s is the case with many mature, commoditized industries, there are a few types of economic agents that help facilitate free and efficient trade. Manufacturers ultimately make goods and services for an end user, but may include in the transaction brokers and resellers. Brokers are in the business of selling information by discovering market prices and introducing buyers and sellers who did not otherwise know of each other. Resellers provide the market with liquidity by timing their purchases from and sales to any market participant in the hopes of capturing a per unit margin for themselves.
Such an intricate ballet of free trade is predicated upon a sufficiently free flow of information between traders. The absence of traders not knowing their counterparts or — and it may seem mind-boggling that I even write this — exactly what good or service they are buying or selling is a recipe for market disaster. Uncertain markets not only attract few traders, but also cause panic among those who have existing positions in the market. Panicked traders have an incentive to close their positions and eliminate their risk exposure as quickly as possible.
This is the anatomy of bank runs and seizures of credit markets. What do Second Life's bank run — prompted by the realization that promises of silly market returns are just that — the market for feed ingredients for cattle, and the current crisis of confidence in our economy have in common? Fundamentally, everything. Whether one trades linden dollars, rail cars of grain products, or credit default swaps, the anatomy of market panics remains the same.
We are being taught a second lesson by Second Life, and it is much more painful this time.
Every seller knows the characteristics of his product for sale, and every buyer approaches him with a similar understanding.Let us trade some feed ingredients, shall we? Because cattle require a certain ration to meet performance targets, considerations of an ingredient's nutrient profile, handling characteristics, color, et cetera, must all be taken into account. Not all market participants know of each other, but every seller knows the characteristics of his product for sale, and every buyer approaches him with a similar understanding. The company I work for manufactures these ingredients and sells them in bulk amounts in trucks and rail cars. Sometimes we seek to make a trade but do not know of an available buyer, so we enlist the assistance of a broker to discover prices and available buyers on our behalf. Sometimes we seek to sell a large quantity for a long time frame and cannot find an end user willing to take such a position, so we sell to a reseller who is willing to take on risk given his market bias. And sometimes we buy product ourselves to cover an unexpected production shortfall, or a take a position given our own market bias.
To be sure, this available array of transaction options can introduce inefficiency and confusion. It is not uncommon for a broker to propose a bid or offer for product from an end user or reseller with whom we already have a business relationship. We have sold to resellers who have in turn resold their position to other resellers, who have in turn sold their position to an end user who is buying product directly from us, as well. In fact, one time we bought a rail car of ingredients from a reseller to cover a production shortfall, who had purchased from a second reseller, who had purchased from a third, who had purchased from a fourth, who had purchased through a broker from a manufacturer five months earlier. We were that manufacturer.
In addition to the many agents that can be involved in — and sometimes overly complicate — a trade of feed ingredients, all participants must assess risk before entering into an agreement. For example, when a rail car of ingredients can be worth $20,000, and 100 rail cars can be sold to a single reseller whose physical assets can be just an office and a phone, there can be a high risk of non-payment, especially if the reseller owes the manufacturer $20,000 per car and because of changing market conditions, can only fetch $16,000 per car today. End users can pose similar credit risks, and typically do so when they have priced only one component of their cattle feeding enterprise, and market conditions have since changed such that they have a negative margin for every head of cattle they sell. A manufacturer or reseller must ask himself: if I deliver a product and a buyer cannot pay, how do I capture as much of the trade's value as possible? Manufacturers themselves pose risks too, most notably surrounding non-delivery. What happens to the cattle that are conditioned to feed on a specific schedule when there is no product available at feeding time?
The devil lies in the details of repackaging.Free markets do indeed evolve in complexity to service the desires of its participants, but obviously some underlying characteristic must remain constant in order for the market itself to be valuable and viable. In all of the aforementioned, the constant is the feed ingredient itself, and because it is traded daily in numerous geographies, its price transparency. Buyers and sellers still know the product's profile and know they are paying a fair market value for it.
What if manufacturers and resellers fundamentally repackaged how they sold feed ingredients? Conceptually, there may be value in doing so. Ingredients are mixed with others before being fed to cattle, so perhaps one rail car could carry multiple ingredients. Perhaps some investors or banks rich in capital could lend money to resellers to take more aggressive positions, who could then resell to others in the same position and capture more revenue against borrowed money. The devil, of course, would lie in the details of managing this new repackaging; after all, the underlying supply and demand of feed ingredients would drive the value of new packages.
Is it not silly to think that a viable package of feed ingredient sales is a rail car of 'stuff' that no one can define, because no one kept track of what ingredients went into the car? Is it not silly to think it wise to lend 500 rail cars worth of money to resellers with little collateral, who could be bankrupt and unable to pay if the market moved against them, leaving the lender out in the cold? Is it not silly to think that an insurer could simply collect premiums from the lender who lent to the reseller, and never really ask the question, "If the reseller defaults on a loan and we have to pay out to the lender, do we have enough money to do so?"
Most would answer to the above queries, "Of course it's silly to repackage feed ingredient sales as proposed. That puts the viability of the market at systemic risk."
Unfortunately, this is exactly what has happened in the housing market.
Like combining multiple feed ingredients in a rail car, many home loans have been packaged into a block of mortgages. One mortgage for $200,000, for example, gets rolled into a set of 20 worth $4,000,000. The mechanism by which these blocks are resold, cut into pieces, and then resold, recut, resold, and recut any number of times makes the value nearly impossible to quantify. This is the equivalent of cutting up a rail car, reselling fractions to resellers, who combine it with other fractions, and continue to resell. How does anyone know what he has bought? How do you assess the value of a packaged rail car that contains 2% of a $200,000 mortgage in California, 50% from Arizona, and 48% from any number of other states?
The market that bought, sold, and split and combined these Technicolor rail cars of mortgages attempted to assess the value of each rail car by rating the debt of the mortgages therein. Debt ratings agencies, however, incorrectly rated the debt's risk of default because their models that did so were obsolete. So now, we have these rail cars of aggregate-only mortgage debt that has been incorrectly rated.
What is the value of the rail car of mortgages defined only in aggregate with a bogus debt rating? In a word, we don't know.
So what caused this crisis in the first place? We need only look at our Second Life for an answer.Uncertainty, coupled with rising rates of mortgage default, has caused the market to panic. Commercial banks, investment banks, hedge funds, and many other investors hold these rail cars of mortgages that now have no buyers. Lenders are unwilling to loan money to institutions that have large portfolios of these mortgages because that's a risk to the borrower's credit worthiness and subsequently, their potential inability to pay back a loan. Much like the Second Life bank run, we have seen first life bank runs and the market for short-term loans, so legitimate business have cash flow to operate, become much more expensive for some, non-existent for others. This problem will not subside until the positions of the portfolios can be accurately valued, or the government (read: taxpayer) buys these portfolios.
So what caused this crisis in the first place? We need only to look at our Second Life for an answer: greed. Loans were made to unqualified homebuyers, brokered by those whose only incentive was to collect a commission on the trade. Debt was rated incorrectly due to overly optimistic models predicting future home values. Borrowers assumed they could refinance interest-only mortgage loans when their house climbed, and only climbed, in value. Banks continued to loan against borrowed money, called leverage, to unprecedented historical ratios. Mortgage insurers assumed they would not have to pay out, but only collect premiums on their policies.
In all of this, I see an element of disconnected connectivity. Walking through an analogous example of potential new ways to trade feed ingredients reveals the folly of assumption and greed behind ill-advised home loans, position quantification, re-sales, leverage, and mortgage insurance. Life has a knack for re-teaching lessons until one learns them. Hopefully man has realized that no amount Second Life promises of 60% return on investment, or first life financial alchemy can shroud the fundamentals of economic behavior and value. Many men like to make a quick buck, so I wager that we will be taught yet again.
