been an argument between the American and Rest-of-the-World publishers about what title the book would be published under…
***Which is, after all, the fundamental reason for having numbers: to measure magnitude.
****And I say “real terms” because with that $300, you would be able to buy what you can buy today for $30,000. Just be careful – nominal returns means that inflation is being taken into account. And inflation is a negative (ie. if that $300 may only buy the equivalent of what $20,000 can buy you today if the 12.2% return was “nominal” rather than “real”).
I have a growing list of things that are certain in life:
But I’d like to add something to the list:
Cash Flows are a form of Moral Philosophy
Statement: all life’s paths can be represented as a series of cash-flows.
Statement: the greater the stream of future cash flows, the better the decision being made.
Statement: moral failure occurs when the stream of cash flows is reduced to its present day value, rather than being nominally cumulative*.
Statement: present day value does not equal the cumulative value because of usury and inflation.
Obvious Conclusion: the root of all evil is the nominal interest rate**.
But jokes aside, even you can be represented as a stream of future cash flows. Over the course of your life, you’ll probably earn a salary or some other income every year. And as you get older, you’ll begin to take on more executive roles, and earn bonuses, and build assets (hopefully). Some of that will be a function of your education; some of that will be a function of your career choices and networking abilities. Most of it will probably be plain Providence.
An investment advisor would refer to the value of that cash flow stream as your “human capital“. And as time goes on, that human capital will decrease (because those future cash flows soon become the parts of your bank account that you blew on a holiday to Thailand and a wardrobe of hand-tailored suits). But hopefully, the decrease in human capital is matched by an equal or greater increase in financial capital (investments). And interestingly, your investment advisor will change his investment advice depending on the type of human capital that you possess.
For example, if you’re young and you work as an Investment Banker – you might think that you should go out and buy shares, because that’s what bankers do. But that’s not quite true – because your job security and bonus is directly linked to how well the market is doing. So if you do buy shares, then both your investments and your job security will disappear in a market crash; which is counter-productive – because your investments are meant to be a safeguard. A teacher, on the other hand, whose employment has nothing to do with the market, should be buying units in the Allan Gray Equity Fund with every spare cent.
Back to the Point of the Post
I’ve been wanting to talk about cash flows and their importance for some time. So when I saw this article making headline news:
“Cerberus Financing Landlords Wall Street Can’t Reach“
…then I knew that the time had come.
And I like this story because it brings together some of my recent posts about banks, reserve requirements, and the fabulousness of debt.
Some Background Theory
An economy is a fickle thing. Sometimes it does well; sometimes it does less well. And the question always is – where do I put my money so that I can do best when things are going well, and do well when things are going to hell?
And the basic rule of thumb: hold stocks in a boom, and bonds in a bust.
Which does make some sense, because debt-holders rank higher than equity-holders in the priority list of “who I pay first”. Just take a homespun example: you sacrifice the family holiday in favour of the mortgage repayment.
This has led to the conventional concept of debt being “safer” than equity, because it’s more reliable in a crisis***.
So in a world of much well-meaning regulation, the Big Institutional Investors (pension funds, provident funds, insurance policy pools, etc) are generally required to put large swathes of their capital into debt securities (more commonly referred to as “fixed income securities” – as the return is generally linked to a set rate of interest). The standard fixed income security is the government bond. But there are also corporate bonds. And since the late 1980s, there has been excitement around asset-backed securities.
Some Background Story
Asset-backed securities… So in the 1980s, Wall Street (and, specifically, the bank of Salomon Brothers), realised that there were two things that they could be certain of:
And they did work out what it is, and they started buying up books of mortgages from any bank/loan-house that would sell them, repackaging them as different types of fixed-income security (known as an Asset-Backed Securities), and then selling them to Big Institutional Investors****.
By a gradual process of over-excitement, this led to the Subprime Crisis.
And at that point, a whole chunk of the fixed income market disappeared. Gone were the mortgage-backed securities. And the credit-card-receivable-backed securities. And the car-financing-backed securities. And the student-loan-backed securities (the bankers had been very busy…). And the asset-backed-security-backed securities (called a Collateralised Debt Obligation). And the asset-backed-security-backed-security-backed securities (also called a Collateralised Debt Obligation).
And after that: Greece, Cyprus, Portugal, Spain and Ireland happened to the sovereign bond markets.
So where is a poor Big Institutional Investor meant to put all the money if the law still requires them to hold fixed income securities? Into all the bonds that were left, is where. Which is partly why we have this awkward situation with the low interest rates**.
But the point is – there is this open gap in the market for some type of fixed income security that would fill the gap left by the lost asset-backed securities.
Welcome Cerberus and their “First Key Lending” Outfit
Cerberus is hedge fund that is quite famous for investing in unwanted and distressed assets, and turning them into great success stories*****. And they have set up First Key Lending to go back into the housing industry.
Because they are looking at the housing industry and saying:
It’s a whole new era of bubble.
Exciting times!
*If you are a douchebag today and you steal money – then that should land you in a future situation of no cash flow (prison). But if you see that risk as being far in the future, then the present value of the stolen cash has a higher value than the future cash flow you’ll lose by going to prison – and that theft then becomes a rational decision…
**See The Drag(hi) of Negative Interest Rates.
***This. This is a whole debate on its own. But another time.
****I described how asset-backed securitisation worked in this post: “What Is a Mortgage-Backed Security?”
*****People are often surprised by the profitability of distressed assets. But let’s say that a company is expected to pay its creditors 10 cents for every dollar that they owe. This means that the market-value of a $1 million loan is $100,000. Which sounds terrible to some. But I go and pay someone $100,000 for the right to that loan (that’s my investment in distressed debt), and then I help the liquidator to salvage 15 cents on the dollar. That means that, on liquidation, I get $150,000. Which is a 50% return on my investment! Don’t let the “cents on the dollar” line fool you. There is plenty money to be made off distress.
If I could ask all the deeply offended to hold back their outrage until the end of this post, that’d be great, thanks.
After months of being distracted by other reading material*, I have finally started reading “Poor Economics” by Abhijit Banerjee and Esther Duflo. And this week, happily, Businessweek.com published an article on microfinancing institutions:
“A Microlender backs startups to bring more than loans to the poor.“
Which gives me a chance to talk about microfinance and the poor.
What is Microfinance?
Muhammad Yunus, and his Grameen Bank, won the Nobel Prize in 2006 for founding microfinance, and for distributing small loans to the women of Bangladesh (which is actually known as “microcredit”). Or, to quote the citation, for “efforts though microcredit to create economic and social development from below“.
I think that we need to make the distinction between microfinance and microcredit… Microfinance is the provision of financial services (banking, loans, insurance, etc) on a small scale to the poor. Microcredit deals specifically with the extension of loans. And microcredit is where most of the media/academic attention is focused – as it’s the form of microfinance that is meant to release the poor from their poverty trap by providing them with the means to get out of it.
How Microcredit Works
The Grameen approach to microcredit (known as solidarity lending) works like this:
The above is a really clever mix of practical sense and human psychology. You make sure that the borrower is accountable to their friends rather than just the bank. You make sure that their default to the bank has a direct impact on their personal life. You heavily incentivise the group to make good on the debts on the individual without specifically requiring it. And some psychological studies have shown that there is a real difference between saying that you’ll do something and promising that you’ll do something**.
Also, Grameen Bank was talking about 98% of their microcredit loans being repaid. So only 2% of the loans made were going bad at the time. Just compare that to Spain today, with its recent bad debt number of around 10.78%. In summary: Yunus and Grameen Bank were saying that the poor are creditworthy.
It’s the type of statement that wins you a Nobel Prize.
The Problem
This news about the creditworthiness of the masses made a lot of investors very excited; and microcredit institutions began to pop up all over Asia, Africa and South America.
Awkwardly, these institutions weren’t nearly as successful… Critics began to say that there was not much evidence to suggest that any poverty alleviation was really happening. There was also some questioning of the Grameen stats***.
And rather unhelpfully, while all this was going on, Mr Yunus was fired from Grameen Bank for embezzlement (he maintains that the accusations were politically-motivated; which does seem to be the party-line of the recently (ironically) discredited).
So where did it all go wrong?
The Flaws in Microcredit
Some observations:
Enter: Poor Economics
When they sit back to logically assess microcredit, many economists make the following argument:
But that’s not what happens in most situations. And Poor Economics gives a great example of this. The authors were investigating whether the poor were stuck in a nutrition poverty trap. Here’s the basic summary of what they were investigating: because you’re poor, you don’t get enough to eat; and because you don’t get enough to eat, you’re too weak to work, so you stay poor.
They did their study in India, where they discovered that increases in income amongst the poor meant that they ate less as their income increased. And that’s not saying that they’re eating enough – because they weren’t eating enough in both situations. But all these poor people being interviewed who were claiming not to have enough money to buy food? They owned TVs.
Now isn’t that interesting?
It’s more than interesting: it’s fascinating. And here’s the explanation offered by one of the gentlemen they were interviewing:
Life as a poor person is boring – I’ve tried to find work, but I can’t – so I usually just spend my day here at home. And if I use my money to eat today, I’ll still be hungry tomorrow. But if I save to buy a TV, at least I won’t be so bored. Sure – I’ll be hungry. But I’m always hungry. So I’d rather have the TV.
That logic is flawless.
But that’s not really so good for the world of microcredit. Because it implies that at least some of those loans (if not most) are going to be used to alleviate boredom…
And maybe the reason we haven’t managed to make much headway against poverty is because the people who can help really don’t understand it at all.
PS: read the book. Even the Freakonomics guy was all over it with the praise.
*Example: the final book in Robert Jordan’s Wheel of Time. Like finally. @Gops_Sid – I hope you’ve also done it!
**Not kidding. But I guess we know it intuitively. It’s why we make marriage vows public, right?
***The 98% was almost definitely too high. According to the Wall Street Journal, over a fifth of the loans in question were overdue by almost a year. It’s a perennial problem with banks. Do you admit that the loans have gone bad? Or do you quickly give the borrowers a new loan to pay back the old loan – so now it looks like all your loans are new? Nothing like making it all look good on paper…
****Mr Yunus was shocked. He announced that he “never imagined that one day microcredit would give rise to its own breed of loan sharks”. Honestly. They should revoke the Nobel for that statement alone. On the one hand – the illiterate and the desperate. On the other hand – the very literate driven by a profit motive. That is a recipe for exploitation. And it’s just standard game theory.