What it means is pretty simple. To explain, let's dust off our test economy again. A young entrepreneur takes out a loan to build an apartment complex. He's done 'due diligence' and knows the market can bear a new complex. He's shown all this to the bank and the bank has issued the loan. He builds his complex.
At first, things go well; he has nearly full occupancy as everyone likes a new apartment. Since he's fully occupied, his rent is relatively low. Since his building is new, maintenance is very low. He's making money and meeting his payments.
Well, after a little time, along comes his first problem. A tenant defaulted on his rent, and has to be evicted. The tenant trashed the apartment in the process. Now the owner has to fix the apartment and find a new tenant. He has reserves for just such a thing, and fixes the apartment as fast as he can. It is a little harder to get a tenant and the time he spends trying to find one he's facing lowered income so it is hard to rebuild his reserves.
If he has ten units, he's lost ten percent of his income waiting for a new tenant. When he finally gets one, he sets about rebuilding his reserve in earnest, but that's when the first problem with the building shows up. Major repairs will ruin him. He takes out another loan.
That loan increases the demand on his income. Whereas before he had around 10% extra income to create a reserve, now he's down around 3% reserve. He really has no choice in order to remain fiscally responsible, so he raises rents back to where he can get his ten percent, which amounts to a 9.7% increase in rent.
And here we find the first margin: say one tenant has a wish to buy a trailer home to get out of the apartment, but he keeps thinking that the apartment is a few dollars cheaper and the utilities are lower. Well, on a $500 apartment, that's a $48.50 raise in cost. He, somewhat annoyed, finds a trailer he can swing for less than that and breaks his lease at the earliest convenience.
We say this happened at the margin because the cost of the apartment changed, so compared to the trailer, the margin that favored the apartment evaporated, indeed, reversed. The difference of 9.7% itself was not much, but the difference was enough to cross a threshold. That is the important point.
Our landlord is in trouble again, although less so because there is far fewer repairs he has to do, but he is once again running right at his margin. Either he gets a tenant or he raises rents again. Well, suppose he finds a tenant, but only by guaranteeing that rent won't go up during the six month lease.
Down the block, an apartment chain puts in 36 brand new units. Since this is a corporation that issued a bond, its interest rates are a lot lower and its overall cost is lower. Now our apartment owner finds out he is not able to compete based on price. The other apartment complex is able to run many more empty units and still compete on price because corporate is funding its startup cost. Our landlord loses another tenant.
As time goes on, he ends up with more and more leases that don't let him raise rent. He begins to fall behind. As each lease renegotiates, he raises rent, but, since he's been losing ground, he has to raise rent way more than he otherwise would.
For instance, had he been losing 1% per month, he will have to raise rent 2% just to get some positive cash flow over the cost of servicing his loans. In reality, he'll raise rents nearer 5%.
Fortunately, the large complex down the block is quite full and people don't often move until seriously annoyed. So, he doesn't lose tenants for a while, although he stumbles into a catastrophe or two with his building, but he manages to get largely back on track and consoles himself that his debt load is not higher than the value of his property.
Now, the market crashes. The large complex down the street is part of a corporation that is stable, has lots of reserves and low debt, so the sudden loss in the valuation of the building does not hurt it. However, our guy is suddenly faced with the realization that he has more debt than value in property. At the same time, two of his tenants become unemployed and move back with their parents.
He is now unable to do anything. If he raises rent, he'll lose tenants as he already commands a high premium over the big complex down the block. If he doesn't raise rent, he will be bankrupt within the year, as his reserves were set up to cover only one tenant gone, which was a reasonable idea when he started.
As time grinds on, he casts about for money. He tries to get loans, but nobody will loan more than the development is worth. With no other real recourse, he files for Chapter 11.
This is the second instance of margin. This man is running a revenue-based business, one that requires a certain minimum revenue to remain solvent simply because of the debt load and the other fixed costs. When his income falls below the minimum costs, he is insolvent. His business valuation goes away.
Another margin starts to crop up. He's been paying taxes on his profits, but this year he will have simply massive losses, so will pay no taxes. Enough of this and the state, which is also revenue-based, will have to cut back.
The other major margin is his bank. His loan was packaged and sold as a CDO tranche. Well, he's not paying anymore in C11 bankruptcy, and won't pay for as many as three months, at which point his bankruptcy either becomes chapter 7 or he gets a renegotiated mortgage. Either way, the bank is getting less revenue.
Now, the bank has sold an investor part of this CDO, but cannot pay the monthly payment for everyone because the income is less then the outlay once again. It makes reduced payments to its investors.
The investors also have a margin. No matter what, reduced income will drive reduced spending, as they investors get nervous and try to build up their margins.
And, here we have the truth of the statement and the reality of why no amount of stimulus short of enough to trigger hyperinflation will stop the current depression. People everywhere are trying to increase their reserve because they're worried about their margins. However, their margin is someone else's income, so that person sees income go down and must increase reserve against further downturn.
Simply give people money and they will save it. This will not drive spending. Give banks money and they throw it at 'fires', ie, their own investors, in order to avoid collapse, as the margin problem causes another problem, the one of concerned investors demanding their money.
In China, governments are handing out vouchers for spending, trying to force an increase in spending this way, but if those vouchers are not greater than the income of the people who receive them, the people will simply use the vouchers for needs and bank the money they earn as reserve. In other words, consumption will not increase.
Now, let's examine two courses of action in our man's case. In one course, the government steps in and injects an amount of money into his business to prevent his failing. In the other course, his creditors force dissolution on him.
In the first course, he is locked into his debt structure because he has not failed. So, he is locked into his rent structure and cannot lower it to be competitive and he will once again be insolvent. In other words, nothing has been 'fixed'; we've only temporarily seen an improvement. This is why bankruptcy courts almost always lower the amount of debt by order to avoid leaving the poor man in the position of guaranteed failure. This is the end of the government bailouts of GM, the banks, so on, that they are failed already and propping them up merely prolongs their death, as it cannot lead to life, because they have costs that exceed what the market will pay for their services.
In the second course, it becomes clear after looking at his books that he cannot continue to operate because he can never achieve profitability. So, the court orders his estate sold. The corporation down the street buys it at sixty cents on the dollar and proceeds to make money with it. The bank that lent him the money gets sixty percent back, which it can use to alleviate its cash problem and allows it to pay its investors, who keep on spending and so on.
Oddly, our guy emerges as a much smarter business man. He works hard and presents a far better prospectus for a more moderate project and succeeds in getting a loan, and, having learned his lesson, he avoids the pitfall his previous project fell into.
Anyway, one of the points I'm trying to make, however poorly, is that all these entities have margin issues. Once the margin goes negative, people react with panic and drive positive margins much larger than the previous negative ones, in order to pay down debt and build reserves. This is what is happening world wide.
The previous 'position' (economic speech for all the deals involved) of the derivative market was worth some $60 trillion. This was producing money for lots of people. This is unwinding.
Now, here's the big problem: the current 'stimulus' package is worth some two billion dollars total, which, using simple math, is a factor of 30 down from the height. Sure, we don't expect to make the whole $60 tn reappear overnight, but we have to somewhat meet the magnitude of the loss.
But, far, far worse is the loss in income to lots of revenue-based situations, including investor income to families, retirement income, insurance and government. It is bad enough that banks are failing left and right as their revenue dries up and they cannot meet their payments.
The big problem is that a family that is accustomed to, say, 10% of its income from investment may suddenly see none of that money, indeed, may find itself in a significant loss due to the depreciation of its house and the loss in value of its stocks and bonds. This means that not only has the family lost 10% of its income, it has lost, say, 40% of its total value, which means that it must increase its savings very significantly to rebuild its retirement portfolio. This means that they must severely curtail spending, which is someone else's income.
Of course, retirees and the government face obvious problems, as their income comes out of profits, which aren't there anymore. However, most people never see the connection between investment loss and insurance. Why, for instance, is AIG, an insurance company, facing bankruptcy?
Well, it's all at the margin. AIG and other insurers take in premiums and invest them in very liquid assets such as bonds and money market-type instruments, the very ones hit hardest right now. Well, the insurance companies have actuarial tables that tell them how much reserve they need to meet their obligations. When their investment portfolio falls, they must severely increase premiums or face insolvency. If they do not do so, they may be accused of fraud and locked up in jail.
To explain, we'll simplify things. A given class of insurance says the odds of falling into a puddle are around 20% per year, and the cost of each incident is $100. That means that, per client, the insurance company needs to keep on hand at least $20. That means, that, for 1000 clients, it needs a $20,000 reserve. This is all very simplistic and probably not very correct, but it illustrates my point.
The insurance company pays out, on average, $20 per person per year, so it must cycle $20,000 per year, meaning that, in a perfect world, each client pays $20. Now, suppose that the investment instrument the insurer uses loses 50% of its value, and now the insurance company's reserve is just $10,000, which is unacceptable by regulation, so it must increase reserves or declare bankruptcy. It has a certain period of time to raise reserves, say, a year, given the magnitude of the loss. It must raise its premiums by 50% to achieve this.
Now, imagine what that sort of thing does to the average purchaser of this insurance. Some will simply deal with the puddles themselves, which is lost revenue to the company. Some will reduce their other costs, which is a loss to the economy. Some will go with another insurance company to avoid the increased cost. This is a loss to the company.
If around 20% of the clients leave, the insurance company must now raise $6,000 (it had $10,000, its new base demands only $16,000 reserves) on the back of 20% fewer people. Here's the really interesting thing: it's prices fall because its requirement falls faster than its revenue as it loses people. This means that instead of $30 per person premium, it is charging $26. As a matter of fact, if it loses 50% of its clients, it does not have to raise premiums at all. Of course, it will have to cut costs significantly as its profits dry up, but it is somewhat better off.
This is one reason why propping up an insurance company is pretty dumb. Essentially, AIG has been locked into its current cost structure. However, AIG is pretty different because it has a massive position in derivatives itself, so it can literally lose more money than it is worth. Let the idiots reap their rewards for writing insurance there is no possibility of covering.
So, everything happens at the margin, and, in a revenue-based system, it is not possible for a cash infusion to fix the business model if it's cash flow has gone negative unless the infusion is large enough to make good a significant amount of debt.
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