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COLLATERAL: Learn and get awsome: Only behavioural economics knows the value of this word!

October 5, 2012

You will never get cheated, robbed, lied to, abused, taken for a ride or taken for granted ever again if you use collateral, well, I don’t know for sure because I don’t know how seriously you read, understand and follow my stuff, but let’s say that you read a lot of average stuff and you finally got it that I am the only source on-line that tells it like it is. Let’s start:

Why did Shakespeare feel sorry for lenders? You got it! In the old days people with extra money to loan got no guarantee that they will see their money back on due date plus interest. Years later, when a legal system developed and these rich folks became bankers, they invented the collateral. Here is the problem: According tp behavioural economics borrowers have less loss aversion (Kahneman’s term) than lenders. According to Dr. Daniel Kahneman, their risk behaviour can be measure. During the 20th century the collateral idea split. Half stayed physical collateral (eg., your home or car or possessions can be the collateral: If you don’t pay your mortgage payments the bank repossess you home, your car, etc. The other half of the collateral idea became mental – a piece of paper (eg., if you exceed your margin borrowing, your broker can sell your shares to recover his money). Then something bad happened that always happens with humans. People started complicating the collateral idea. People, insurance companies, governments , God himself became a guarantor of loans! (eg., surety, I was once a guarantor of my daughter’s student loan). The trouble stated with the 1929 depression, collaterals lost their power, but the problem became a real mess in the 21 century. Today, bankers have no loss aversion left so they can sell mortgages without a collateral and give bank loans with having only 10% cash as collateral to cover a possible stumped on the bank. Here is the behavioural economics rule that explain it: If the lender can easily recover his money from a guarantor as huge as the federal government, he will lend money to even a homeless person who has no money. The government will pay.  This behavioural economics rule is simple: Behaviour is controlled by its consequences. The average person makes 200 mistakes in this area alone per day, anything from, “Daughter, you lost the money I gave you, no problem, here is another $100, just be more careful next time when you go shopping in the mall, OK? to “Honey (wife), we lost money on the investment, do you think we should put more money into it to recover our loses?” “Yes, I think so, it’s basically a good investment.” (She broke the rule: Don’t reward a loss by dismissing your loss aversion psychologically). The topic of collateral is awesome and simple. Borrowers are luckier than lenders if they use the money to make more money and lenders are luckier than borrowers if they get a good collateral or have a stupid government to reward their misbehaviour!

 

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