How did things get so messy?
18 Jan 2012

This weekend I tried to avoid the news. ‘Unemployment at 17 year high’, ‘Greek economy to be run by European Union’, ‘bank bonuses spark public and political outrage’, and so it goes on. This sort of potentially self-fulfilling prophecy always leaves me looking for good news, which is pretty hard to do in economic terms at the moment.

This general wave of difficult data and bad news makes people uneasy, and leads to a battening down of the hatches, which in turn leads to reduced economic output.

As I sat on Sunday morning contemplating the question, 'how did things get so messy?' I was reminded of a story that, whilst amusing, explains very well in my opinion, some of the mess that contributed to the start of the credit crunch in the first place.

Heidi is the proprietor of a bar in Detroit.

She realises that virtually all of her customers are down on their luck and struggling with money and, as such, can no longer afford to patronise her bar. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later

Heidi keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Heidi's bar. Soon she has the largest sales volume for any bar in Detroit.

By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi's gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognises that these customer debts constitute valuable future assets and increases Heidi's borrowing limit. He sees no reason for any undue concern, since he has the debts of the down on their luck drinkers as collateral.

At the bank's corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINK BONDS. These "securities" then are bundled and traded on international securities markets.

Naive investors don't really understand that the securities being sold to them as "AAA Secured Bonds" really are debts of down on their luck drinkers. Nevertheless, the bond prices continuously climb and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

One day, even though the bond prices still are climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi who then demands payment from her patrons, but being down on their luck, they cannot pay back their drinking debts.

Since Heidi cannot fulfil her loan obligations she is forced into bankruptcy. The bar closes and Heidi's 11 employees lose their jobs. Overnight, DRINK BOND prices drop by 90%. The collapsed bond asset value destroys the bank's liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds.

Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

The bank and the brokerage houses however are saved and bailed out by a multibillion dollar no-strings attached cash infusion from the government. The funds required for this bailout are obtained by new taxes levied on folk who in the round have never been in Heidi's bar.

So the story is a little tongue in cheek, but it does illustrate the damage that an oversupply of credit (and the complex structures which assist that oversupply) can do.

For me the moral is "keep it simple", which is exactly what I intend to do at OneSavings Bank and Kent Reliance.