Trying to understand credit
18.19, Tuesday 6 Mar 2012 Link to this post
I just visited the bank and had an impromptu tutorial in international trade – good stuff. Recently they told me they’d lost a payment we were supposed to receive, and two weeks later it turns out they hadn’t lost it at all. It was a mess, and I have to admit there was a bit of shouting in the meantime. The shouting resulted in me being handed up to a more senior “relationship manager” and this is the chap who ran me through the basics of how banks can help orchestrate aforementioned international trade. So all’s well that ends well.
I have models in my head of how things work. In my model of how the business of BERG works, I model cash, attention, and risk. My model of credit encompasses things like overdrafts, 30 day payment terms, loans and whatnot, and my understanding of it comes from two sources: my personal experience of debt (my advances on pocket money, the slow repayment of my student loan, credit cards) and macro-economics, on which topic Ray Dalio’s paper A Template for Understanding What is Going on is an astoundingly good explanation of the current global credit crisis. Dalio explains:
- the difference between credit and money:
credit is the promise to deliver money, and credit spends just like money. While credit and money spend just as easily, when you pay with money the transaction is settled; but if you pay with credit, the payment has yet to be made.
- that while money exists, credit is created and disappears simply by belief:
most of what people think is money is really credit, and it does disappear. For example, when you buy something in a store on a credit card, you essentially do so by saying, ‘I promise to pay.’ Together you created a credit asset and a credit liability. So where did you take the money from? Nowhere. You created credit. It goes away in the same way. Suppose the store owner justifiably believes that you and others might not pay the credit card company and that the credit card company might not pay him if that happens. Then he correctly believes that the ‘asset’ he has isn’t really there. It didn’t go somewhere else.
- and finally, in two paragraphs so deft that they have to be read to be believed, a description of the game of Monopoly firstly in terms of property vs cash, and secondly a version modified to allow the bank to create credit, in which case the game starts exhibiting the same credit cycles as our actual economy.
He frames the credit crisis as a “deleveraging” - a kind of global disarmament of credit - and the essay is simultaneously illuminating and bleak, bleak stuff. So I get that.
On the other hand I have very little deep understanding of what my mortgage means. Is it good or bad to have this credit? What if I rent out my mortgaged house and rent somewhere else? Too confusing.
I used to understand credit as the swap of risk and cash, i.e. I promise to pay the bank some cash in the future in order for them to take a risk now. For example: they front me cash as a loan (or, more informally, an overdraft) and I pay it back plus some percentage. The fee I pay covers them not having the money in the meantime, plus the risk they take on me not returning the cash.
After my meeting with the bank I understand credit a little differently.
I now understand credit as transferring no risk. The bank may front me cash now, but I give them security in the form of my house or something else. I retain all risk, nothing is transferred. There is no risk to the bank in issuing the credit. What I’m paying the bank for is access to their proprietary marketplace to exchange forms of capital - in the case I mentioned, cash and houses - together with a promise that the exchange won’t be finalised so long as certain conditions are met. So credit is possible not because the bank is able to absorb risk, but because:
- the bank has an internal marketplace in which it is able to hold open many capital exchanges; and,
- the bank is able to enforce - using the legal system itself - the fungibility of capital and obligation: if it gives me cash, it can get my house in return.
Yes, the bank does have risk here, but it’s not the same risk as my risk. It’s new risk.
Interestingly what this leaves available is a system in which risk and cash are exchanged, where risk is transferred. This is what investment is, and this is what Kickstarter does.
Anyway this seems obvious now I write it down, but I thought I’d share.
Ultimately where it leads me is to start looking for a relationship between risk and credit as if they are the same thing but one observed as static in time and the other in motion, in the same way that magnetism and electricity are the same thing separated by the speed of light.
Update: On a little reflection, a bank isn’t quite a marketplace because the transaction types are highly limited. Cash flows in and out, and cash flows out transacted for security (a promise on other capital). It would be worth diagramming the systems of banks, individual lending, and investments in order to see where the thing called credit emerges.