Saturday, September 20, 2008

On the economy

Image credit to Paul Krugman. But I'm talking about his column and need the example.

I think I'm getting it. I might be getting it in teeny, tiny bits, not even bites, but I'm getting it.

On his blog today, Paul Krugman writes about doubts on the latest bailout.
I think of a hypothetical institution, which tradition says we should call Capital Decimation Partners. CDP’s balance sheet looks like (the above image)

Now, obviously CDP is in trouble if it can’t sell the toxic waste at all. But suppose that Hank Paulson does his reverse auction, and it turns out that the Treasury’s price for toxic waste is 40 cents on the dollar. Even so, CDP is still underwater. So what does Treasury do then?
Apparently, if I have this right, assets does not always equal money in the bank, or a building, or the cars and computers owned by the company. I can also include IOU's other people have given you, in exchange for something like money to buy a house.

An IOU is an asset. Got it.

So what this image is saying is that the company in the example, CDP, is claiming $515 in assets, and has given IOU's to other people for $500. On paper they should be able to pay off the IOU's they wrote, and still have $15 left over.

But they never had at least $50 of that on hand. Maybe even more than $50. It was just an IOU from someone else, someone else's good name.

Now, in the current economy $50 in those IOU's are not going to be paid back, and so even if the government says they'll take those IOU's. But they're not going to pay you $50 for a pile of worthless promises. The example says $0.40 on the dollar. Which means they would now have

OK stuff = $465
Money for
bad stuff
from the
govt. = $20
$ 485

And they are still short $15, just to pay back all their promises, let alone keep going.

Now, the elephant in the room no one is talking it just me or is calling an IOU from someone else an "asset" kinda dumb. If I have $100 in my checking account, loan $50 to my sister, then write a check for the whole $100, that check is going to bounce, regardless if I tell the bank I have an asset in the form of my sister's IOU or not.

I humbly suggest to the financial community that they stop calling IOU's assets, stop using them to figure up how much you have. Assets are what you have, be it stocks or land or cash or goods. Debits are what you owe other people. And IOU's get their own column. Call it profit if you like, when it gets paid back. Pocket it. But don't use it to figure what you're worth.

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