Krugman describes Geithner's plan as a "put option." So does Nemo, here
I am of the opinion that most people, even intelligent laypeople, do not know that non-recourse high-leverage loans are equivalent to a put option. I suspect many of them do not even know or care what a put option is.
Well, I'll try to help. But before I do, please be advised that I am the only person I know who could not qualify for a home loan in 2004. In other words, few would consider me an expert.What is a put option?
A put option is a bet that the price of a stock will go down.
Your name is Ed. You make a deal with Fred. "Fred," you say, "right now the price of BigWeenie Inc. is $12 a share. I want the option to sell you ten shares for that price -- one month from now. If you take this contract, I'll pay you a premium of a buck a share, right here and now. Such a deal, right?"
"Wow!" says Fred, who is easily impressed. "Ten whole smackers! How can I pass that up?"
A month passes. If BigWeenie shoots up, you're screwed. You don't have to go through with the deal (that's why it's called an option) but you never get that premium money back. You lost ten bucks. BigWeenie leaves a bad taste in your mouth.
But let's say BigWeenie goes flaccid. Let's say it's worth a limp and puny $5 per share. You buy ten shares for $50 and now you can sell them to Fred for $110. (Unlike you, Fred is obligated to keep his part of the bargain. That's why you paid him that premium.) Now Fred is the one who feels screwed by BigWeenie.What is a non-recourse loan?
Ed wants to borrow $30,000 from Fred. As collateral, Ed offers his prized copy of X-Men number 1. (This is actually a good price.) Fred takes the deal.
The time comes for Ed to pay back the loan -- but he doesn't. "Fine," says Fred. "I'll take the comic book." And so he does.
Bad news: The local comic book dealer tells Fred that the bottom has fallen out of the market. Maybe there was a bubble, and maybe the bubble has burst. For whatever reason, that copy of X-Men #1 is now worth $15,000 -- max.
And that's it. That is a non-recourse loan. Fred can't get any more money from Ed. Ed has no personal liability. The comic book -- the collateral -- is all Fred gets. He has no other recourse.What is leverage?
Leverage is borrowing money to invest. This occurs when Fred, who has $100 bucks, borrows enough cash to buy $1000 worth of BigWeenie Inc.
The bank indulged in a leverage fantasy when it offered Ed a house loan for no money down, on the expectation that the property would keep going up in value. An even more dangerous leverage fantasy occurred when an investment bank borrowed money to buy a fancy-schmancy financial instrument based on the hallucination that Ed was going to keep up his payments. As St. Anthony of Padua once observed, leverage is a motherfucker.