Wednesday, March 11, 2009

The financial crisis made clear to all (except bankers of course)

Hat tip to a Mr Lynn Jones, recently of General Motors, for this wonderfully lucid explanation of the financial crisis.

Seanie is the proprietor of a bar in Dublin .

In order to increase sales, he decides to allow his
loyal customers - most of whom are unemployed
alcoholics - to drink now but pay later. He keeps
track of the drinks consumed on a ledger (thereby
granting the customers loans).

Word gets around and as a result increasing numbers of
customers flood into Seanie’s bar. Taking advantage of
his customers’ freedom from immediate payment
constraints, Seanie increases his prices for wine and
beer, the most-consumed beverages. His sales volume
increases massively.

A young and dynamic customer service consultant at the
local bank (Angola Irish Bank) recognizes these
customer debts as valuable future assets and increases
Seanie’s borrowing limit. He sees no reason for undue
concern since he has the debts of the alcoholics as
collateral.

At the bank’s corporate headquarters, expert bankers
transform these customer assets into DRINKBONDS,
ALKBONDS and PUKEBONDS. These securities are then
traded on markets worldwide. No one really understands
what these abbreviations mean and how the securities
are guaranteed. Nevertheless, as their prices
continuously climb, the securities become top-selling
items.

One day, although the prices are still climbing, a
risk manager (subsequently of course fired due to his
negativity), of the bank decides that slowly the time
has come to demand payment of the debts incurred by
the drinkers at Seanie’s bar.

However they cannot pay back the debts. Seanie cannot
fulfill his loan obligations and claims bankruptcy.
DRINKBOND and ALKBOND drop in price by 99 %. PUKEBOND
performs better, stabilizing in price after dropping
by 95 %.

The suppliers of Seanie’s bar, having granted him
generous payment due dates and having invested in the
securities are faced with a new situation. His wine
supplier claims bankruptcy, his beer supplier is taken
over by a competitor.

The bank is saved by the Government following dramatic
round-the-clock consultations by leaders from the
governing political parties. The funds required for
this purpose are obtained by a tax levied on the
non-drinkers.

RL:Brilliant. The nub (or one of the nubs) is here "Nevertheless, as their prices continuously climb, the securities become top-selling items."


The economist Hyman Minsky classified derivatives into hedge, futures and Ponzi. It is this Ponzi aspect that has created a "value" for these instruments which is an order of magnitude greater than the world's GDP. When they come home to roost, they will break the banks. Governments need to identify and neutralise these Ponzi derivatives, perhaps by making them the responsibility of the CEOs who negligently bought into them. This would be unfortunate for the CEOs because they would go bankrupt despite their bonuses and pensions, but hey, you cannot make an omelette without breaking eggs.

...And for those who remain confused despite this simplified explanation, here is a visual pictorialisation of the whole process of the bank rescue...

2 comments:

weggis said...

Moral: Always pay for your beer.

Toronto Real Estate Agent said...

That settles it then. Everything from simple math problems to physics to economics should be explained via an 'alcohol and bars' example. This one is a great one, it sure explains it how it really is and even a 10-year old can understand it.

Take care, Julie