The Congressional debate over the infamous $700 billion bailout plan this week reminds me of what two guys down the hall in my college dorm once did. They both wanted something that they couldn’t afford – a Domino’s Pizza.
These guys colluded and ordered a large pizza – about $7.50 back in the Dark Ages of my college years. One of them presented the Domino’s driver with a check (tip included) for $8. It was a hot check and both guys knew that they didn’t have enough in both their accounts combined to pay for the pizza.
Back then, banks did not immediately process checks electronically and you could play the “float”. It took 3 or 4 days for your account to have funds disappear after you wrote a check, but when you deposited a check, the bank would immediately allow those funds to be drawn against other checks coming in. Don’t try this today, boys and girls. It’s not the same nowadays.
So, the second guy wrote a check for $8 to the first guy who waited two days and then deposited the check. Consequently, the check to Domino’s got paid to Domino’s. Then, the first guy (who wrote the check to Domino’s) had to write another check for $8 to the second guy so that his hot check to the first guy would be covered. Two days later, the second guy has to write another hot check to the first guy to cover his prior hot check to the second guy.
These guys kept covering each other’s hot checks for a couple of weeks until they got another paycheck from their part time jobs. Then one of them finally convinced the other to cough up $4 cash. At that point an $8 check was allowed to clear successfully and the original cost of the $8 pizza was effectively split between the two.
There are a lot of parallels between this story and the current credit market mess that we face. Let’s say that “Joe Homebuyer” wants a house that he can’t afford. “Bob the Broker” finds the money for Joe to buy the house and signs Joe up to a payment plan where the payments jack up to an unbearable level in three years. Then Bob the Broker sells the loan to “Riskmanager Randy” who hedges his risk and buys credit default swaps from “Issuer #1” to cover himself in case the homeowner can’t handle the unbearable payments that are coming. Then Issuer #1 buys credit default swaps from “Issuer #2“ to cover himself in case he ever has to pay Riskmanager Randy for the credit default swaps that Riskmanager Randy bought. Issuer #2 covers himself by buying credit default swaps from “Issuer #3”. Issuer #3 buys credit default swaps from “Issuer #4”. And the chain continues. And what’s worse is that all these Issuers sell far more credit default swaps than they can pay for should they all come due.
All in all, it’s like a bunch of folks getting together to cover each other’s hot checks. But rather than $8, the credit default swaps amount to something like $62 trillion. And now that Joe Homebuyer can’t make the unbearable payments, Riskmanager Randy has found that Issuer #1 can’t pay out on the credit default swaps. This has started $62 trillion worth of dominos (no pun intended) toppling and now we’re betting that $700 billion taxpayer dollars can work like the paychecks that came to the guys in the pizza scam above and stop the collapse.
I’m really glad that the hosting business model is pretty simple at its core. Provide gear, connectivity and services to customers who pay you monthly to use it. If the customers don’t pay, simply turn them off and sell it to someone who will pay. There is no need for hedging. No credit default swaps. No dominos ready to collapse.
The hosting business is certainly not without risk. We hedge electricity risk with UPS units and generators. We hedge bandwidth risk by using a portfolio of providers. But these hedges are tangible, not some nebulous financial market derivative outlined on a sheet of paper.
Bottom line: don’t stretch to get something that you know you can’t afford. Even if it’s a pizza.