Wednesday, October 01, 2008

Where's the money gone?

This was the question posed to me by someone regarded the current economic slump. His argument was that the money had to have gone somewhere. My response was simple -

"It's gone back to the place it came from - nowhere"

Well I thought it was easy to understand, but it required more explanation.

Imagine a company worth £1m who decides to go public with 1m shares, logically each share is worth £1. Later on rumours start up that the company is about to launch a new product that will increase its worth; traders try to buy its shares and offer £2 a share. The company is now worth £2m, but where did the extra £1m come from? Not all the shares have been traded, in fact no shares at all need to be traded the price is derived simply from what someone is prepared to pay. Later on more rumours say this new product has failed and share prices drop to £1; so where's the £1m gone? Same place it came from.

Where things get complicated is that the company might have borrowed some money against its share price of £2, it borrowed it from the bank who in turn borrowed it from the money market. So where did that money come from? It came from the potential realisation of the share price.

In other words if the company sold all its shares it would get £2m, but it doesn't have that cash to hand so it borrows, say, £1m from the bank. The bank instead of using its own assets uses the money that it would get if it sold shares it owned, possibly even in the same company its loaning too. So once again - where did that money come from?

Okay I'm simplifying this a lot, but the crux is that the money was fictitious. It was all potential money, but sadly none of the debt was.

My friend's response was that the money was in property - that the houses were worth money.

"Who decides on how much they're worth?", I asked. "If this house was bought using money borrowed two years ago is it still worth that same amount now?"
"No, less"
"So where's the shortfall come from, where's the money gone?"

Same place it came from - nowhere.


Don B said...

Ah but when I work I am paid in money. I spend that money to buy the goods I need and save some to buy the more expensive items that I could not afford that week. I decide to put that money somewhere where I am told it is safer than keeping it in the teapot on the mantlepiece. What I do not want is the bank where I have placed it for safe keeping to use it by placing bets in the stock exchange on whether the shares in your fictional company will go up or downand then when he wins goes and have a meal with wine at £1,000 per bottle and when he looses comes back to me and says "Sorry mate I've lost your money at the betting shop. Can you lend me a quid for my housekeeping this week"

FlipC said...

But how else are they going to pay the bloke who adjusts the seat temperature in the Mercedes?

Okay but seriously banks have always done this, just not in these quantities and to this extent. Panorama last Monday talked about this pointing out that Northern Rock had a loan-deposit ratio of 3; that is it was loaning out three times as much money as it had deposited; Bradford and Bingley had 1.666 and HSBC had 0.9something. It's not the only measure, but it's a good indicator.

Oh and annoyingly it's seems to be referred to as a percentage so NR at 1/3 would be 33% (bad) but HSBC 0.9 would be 111% (good) which as definitions claim "the higher the ratio the more the bank is relying on borrowed funds" seems to me to be counter-intuitive; then again banks do seem to love quoting everything in percentages.