Feb 27 2009

The Cow Theory of Economics and Accounting

Kal @ 14:00

John Carney at The Business Insider Clusterstock, gets a lot of mileage out of cows. On 5 February:

AIG Implodes: The Two Cows Version

"Still confused about how AIG lost its shirt by going into the securities lending business big time? We understand. It's terribly complex and full of words that make your eyes glaze over."

So we decided to break it down into the simplest terms Wall Street transactions can be explained: the two cows story.

You have two cows.

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

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.

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.

A third of the country goes vegetarian.

You thought your two cows were worth $200 and now they are worth $140.

You express confidence in your financial health. Your assets are now worth only $200--your two cows plus the one John owes you--but your liabilities are still only $100. If necessary, you could sell the assets at this distressed price and pay off all your loans.

You hold onto your cows because you are sure the market is "dislocated." Some day someone will want to eat beef again.

The rest of the country goes vegetarian. Your two cows are now worth $2 each to guys who want to make dog food.

John Paulson buys a cow in the market for $2 and he gives it to you as repayment of the loan. You now have three cows worth six bucks.

John wants his $10 back.

The bank calls. It wants its $90 back.

You call the Federal Reserve and ask for a bailout.

 

 Then of 6 Feb he had a simple explanation of accounting rules, again using cows.

Suspending Mark To Market Accounting: The Tale Of Two Cows

"Talking about accounting rules is famously obscure, my-eyes-glaze over stuff. But much of what happens inside of investment banks--including all those writedowns you've heard so much about--turns on accounting rules.

Now there are reports that the SEC is planning to give banks "flexibility" on mark-to-market accounting rules. It may even suspend mark to market rules. What on earth could that mean?"

Let's go to the cows.

You have two cows.

You write down on a piece of paper that the cows are worth $100 each.

You notice the cows are on fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the fire.

Your cows are dead from fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the dead cows.

You notice that you aren't getting as much milk as expected, so you adjust the model and mark the cows down to $98. You are confident, however, that the dislocated stream of milk revenue will quickly revert to expectations.

You need to borrow some money so you ask investors for a loan against the cows. The investors tell you the cows are dead, and you already owe them $200 dollars you borrowed to buy them in the first place. You show them the paper that says the cows are worth $98 each.

They light your paper on fire.

You ask the government to buy the dead cows at $98 each.

The government holds meetings all weekend and finally comes up with a plan to inject $45 dollars into your cattle ranch. In exchange, the government gets a right to milk generated from the cows at some point in the future. It expects you'll buy a new cow with the $45.

You have two dead cows, $45 and $200 in debt to your investors. You have no plans to buy new cows.

Tags:

Category: Accounting | Conventional Economics | Economics

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