A Finance Primer

“Just as the rich rule the poor, so the borrower is servant to the lender.”
PROVERBS 22:7 (NLT)

“Neither a borrower nor a lender be; / For loan oft loses both itself and friend.”
HAMLET, Act 1, Scene 3

I’m not going to try and explain all the bailouts, even if I pretended I knew exactly what is going on. There are others who are doing that.

But I would like to make some important points about finance in general, and hopefully make it a bit more clear. I hope people find this “explain like I’m five” somewhat useful.

From a very, very big picture perspective, haute finance is the creation and propagation of financial instruments. That’s it. The swapping and trading of these financial instruments constitutes the main activity of finance.

In the jargon of finance, these instruments are called securities. Both stocks and bonds are examples of securities, but there are many, many more.

More broadly, you can think of these as legally binding claims to some kind of resource. That could be real, tangible resource, or something less tangible like a loan or income stream.

The “legally binding” thing is important. A security has to hold up in court. You have to be able to take people to court and have the claim hold up in court for a security to mean anything. Hence the term “secure.” Securities are regulated by the Securities and Exchange Commission (SEC) in the United States.

The term “security” is interesting in itself. It is intended to inspire confidence like so many other financial terms like trust and credit. It is intended to express something fundamentally safe and sound, coming from the Latin securitas, meaning “free from care.” That is, no need to worry—your money is being kept safe.

Securities have two important characteristics: they are fungible, which means they can be turned into other things. The most obvious example is turning stocks or bonds into cash. You can also do the reverse: turn cash into stocks or bonds by buying them from a broker. Securities are protean by design.

How easily one thing can be converted into another thing is called its liquidity in financial jargon. Liquid assets can be converted into other things very easily. Illiquid assents can’t be. For example, I can’t convert stocks directly into bonds. And I can’t change from real estate to stocks unless I sell my real estate first (or find someone willing to exchange one for the other).

Cash (i.e. money, banknotes, or currency) is the ultimate liquid asset, in that it can be converted into pretty much everything else very easily—stocks, bonds, real estate, insurance policies, commodities, what have you.

The other important property of securities is that they are negotiable. Negotiability means that they can be easily passed along from person to person, with ownership passing to each person in the chain. I can pass along a security to you, or the guy over there, or the government, with ownership to the underlying claim passing to each entity in turn. That is, negotiable instruments do not have your name on them; they are not tied to you as a person. Ownership is always temporary and at-will.

Basically, if it can be traded, it’s negotiable.

That, then, is a security: a fungible, negotiable financial instrument that conveys ownership rights or creditor rights (an IOU). It can pass from owner to owner without limit and can be converted into cash. It’s an investment as either an owner or a creditor in which the investor hopes to make a profit. If it can easily be converted into cash, it is called a marketable security in the jargon.

If I buy a security, I give up the use of my money for a specified period of time. Why would I do that? I do it in the hope of getting more money back in the future. The longer I give up the use of my money, the more I will expect back in the future, generally speaking.

[Tangentially, I would argue that the concept of investing money now, in order to get back more money later (whether as profit or interest or whatever) is the core, animating idea behind capitalism.]

So when you hear the word “security,” think “financial instrument designed to transfer debt (or ownership claims).” And you will hear the term used all the time in financial jargon. What you should ask yourself when you hear the term is, “from whom to whom?” And why.

Securities are of just two major types: debt and equity; that is, ownership or loanership (or a mixture of the two). Equity is just a fancy term for ownership. Equity is an ownership claim on some real underlying resource.

The principle example of an equity security is stock. Businesses issue stocks to raise money from the public. When you buy a company’s stock, you buy a small slice of ownership in the company. It is an ownership claim. In the jargon, you have equity in the company.

Equity is typically ranked. In other words, some ownership claims take precedent over others. This is determined by a country’s laws.

Stocks are issued by companies, typically very big companies. The biggest companies of all are the corporations listed on the various stock exchanges we always hear about: The Dow Jones Industrial Index, the Standard and Poors (S & P) 500, the NASDAQ (National Association of Securities Dealers Automated Quotations), and so on. Different countries list their companies on their own stock exchange. Governments do not issue stock; you cannot purchase equity in the United States or Japan, for example. This is because governments have the ability to tax, which companies to not have.

The value of all the stocks on the index in the aggregate determines whether the index of that particular stock market is “up” or “down.” Theoretically, the value of the stock is determined by the underlying value of the company issuing it—how profitable it is, expectation of future growth, etc. (in practice, however, this is often rather different).

A debt security is simply an IOU.

An IOU expresses a debtor/creditor relationship. The holder of the IOU is the creditor. The issuer of the IOU is the debtor. In financial jargon, the person owning the security is called the bearer (or payee), and the entity issuing the security is called the maker, payer, or most commonly, the issuer.

So an IOU is simply a way of raising money. Typically, an IOU comes with the promise that more money will be repaid in the future over and above the original amount. That is why people buy them, after all—the expectation of getting more money back in the future. In the financial jargon, the original amount of money loaned is called the principal. The additional money you get back is the interest. The length of time of the loan is the maturity. That could be anywhere from overnight to thirty years, and everything in between. The total amount you receive from the bond purchase is called the yield.

In a pettifogging sense, there doesn’t have to be interest. I could loan you 50 bucks, and you pay me back 50 bucks. But since I’m giving up the use of that money for a specified period of time, the thought is that I should be compensated for the opportunity cost of not having that money available to me right now. Hence the interest. It’s basically a motivator for the loan. Its the cost of renting money.

The likelihood you will ever see that future cash is what determines the interest rate on the IOU, broadly speaking. If you are almost certain you will be paid back: low interest rate. If you are pretty uncertain you will ever get paid back: high interest rate. Loan to the neighborhood millionaire: low interest rate. Loan to your unemployed deadbeat brother-in-law: high interest rate. And so on.

The basic idea is that you need additional motivation in order to make a risky loan. The higher the risk, the higher the (potential) reward. If the debtor welshes on paying back the loan, it is called a default. If they don’t pay back anything, it is a full default, otherwise if they pay back a portion it is a partial default. In either case, the bond holder is said to have taken a haircut (!!).

For every debtor, there is an equivalent creditor. That’s something to keep in mind, and it will put you ahead of 99 percent of the galaxy brain armchair commenters on the internet. When you hear about the debt—any debt—don’t just think about the debt, think about who the creditor is, because there cannot be one without the other. It’s simply impossible. In order for their to be debt, there has to be a loan, and in order for a loan to exist, there has to be to somebody, somewhere, who loaned the money in the first place.

The principle example of a debt security is a bond. It is the most common debt instrument. A bond is an IOU. Unlike stocks, bonds are issued by both governments and businesses. Like stocks, they are a way of raising money. As noted above, typically in order to motivate people to lend to it, the entity issuing the bond pays it back with interest. The perception of reliability in paying back the bond determines what that interest rate is. They are typically issued for a fixed term, which is a specified amount of time for the money and the interest to be paid back.

One very common type of security is a treasury security. As the name implies this is an IOU issued by the treasury department of a government. The treasury borrows money, and pays it back in a certain amount of time. It is a government IOU. You become a creditor on the government by buying a treasury security.

You may be wondering what the difference is between a treasury security and a government bond, or whether they are, in fact, the same thing. Really, they’re different names for the same thing. Again, the financial jargon here makes it less clear. But typically, the IOUs issued by the government are classified according to how long the loan to the government is for.

The shortest-term loans are called “T-bills” (‘T’ for “treasury”) and are for only four weeks to a year. “T-notes” are for a longer period of time—between two and ten years. “T-bonds” (i.e. government bonds) are the longest term securities—thirty years—and pay interest annually. Investors use a combination of all three of these to manage money. Long-term bonds in the UK and some Commonwealth nations are commonly referred to as “gilts” because the original paper bonds issued had gold edges. Many early gilts had no maturity date; that is, they were perpetual.

Treasury securities are a way of taking money out of the system (i.e. “locking it up”) for a specified amount of time. How long it’s locked up for is the term of the security. Taxes, by contrast, are away of taking money out of the system permanently. That is, taxes are “unprinting money.”

The government buys and sells securities via its central bank to manipulate the amount of money floating around in the system, and hence to manipulate the overall interest rate (i.e. the price of money). That’s a big topic which we’ll leave alone for now.

Earlier I said that bonds are a way to raise money from the public. In the case of government this seems prima facie true, but it is not the actually the case; the government is the sole issuer of currency and does not need to raise money in order to spend. It is true, however, in the case of currency users like state and local governments, which do not issue their own currency. At the national level, then, governments issue bonds as 1.) safe havens to store money, and 2.) a way to transfer debt liabilities between entities, especially the public and the private sector, but also between nations (typically via central banks).

Treasury securities are usually considered the safest assets to own by investors. That’s because, unlike private entities, the government has a printing press (or, more realistically, keystrokes). Consequently, the interest rate on treasury securities is typically quite low. The only concern with such securities is whether the money that the security is converted into will be worth more or less in the future, which is determined by whether there is inflation or deflation. That’s a topic for another time.

At the other end of the spectrum, bonds issued by entities with a very low likelihood of paying back the money are called junk bonds.

Securities are issued by entities (governments or businesses) typically through financial intermediaries (called brokers). In rare cases, they are issued directly to the public. Once they are released into the wild, they are then traded around all over the place from person to person, entity to entity, in what are termed secondary markets (because they are negotiable, remember).

The interest rate (yield) paid by the bonds is determined determined by the face value of the bond, regardless of the price the bond is traded for in secondary markets. This means that if bonds can be bought on the cheap, there is a large potential for profit.

If we had a Venn diagram, then, all of the T-notes, bills and bonds are all treasury securities, which fall into the larger category of securities, which includes both stocks and bonds. Into that larger circle of the Venn diagram of securities we would also place other things like options, promissory notes and bills of exchange, which I’m ignoring for now. Outside of it would be things like insurance policies or retirement accounts (IRAs or 401Ks), which hold securities but are not securities themselves—don’t worry too much about this distinction).

An ordinary person like you or me does not issue stocks or bonds they way governments and companies/corporations do. They do take out loans, however. Both individuals and households often have outstanding debts from loans. These are usually paid back over time from their income.

Another dyadic relationship is the one between assets and liabilities. For every liability there is a corresponding asset. In total, these sum to zero. From the perspective of the lender, for example, the loan is the asset, the thing the loan is for is the liability. For the debtor’s perspective, the thing they took out the loan for (a house, say) is their asset, and the loan is their liability. Again, one cannot exist without the other. That mirrors the creditor/debtor relationship.

A bank’s assets are all the money it is owed. It’s liabilities are the money it must pay out to others. A $1,000 loan to someone is an asset (as long as they are able to repay it). A check drawn on the same bank for $1,000 is a liability. Recall that banks also borrow from, and lend to, each other. A bank’s (or any company’s) assets must exceed its liabilities in the long term, otherwise it is insolvent. Because loans are typically paid back over time, a bank could be solvent, but still illiquid (i.e. not enough cash on hand for current use). In such cases, central banks are designed to bridge the gap.

Thus, financial instruments (securities) are ultimately ways of transferring debt and ownership about. Debt and ownership are saleable commodities, just like aluminum or pork bellies. That’s the basic, underlying concept of finance. The sheer numbers and complexity of these exchanges is what makes it mind-boggling to the average person on the street, but hopefully the above explanation may help you to understand the basics a little better.

The big, big picture problem with the financial system is that the steps from the original borrower and the original lender (or from the original owner to the current owner) are so confusing and convoluted thanks to all the secondary markets and wheeling-dealing going on around the world that the system resembles nothing so much as the proverbial Gordian Knot—unknowable and unwindable. So someone taking out a loan from a bank to buy a house in Michigan, for example, may find that his mortgage repayments are funding a pension system in Lithuania, or some such.

TRANSFERRING RISK

Insurance is not a security; it is a way of transferring risk.

Options are also ways of transferring risk, but the are securities. An option is a right (but not an obligation) to buy or sell an asset (a security or commodity) at a specified price (called the strike price) at some point in the future. If the option is for buying, it is a call option. If it is for selling, it is a put option.

Basically, these are bets on whether the underlying asset will go up or down in price.

From a call perspective, if you expect the price to drop, you are short, if you expect it to go up you are long. From a put option perspective, the reverse is true. Often times options contracts are written on securities that the options trader does not actually own.

In general parlance, to short something means that you think it will go down in price or become less valuable (“shorting a currency”). To go long means that you expect it to go up in price or become more valuable.

If the value of an asset is dependent upon what the market does, it is considered to be a speculative asset. Speculation in financial jargon is just a fancy term for gambling.

Here’s a good explanation of futures contracts courtesy of a Reddit user:

[F]utures contracts are essentially pre-ordering something, hoping it sells out, and then scalping it on eBay, but on a far larger scale. You have a contract agreeing that you’ll buy something at a certain price (the settlement price) at a certain date (the settlement date). Let’s say that you make orange juice, and I want to buy orange juice. I offer to pay you $3 for a gallon of orange juice that I’ll pick up next Saturday. When Saturday comes by and I pick up the orange juice, if the price goes up to $5 a gallon, you still have to honor our contract and give it to me. I then can sell it for a $2 profit. If the price had gone down to $2 a gallon, I’d be left with a $1 loss.

IS MONEY A SECURITY?

Is money (cash) a security? Well, it depends on how you look at it. Most definitions would say no; money is what you use to buy securities. But I think it is possible to see money as another kind of security.

There is a good historical argument that paper money began in China as circulating IOUs from prominent merchants in place of cumbersome iron coins. These IOUs then started to be passed from person to person within the province. That is, they were fungible, since they could be converted into other things (real goods, securities, real estate, etc.), and they were negotiable, in that they could pass from person to person. Eventually, the government got in on the act and began issuing their own IOUs which could be used to pay taxes. Often these had an expiration date (like bonds, but unlike modern currencies). These became a form of portable, anonymous wealth based on paper.

Thus, money is the government’s liability. What backs it is the wealth of the nation issuing it, along with its laws and institutions. They are government IOUs in the sense that you can always settle your debts to the government with them. The government also declares them to be legal tender for the settlement of private domestic debts as well. Since everyone needs them to pay taxes, fees and fines, they become broadly accepted as a means of exchange and payment in the wider society.

The way that MMT economists often express this is that money is circulating tax credits. The money that is in circulation—in people’s bank accounts and wallets and so on—are tax credits that have not been redeemed yet.

On the other hand, securities are often distinguished from cash in that they are not perfectly liquid, and they can expressed in terms of currency. By contrast, the value of currency can only be expressed in terms of itself. Securities also typically provide some sort of return, although this is not absolutely necessary—you can have a zero (or even negative) interest bond, for example.

But cash by its nature does not provide any sort of return. If you put it in a bank account it does, but then the bank account is the security, not the money itself. That is, a security is typically considered to be an investment, whereas cash is clearly not an investment. Also, in the U.S. at least, money is legally exempted from being a security. See: https://economics.stackexchange.com/questions/14772/is-cashcurrency-a-security-and-a-debt-instrument

Nevertheless, in terms of exchanging value and being an IOU issued by the government, I think it’s safe to think of money as another type of security for now, albeit a very special and unusual one.

Money is exchanged for securities; securities are changed back into more money, that money is once again exchanged for securities (or securities are simply rolled over); so goes the pulsating heartbeat of finance all over the planet. That’s really what it is at heart—swapping securities all over the place. And everyone’s doing it—governments, businesses, individuals, and so on. It’s basically debt-swapping on a global scale.

So that’s haute finance in a nutshell: everyone is trying to at least preserve their existing wealth and, preferably, to increase it relative to everyone else. But again, the question is: who’s doing the swapping, what for, and what is ultimately lying beneath it all. That’s what you should be asking yourself whenever you hear about all this financial stuff in the press.