The Bubble in Artwork by 8-Year-Olds

I got this from some friends who have an 8-year-old daughter whom I’ll call Franny:

Friend (looking at Franny’s artwork, which is labeled “$10,000”): How much do I have to pay you for that picture?

Franny: $10,000.

Friend: Is that in real money or pretend money?

Franny: You can pay me $5,000 in real money and $5,000 in pretend money. And if you only want to pay me the pretend money, then you get to borrow the picture for the weekend.

I’ve been struggling for weeks trying to think of the perfect real-world analogy – maybe something to do with assets being held on the books at $10,000 that everyone knows are only worth $5,000. Maybe one of our readers can come up with right answer (like in The New Yorker’s cartoon caption contest).

By James Kwak

9 thoughts on “The Bubble in Artwork by 8-Year-Olds

  1. The LIBO in LIBOR, but I am sure that Fanny’s picture is worth much more for REAL!

  2. Dear James and Simon,

    Let me start by saying I really enjoyed your blog and have learned a great deal. However, I like to offer a constructive critism.

    You guys are over simplifying the very important issue of bank solvency. The issue at hand is very much more complex than merely real money vs. pretend money. To be frank, your presentation is a disservice to your readers. I highly recommend you and your reader to read up on the following by John Hempton.

    I was elated after I came across on John’s blog and read it. For a long time I tried to get at a deeper truth. The long reading was was time very profitably invested.


  3. That sounds like two types of mortgages: $5000 in real money plus some pretend money gets you the house while pretend money only (ie. no down payment) lets you enjoy the house for a little bit, but then you have give it back.

  4. I don’t know exactly what you’re looking for Mr. Kwak, but I think if you “buy” a car directly from the financing department at an auto-dealership it works very much like that. Of course none of them would admit that but they PURPOSELY get people “upside down” on the car. They know they’ll never pay off all the loan, but they make a few high interest payments and in short time the dealership gets the car back and then offer the same type loan to the next sucker they know will never pay it off. It ends up being a lease—but they sell the poor fools in to thinking they will eventually have ownerships. They do the TV ads that last 30 minutes on local TV saying “I want to help the ‘poor joe’ to own his own car” but the dealership just wants to get the high interest rate and just “flip it” (I think that’s the terminology) to the next idiot.

  5. The only analogy I could come up with is the relationship between AIG and its creditors: If you put up half of the obligations in cash and half in bonds, they’ll cancel the obligation but if they pay out only bonds, eventually they’ll want all of it cash.

  6. Friend pays the pretend money and borrows the painting for the weekend.

    Friend, of course, sells the picture to his buddy, Peter for $5,000. Peter, of late, has been on a major acquisition trail in the picture market.

    Later in the weekend, Friend buys an identical picture from another buddy, Steve, for $3,000. Friend then gives this picture to Franny.

    Meanwhile, Peter has a portfolio of pictures, many of which are no more than badly-drawn stickmen. Peter is also very casual about the way he stores the artwork.

    But, Peter has a cunning plan. He persuades Moe, Fred, Pat, Rick and Paul to buy a stake in his $50,000 Enhanced High Value Art fund. They in turn…..

  7. James, please try to exert your utmost influence to ensure that little Franny becomes an artist when she grows up and not a banker.

  8. I think this is perfectly analogous to the situation with tangible common equity and preferred stock.

  9. This sounds like she is intuitively aware of both “lock-in” and consumer price preferences. You get the artwork for free for a weekend, and at the end of the weekend you’re much more likely to simply keep it to avoid hurting her feelings, or to keep it because you are lazy, or because you like it more now than you did.

    Additionally, someone who is truly willing to pay 10,000 in real cash will put up the full amount of money, but someone with a slightly tighter budget can pay only half and get it on the cheap.

    Pretty smart kid. ;)

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