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Bankruptcy Explained

Posted by Vishal G R on July 19, 2011 at 1:40 PM

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 rupees as there were only two pieces of 1 rupee coins circulating around.

1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 rupee.

2) B decided to purchase the land from A for 1 rupee. So, now A and C own 1 rupee each while B owned a piece of land that is worth 1 rupee.

* The net asset of the country now = 3 rupees.

3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 rupee from A, and together with his own 1 rupee, he bought the land from B for 2 rupees.

* A has a loan to C of 1 rupee, so his net asset is 1 rupee.

* B sold his land and got 2 rupees, so his net asset is 2 rupees.

* C owned the piece of land worth 2 rupees but with his 1 rupee debt to A, his net residual asset is 1 rupee.

* Thus, the net asset of the country = 4 rupees.

4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 rupee loan to C. He then borrowed 2 rupees from B and acquired the land back from C for 3 rupees. The payment is by 2 rupees cash (which he borrowed) and cancellation of the 1 rupee loan to C. As a result, A now owned a piece of land that is worth 3 rupees. But since he owed B 2 rupees, his net asset is 1 rupee.

* B loaned 2 rupees to A. So his net asset is 2 rupees.

* C now has the 2 coins. His net asset is also 2 rupees.

* The net asset of the country = 5 rupees. A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 rupees. The payment is by borrowing 2 rupees from C, and cancellation of his 2 rupees loan to A.

* As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 rupees.

* B owned a piece of land that is worth 4 rupees, but since he has a debt of 2 rupees with C, his net Asset is 2 rupees.

* C loaned 2 rupees to B, so his net asset is 2 rupees.

* The net asset of the country = 6 rupees; even though, the country has only one piece of land and 2 rupees in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blew, and an evil thought came to C’s mind. “Hey, what if the land price stop going up, how could B repay my loan. There is only 2 rupees in circulation, and, I think after all the land that B owns is worth at most only 1 rupee, and no more.”

(8) A also thought the same way.

(9) Nobody wanted to buy land anymore.

* So, in the end, A owns the 2 of the 1 rupee coins, his net asset is 2 rupees.

* B owed C 2 rupees and the land he owned which he thought worth 4 rupees is now 1 rupee. So his net asset is only 1 rupee.

* C has a loan of 2 rupees to B. But it is a bad debt. Although his net asset is still 2 rupees, his Heart is palpitating.

* The net asset of the country = 3 rupees again.

(10) So, who has stolen the 3 rupees from the country? Of course, before the bubble burst B thought his land was worth 4 rupees. Actually, right before the collapse, the net asset of the country was 6 rupees on paper. B’s net asset is still 2 rupees, his heart is palpitating.

(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 rupees bad debt to B, but in return he acquired the land which is worth 1 rupee now.

* A owns the 2 coins; his net asset is 2 rupees.

* B is bankrupt; his net asset is 0 rupee. (He lost everything)

* C got no choice but end up with a land worth only 1 rupee

* The net asset of the country = 3 rupees.

End of the story;

BUT

There is however a redistribution of wealth.

A is the winner, B is the loser, C is lucky that he is spared.

A few points worth noting:

(1) when a bubble is building up, the debt of individuals to one another in a country is also building up.

(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island’s own currency. Hence, there is no net loss.

(3) An over-damped system is assumed when the bubble burst, meaning the land’s value did not go down to below 1 rupee.

(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.

(5) If there is another citizen D either holding a rupee or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land goes up and down like a see saw.

(6) When the bubble was in the growing phase, everybody made money.

(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game. But you must know when you should change everything back to cash.

(8) As in the case of land, the above phenomenon applies to stocks as well.

(9) The actual worth of land or stocks depends largely on psychology (or speculation)!

 

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1 Comment

Reply raghunath
11:21 AM on May 25, 2014 
smart people buy when the bubble starts and sells before it burst. life is also like this we dont

know when the bubble burst