Thursday, December 17, 2009
Friday, December 4, 2009
Thursday, December 3, 2009
Egads! Winterspeak is shocked
In a post entitled winterspeak.com: Banks are even more super than I thought, Winterspeak is groping towards an understanding of what it means for balance sheets to expand, and the role of money in funding investments (it doesn't).
The idea that banks fund themselves by expanding their balance sheets is not unique to banks -- that is how all investment works for both bank and non-bank entities.
The only super thing about banks is that they have below market funding costs and access to government overdraft facilities that allow them to evade market pricing of assets. Banks can jump in and out betwee mark-to-market (when it suits them) and mark-to-model (when it suits them better).
Investment is not funded by savings, but by expectations of future returns, discounted by opportunity cost (e.g. by all other return prospects). The role of savings (== profits, as flows), is to help price financial claims against each other. E.g. if one investment pays out $1/share each month and another investment pays out $2/share each month, then the share prices of both investments are adjusted so that the risk-adjusted cash-flows of both investments are equal.
For example, suppose I have a bright idea to make money in real estate, or giving massages to former Soviet Hockey players. It doesn't matter what the idea is, I want to float bonds (or equity). So I am willing to assume a financial obligation:
All I have now is a piece of paper -- a promise. I then sell my paper to the financial markets. In exchange for this promise I obtain cash to buy a new massage table or a shopping center in the desert, as the case may be.
How does my investment get funded?
An investor holds money in a money market account, that is backed by treasuries. The investor liquidates this account and buys my paper. I take the proceeds from the investor and put them into a money market account, backed by the same treasuries that the investor sold.
For every buyer there is a seller. In this case, I sold my paper and bought treasuries, and the rest of the market (by identity) had to sell me treasuries and buy my paper. We just made an exchange, in which both treasuries and paper were priced in terms of cash and then an equal amount of one was exchanged for the other.
The whole thing could be achieved if the economy contained only 1 ruble (and advanced settlement software). I could raise hundreds of billions in ruble assets even if only a single ruble exists in the whole world. Money is not used up in the buying and selling of financial claims, and money does not fund investments, rather financial claims are all priced in terms of money.
In this way, the portfolio of the investor did not increase or decrease as a result of making the investment. All that happened was they he shifted his portfolio holdings in a way to reflect his return expectations. Tomorrow, he could sell his claim on me and instead buy treasuries again. In the process of doing so, the price of my paper my rise or fall in relation to treasuries, and therefore the investor can suffer a gain or loss on the investment.
The only way that an investor can profit from financial transactions is via capital gains or losses, as the present value of dividend and interest payments (discounted by opportunity cost) are already reflected in the price of the asset. It is only misperceptions of this present value that can enrich or impoverish an investor.
Therefore investments are funded by an expectation of future profits. They are not funded by savings (=profits accumulated in the past).
The only special thing about banks is that they have government backing and government-set cost of funds, whereas private investors have to pay the market price for funds. When a private investor wants to buy an asset with leverage, he must pay the market price for funds, whereas a bank is able to pay the government-set price for funds. That, and a lot of subsidies + direct phone calls to Treasury, is the only difference between banks and non-banks :)
The idea that banks fund themselves by expanding their balance sheets is not unique to banks -- that is how all investment works for both bank and non-bank entities.
The only super thing about banks is that they have below market funding costs and access to government overdraft facilities that allow them to evade market pricing of assets. Banks can jump in and out betwee mark-to-market (when it suits them) and mark-to-model (when it suits them better).
Investment is not funded by savings, but by expectations of future returns, discounted by opportunity cost (e.g. by all other return prospects). The role of savings (== profits, as flows), is to help price financial claims against each other. E.g. if one investment pays out $1/share each month and another investment pays out $2/share each month, then the share prices of both investments are adjusted so that the risk-adjusted cash-flows of both investments are equal.
For example, suppose I have a bright idea to make money in real estate, or giving massages to former Soviet Hockey players. It doesn't matter what the idea is, I want to float bonds (or equity). So I am willing to assume a financial obligation:
To pay the bearer of this instruments 10 rubles a week.
All I have now is a piece of paper -- a promise. I then sell my paper to the financial markets. In exchange for this promise I obtain cash to buy a new massage table or a shopping center in the desert, as the case may be.
How does my investment get funded?
An investor holds money in a money market account, that is backed by treasuries. The investor liquidates this account and buys my paper. I take the proceeds from the investor and put them into a money market account, backed by the same treasuries that the investor sold.
For every buyer there is a seller. In this case, I sold my paper and bought treasuries, and the rest of the market (by identity) had to sell me treasuries and buy my paper. We just made an exchange, in which both treasuries and paper were priced in terms of cash and then an equal amount of one was exchanged for the other.
The whole thing could be achieved if the economy contained only 1 ruble (and advanced settlement software). I could raise hundreds of billions in ruble assets even if only a single ruble exists in the whole world. Money is not used up in the buying and selling of financial claims, and money does not fund investments, rather financial claims are all priced in terms of money.
In this way, the portfolio of the investor did not increase or decrease as a result of making the investment. All that happened was they he shifted his portfolio holdings in a way to reflect his return expectations. Tomorrow, he could sell his claim on me and instead buy treasuries again. In the process of doing so, the price of my paper my rise or fall in relation to treasuries, and therefore the investor can suffer a gain or loss on the investment.
The only way that an investor can profit from financial transactions is via capital gains or losses, as the present value of dividend and interest payments (discounted by opportunity cost) are already reflected in the price of the asset. It is only misperceptions of this present value that can enrich or impoverish an investor.
Therefore investments are funded by an expectation of future profits. They are not funded by savings (=profits accumulated in the past).
The only special thing about banks is that they have government backing and government-set cost of funds, whereas private investors have to pay the market price for funds. When a private investor wants to buy an asset with leverage, he must pay the market price for funds, whereas a bank is able to pay the government-set price for funds. That, and a lot of subsidies + direct phone calls to Treasury, is the only difference between banks and non-banks :)
More on wage shares in OECD
Data source for wages:
http://www.oecd.org/document/63/0,3343,en_2649_33729_38939455_1_1_1_1,00.html
GDP/capita taken in current prices from OECD country statistical profiles.
Wednesday, December 2, 2009
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