Drunk Bonds

Generally I do not publish texts taken from other sites. All articles on this blog are original, they have been written by me or by other authors whom I occasionally host on « The Independent». This story, which has been shared on the web for a while, however, explains so clearly the causes of the current financial crisis, that I thought it was worth to publish it again to complement the articles I have written previously on that subject, namely

Compared to the original tale, I did some variation on the theme, but basically it is mostly the same.

The crisis explained in a simple way

Mary is the owner of a pub, the kind where you drink like a fish. Realizing that most of her customers are unemployed and therefore they will reduce both drinking and attending, she devises an ingenious marketing plan that will allow them to drink now and pay later. Practically she takes note of the drinking in a register called the Book of Credits, that is, the book of debts of customers.

The “drink now, pay later” system is immediately very successful: word spreads quickly and shoots up the business: Mary’s pub quickly becomes the most important and frequented bar in the city.

Given the success, Mary occasionally increases the prices of drinks. Obviously no one complains, since no one pays: for customers it is in all respects a virtual rise. So the sales volume continues to increase.

At this point Mary’s bank, reassured by turnover and strong sales, increases her credit limit. After all, the risk managers say, the exposure is secured by all claims that the bar makes against its customers, that is, the collateral for the bank. Next, the Bank Office of Investments and Financial Alchemy has a brilliant idea: they take the claims of Mary’s pub and use them as collateral for a brand new bond issue to sell on the international market — the Drunk Bonds.

The bonds in question immediately get an AA+ rating, the same as the issuing bank. However, investors do not realize that the titles are in fact guaranteed by the debts of unemployed drunks. Because the yield is outstanding, large groups of people buy the bonds. Consequently, the price goes up, which leads Pension Fund managers to buy a considerable number of bonds, drawn by the irresistible combination of a high rating and a price that continuously increases. So portfolios around the world are filled in by Drunk Bonds.

One day, however, a new director comes to Mary’s bank and, looking to reduce risk due to the crisis atmosphere , reduces Mary’s credit limit and asks her to recover the portion in excess of the new limit. At this point, Mary, to find the money she owes the bank, begins to ask customers to pay their debts, which is obviously impossible because they are unemployed persons who “drank” all their savings.

Mary very soon realizes that she is not in a position to refund what she owes the bank so the bank cuts her funds. This causes the pub to fail and Mary gives all her employees their walking papers. Needless to say, the price of the Drunk Bonds falls by 90%. The same bank that issued the bonds enters into a liquidity crisis and immediately freezes all activities: no more loans to companies. The local economy is paralyzed.

Meanwhile, Mary’s suppliers, who by virtue of her success had provided her the alcohol with long payment terms, are now full of bad loans since she can no longer pay them. Unfortunately they too had invested in the Drunk Bonds, which lost 90% of their value. So the beer supplier begins first to fire people and then fails too. The local wine supplier is instead acquired by a competitor who immediately shuts down the local plant, sends home all employees and outsources the production to a locationover 3,000 miles away.

Not everyone is so unlucky, however. The bank, in fact, is rescued by an interest-free government mega-loan with no need of guarantees. To raise the necessary funds, the government has simply taxed all those who had never been to Mary’s pub because teetotal or because they were too busy working. The heavy taxation, however, reduces consumption and many other businesses are forced to close. This in turn undermines other banks that are in turn saved by governments that, unable to further increase taxation, issue special bonds ultimately growing the public debt out of proportion.

Does that remind you of anything? Try to revel to apply the dynamics of the Drunk Bonds to current situation, just to be clear who is really sober and who is drunk… I dedicate this story to the Monti’s Government, who saved the markets, the investors, and the speculators bringing to its knees a country whose economy still had survived the previous crisis.

Translation reviewed by Gregory Cifelli — any remaining error is due to the author.

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