The financial crisis explained in simple terms

This email was passed on to me by my office manager. It makes what happened seam absurd:)

Heidi is the proprietor of a bar in Berlin. 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 flood into Heidi's bar.

Taking advantage of her customers' freedom from immediate payment constraints, Heidi increases her
prices for wine and beer, the most-consumed beverages. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes these customer debts
as valuable future assets and increases Heidi'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 his negativity) of the bank decides that slowly the time has come to demand payment of the debts incurred by the drinkers at Heidi's bar.

However they cannot pay back the debts.

Heidi cannot fulfill her loan obligations and claims bankruptcy.

DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %.

The suppliers of Heidi's bar, having granted her generous payment due dates and having invested in the securities are faced with a new situation. Her wine supplier claims bankruptcy, her 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

  • You left some things out:

    The FED loaned her a million dollars at 1% interest …

    The Congress and the President blocked her from expanding her business until she agreed to give the drunks all the drinks they could drink on credit.

    The FED for 40 years bailed out any bar that went underwater.

    Government created and controlled “private” banks originated the market for DRINKBONDS, ALKBONDS and PUKEBONDS — with an implicit taxpayer backing for these junk bonds.

    Well, that’s part of what you left out …

  • Hi agnitio,

    I think that the example makes the government at the end sound ridiculous. All the firms linked to the bar in the above example existed “because” of the false belief’s surrounding asset values – if that real wealth doesn’t exist those firms shouldn’t be there in the first place. Bailing one body out to save those others is, weird …

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  • Matthew

    I just saw another great way to explain the crisis to your kids here:

  • Hi Matthew,

    I don’t think that the explaination from the Freakonomics guys actually lines up with the reality – I also don’t think a kid would enjoy that fairytale very much 🙂

  • Greg,

    Your explanation involves blaming the government – which doesn’t hold water. You seem to be somehow blaming the government for the CDO?

    The Fed did make a mistake and there is (and will be) a moral hazard problem from bailouts – but that is far from the whole story.

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  • LaSombra

    I love that explanation 🙂 As for Greg Ransom’s comment, I think it’s irrelevant. This article is titled “The Financial Crisis in Simple Terms”. I think it’s simple, yet accurate enough. Kudos to the author.