Subprime crisis explained [How Heidi and her bar caused the 2008 global economic crash]

Toronto Sun ^ | 2011-11-19 | Lorrie Goldstein

[Clive]

Anyone doing research into the 2008 subprime mortgage securities scandal inevitably comes across the Internet gem below.

Often titled “Derivative markets — an understandable explanation” but more commonly known by its first sentence — “Heidi is the proprietor of a bar in Detroit,” it appears to have been written in 2009 by an author with considerable understanding of financial markets and a great sense of humour.

And it provides a good, basic explanation of the origins of the subprime mortgage securities crisis that led to a global credit freeze and the ongoing world-wide economic tsunami from which we may never fully recover.

Without further ado, here it is:

•••

Heidi is the proprietor of a bar in Detroit .

She realizes virtually all of her customers are unemployed and, as such, can no longer afford to patronize 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 Heidi’s local bank recognizes 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 unemployed alcoholics as collateral!

At the bank’s corporate headquarters, expert traders figure out a way to make huge commissions, and transform these customer loans into DRINK BONDS.

These “securities” are bundled and traded on international securities markets.

Naive investors don’t really understand the securities being sold to them as “AAA Secured Bonds” really are debts of unemployed alcoholics.

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 Heidi’s bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts.

Since Heidi cannot fulfill her loan obligations to the bank 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.

In addition, the laid-off workers’ pension funds and Individual Retirement Accounts all suffer substantial loss in value.

Fortunately, though, the bank, brokerage houses and their respective executives 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 employed, middle-class nondrinkers who have never been in or heard of Heidi’s bar.

Now do you understand?

•••

If anyone knows the author of this piece, please let me know as I’d like to give him or her credit.

[Clive]

Lorrie Goldstein ping.

[grey_whiskers]

If anyone knows the author of this piece, please let me know as I’d like to give him or her credit.

Screw that -- I'd like to buy them a drink!

Cheers!

[grey_whiskers]

BTW, is it any coincidence that on many websites (including FR), whenever the weekly unemployment numbers are announced as "unexpected," that a clarion call of responses immediately cries out, "DRINK!" ?

Cheers!

[Toddsterpatriot]

Fortunately, though, the bank, brokerage houses and their respective executives are saved and bailed out by a multibillion dollar, no-strings attached cash infusion from the government.

Fortunately, they repaid the loans from TARP at a profit to the Treasury.

[Chode]

something similar but in this case we are the hotel that loses out...

It is a slow day in the small Minnesota town of Marshall , and streets are deserted. Times are tough, everybody is in debt, and everybody is living on credit.

A rich tourist visiting the area drives through town, stops at the hotel, and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs to pick one for the night.

As soon as he walks upstairs, the hotel owner grabs the bill and runs next door to pay his debt to the butcher.

The butcher takes the $100 and runs down the street to retire his debt to the pig farmer.

The pig farmer takes the $100 and heads off to pay his bill to his supplier, the Farmer's Co-op.

The guy at the Farmer's Co-op takes the $100 and runs to pay his debt to the local prostitute, who has also been facing hard times and has had to offer her "services" on credit.

The hooker rushes to the hotel and pays off her room bill with the hotel owner.

The hotel proprietor then places the $100 back on the counter so the rich traveler will not suspect anything.

At that moment the traveler comes down the stairs, states that the rooms are not satisfactory, picks up the $100 bill and leaves town.

No one produced anything. No one earned anything... However, the whole town is now out of debt and now looks to the future with a lot more optimism.

And that, ladies and gentlemen, is how the United States government is conducting business today.

[federal__reserve]

If you can believe this, I received that article a week ago in an email from my contact in India! I forwarded it to all my contacts here in US.

[Fee]

Here we go again. If the bankers did not load up mortgage backed securities with liar loans and rated them AAA paper when they were actually junk we could have survived the subprime meltdown. The first 18 months most of the failure in mortgage notes involved subprime mortgages. Mathematically the US financial system can survive the hit because subprime mortgages are clearly flagged before the investor buys them. The concept of subprime is economically stupid and time proved it because more then 1/3 defaulted and the taxpayer was on the hook for the losses. The coup de grace was the liar loans collapsed after the subprime. Here the losses were much larger because the investors paid higher prices for them because he thought they were AAA investments. Even worst the buyers used leveraged money to buy them. Derivatives were based on AAA odds of failure not junk odds. That makes a major difference in price and the cost of failure. We took a serious hit with subprime but we took a more severe hit from the liar loans. The gov CRA policy encouraged subprime, but never liar loans. That was invented by greedy bankers when they discovered that Freddie Mac and Fannie Mae were not reviewing the mortgage notes they were buying from the bankers and mortgage companies.

[GeronL]

uh huh. Sure.

The taxpayers are still in the tank for tens of billions with GM alone. Can’t sell the stock without losing $16 billion or more.

Government should NEVER get involved with running or funding businesses. ever.

[GeronL]

It happened because of government financed Freddie Mac and Fannie Mae. It’s that simple. Government needs to get out of the private economy, it doesn’t know anything about common sense or logic.

[Toddsterpatriot]

uh huh. Sure.

The banks and the brokerage houses paid back the loans, at a profit to the Treasury.

The taxpayers are still in the tank for tens of billions with GM alone.

Don't forget Chrysler, Fannie and Freddie. Those will cost us tens of billions.

Government should NEVER get involved with running or funding businesses. ever.

I agree.

[<1/1,000,000th%]

The story leaves out the part where Heidi’s bank is threatened by the federal government to find a way to market the debt.

[GeronL]

Chrysler is now a foreign company, owned by Italian-Fiat. Why should we do a thing for them? :p

[okie01]

That was invented by greedy bankers when they discovered that Freddie Mac and Fannie Mae were not reviewing the mortgage notes they were buying from the bankers and mortgage companies.

Actually, the first party to bundle sub-prime and liar loans and issue so-called mortgage-backed securities was Fannie Mae and Freddie Mac.

It's how they got additional funds to buy even more sub-prime and liar loans.

The AAA rating traced to the fact that Fannie Mae and Freddie Mac were "instrumentalities of the United States government" -- inferring a high degree of security.

The banks bought these...then began trading them.

No matter what direction you approach the problem from, you keep ending up back at Fannie Mae and Freddie Mac...and the federal government. All the rest of the exploitation and fraud was second order -- accessories after the fact.

[Intolerant in NJ]

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 little piece missing - Sam, the local bookie, knows about these bonds and that they're all based on the shaky business of Heidi's bar - so he lets it known on the street that he's willing to bet all comers that these bonds will be worthless in three years (credit default swaps) - the word gets around and a lot of the local businessmen, also aware of the bonds and how fast they're growing in value, take Sam's bet for money they don't have in case they lose, because they think they can't lose (AIG, etc etc) - eventually the bonds collapse in value and even more businesses than those in the original example go under after being liquidated to pay off some of what they owe...but Sam lives happily, or at least in riches, ever after......

[Para-Ord.45]

BINGO

The analogy is pure bullshit. Once again it`s the false narrative where they point to one of the last dominoes to fall and try tell us it all started there.

There could be no derivatives without the underlying assets created by govt.

Remove the decades of legislative Big Govt. interference in the free market, the decades of legislation, Fannie Mae, HUD.

[Para-Ord.45]

*Remove the decades of legislative Big Govt. interference in the free market, the decades of legislation, Fannie Mae, HUD, and there would have been no housing bubble.

[Fee]

In a court of law, you will lose on such notion without a written agreement or guarantee from FMFM to claim AAA like US T Bills. Claiming something AAA means the mortgage company selling the portfolio must verify all the data for each loan in the package, all proper documents on its ownership of mortgage (ala title) before making such claims on a prospectus. Mortgage companies and bankers are learning the hard way that if you claim AAA mortgage backed securities you can be subject to put back option by the buyer if the information on your prospectus is inaccurate. Several large US banks were forced to settle when they sold AAA MBS to investors, hedge funds, Freddie Mac and Fannie Mae, and pension funds when they sued that the investments they brought were not AAA. The lawyers for the banks knew they cannot claim AAA by inferring that the gov will guarantee it because such guarantee never existed. Why else should the banks be forced to settle and how come FMFM sued the bankers that sold them the notes????!!!! Please know the laws before making claims. Look I am not saying the gov is totally off the hook, but the banks went beyond what was allowed because the Fed regulators did not monitor them and very hesitant to enforce the laws that existed until it was too late. Banks were not broke or desperate when they encouraged liar loans, they were simply greedy and reckless. If they had followed the laws and common practices they would have made tons of money in a booming real estate market without the need for liar loans. Our country would have weathered the damages from subprime loans much better. We may have survived and be on the road to recovery by now. The financial damage from subprime was survivable, but additional damage from the liar loans was the tipping point into the financial abyss.

[GOPJ]

Great post... thanks.

[Lmo56]

Foster Brooks shoulda told this story - too bad he died ...