Friday 20 March 2009

The Credit Crunch Explained

With the publication of Lord Turner’s plans for “tougher regulation” of UK financial services (didn’t notice anything about having to ask permission to go to the toilet – a grave omission in our view) we thought we would share this little story with you. It was sent to us by our longtime business associate and partner Terry Murphy, author and publisher of the Achievement Process. In the form of a light hearted parable it gives the clearest explanation we have seen to date of how the world’s banking and financial system collapsed.

Linda is the proprietor of a bar in Cork. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. She 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 (still mostly unemployed alcoholics) flood into Linda's bar. Taking advantage of her customers' freedom from immediate payment constraints, Linda increases her prices for wine and beer, the most popular drinks. Her sales volumes and profits increase massively.

A young and dynamic “customer relationship manager” at the local bank recognizes these customer debts as valuable “credit assets” and increases Linda's borrowing facilities. He has no concerns since he has the debts of the alcoholics as collateral and Linda’s apparent healthy profit margins means she can afford the premium interest rate the bank has charged. Also he beats his loans targets hands down.

At the bank's corporate headquarters, these premium interest rates enable expert bankers to transform the loan into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on markets worldwide. No one really understands what these abbreviations mean or exactly what the assets are behind them. What they do understand is that their prices continuously climb and the securities become top-selling items. The expert bankers beat their targets hands down and are rewarded with substantial bonuses.

One day, although the prices are still climbing, a risk manager of the bank takes a different view of the value of these debts and others like them and changes the risk criteria, thus triggering a demand for repayment of Linda's loan. He is of course fired in due course for his negativity but not before the demand for payment has been executed.

The drinkers cannot pay back the debts to Linda’s bar (it hadn’t occurred to them that they would ever be asked to) and consequently Linda cannot meet the repayment demand and has no choice but to file for bankruptcy.

DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. There is, as with everything that went before no rational explanation for this difference.

The suppliers of Linda's bar, having granted her generous credit terms and, encouraged by their bankers and advisors, invested in these securities are suddenly faced with a dire situation. Her wine supplier goes into administration; her beer supplier is taken over by a competitor.

The bank however is saved by the Government following dramatic round-the-clock negotiations with leaders from the governing political party (and vested interests). The funds required for this purpose are obtained by a tax levied on the non-drinkers.

Everyone we have relayed this story to has reacted in much the same way. “Finally an explanation I can understand, that’s exactly what happened.” Much has been written about the lessons to be learnt from the credit crunch but for us this little story highlights three in particular.

1. Alcoholics are only concerned about getting the next drink. So if you give them a drink they will drink it and if you give them another they will drink it and so on. The transactions produce no value as the one consumes the other and vice versa.

2. A wise old mentor of ours once said, “Profit is someone’s opinion, cash is fact. Stick to facts”.

3. Every party will have a pooper. However the damage has been done long before the pooper triggers the consequences. So don’t blame the party pooper.

Now please read the story again, can you spot the connections?

"You're having a laugh ... seriously" is brought to you by Steve Goodman and Tony Ericson. It is one of our "Excellence Quartet" of blogs promoting the cause of Excellence as the key to prosperity. Each blog has a new article each month using a recent business/financial topic to highlight different perspectives and conclusions from those obtained using conventional thinking and techniques. You can read the other three blogs at "Exceeding Expectations" , Business Bloop of the Month Award", "Capitalism or ... Common Sense" .

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