My mom recently asked me to explain how this financial crisis happened. I didn’t have a great answer, so I decided to draw an analogy and then take from there.
Subprime lending is kind of like an ice cream truck lending money to kids to buy ice cream during a hot summer – even if their allowances don’t support that kind of spending. Then there are mortgage backed securities, the equivalent of a local dog track owner buying all those ice cream loans, and selling them as an investment to betters on the dog track. Sounds like it could work in a hot summer, however, always keep in mind.it is pretty difficult to control the seasons.
When a market is hot, you can always find a financial genius who can figure out how to make money out of more money.
Take the town of Wasilla, Alaska, which experienced the greatest heat wave in history this year. During the summer, temperatures were breaking 90 degrees, and you could fry a moose-burger right on the pavement. The market was particularly hot for one item. Ice cream. Kids were running through the streets chasing ice cream trucks with loose change and dollar bills, but some kids just didn’t have the allowance to afford ice cream..Was there a way to take advantage of the heat of the moment?
Joey Countrywide, the owner of an ice-cream truck in town had a bright idea. He watched as Allen Greenham, the town finance minister, slashed interest rates on municipal bonds, making borrowing cheap for everyone in an attempt to revive the town economy after the crash of the Winter shovel bubble. Countrywide would borrow and borrow and borrow, and then loan desperate kids ice-cream using “subcone loans.”
Subcone loans didn’t require formal checks on what the kids did to get their allowance, or whether or not they actually owned a lemonade stand. They all offered up confusing terms like “variable melting option,” and actually carried very high interest rates after an initial period – but these kids were just happy to be getting the ice cream that they had been dreaming about for their entire lives.
Then another financial genius had an idea. “These subcone loans seem to be a hot commodity. What if I find a way to get rich by taking these hot commodities, pooling them together, and creating a standardized instrument that I could sell to speculators? All I need is a market place..” These were the thoughts of Thayer Stearns, the owner of one of the town dog tracks.
Stearns started buying hundreds of loans from Countrywide and used them to advertise “the highest payouts of any dog track in town,” which pulled every gambling addict out of OTB. Frank “Moody” Mudinowski, the local bookie, set the odds for each race, giving credibility to these betting instruments – so everyone felt safe placing their bets with Thayer Stearns. With all this risk spread out over the diverse pools of loans, Arty Irwin Grimace (A.I.G.), the local insurance broker began offering insurance on the betting slips with Cone Default Swaps (CDS).
And it worked. Man did it work. It just kept getting hotter in Wasilla. The kids kept refinancing their subcone loans, and ice cream was flying everywhere. Countrywide bought a bigger freezer, and kept pushing new subcone loans on the market. Thayer Stearns was getting everyone to spend their paychecks at the dog track. People at the dog track were making a killing, and thought that their bets were safe. And A.I.G. sat on the porch of his insurance shop, chewing beef jerky and watching the premiums roll in.. To be sure, it was getting tough to tell whether the risk was sitting with the ice cream trucks, the dog track, the insurance broker, or the gambling addicts at the track – but it didn’t really matter. Who needed risk visibility, just as long as long as it stayed hot as the Dickens outside..?
But then something happened that no one was expecting. The earth rotated on its axis. Fall came around. It got chilly in Wasilla. Then…It snowed.
Demand for ice cream plummeted. Interest rates soared and kids started defaulting on their loans as it turned out that these kids were either fibbing about their insurance, or didn’t anticipate a rise in interest rates. Countrywide was left on the hook for many bad loans. Thayer Stearns’ betting slips plummeted in value. Gambling addicts were losing their shirts, and ended up spending many nights sleeping on the couch. AIG was now on the hook to cover the losses on the Thayer Stearns betting slips, and it didn’t have the liquidity to do that.
The ice-cream bubble had finally burst
For the time being, the carnage seemed to be restricted to Fall Street, the street where all the local dog tracks resided – but unfortunately, the problem was likely to spread to Main Street. Main Street bank had been using its savings deposits to place bets at the dog track, and now suddenly had no liquidity for lending to John Q. Public. Residents wouldn’t be able to get small loans for hunting permits, and snow shovel businesses. The local hockey rink wouldn’t be able to borrow money to buy a much needed Zamboni machine, so the rink was closed down. Hockey moms who supplemented their income by selling hot chocolate at their sons’ hockey games would see the financial crisis hit their wallets. The trickle down effect had finally shown itself.
The mayor, Jorge W. Buche and Hank “the Tank” Raulson, the town treasurer sprung to action. They drafted a plan to buy all the dog track betting tickets using the town treasury funds – which they were sure would restore confidence to the market, allow these intertwined pivotal institutions to stay afloat, and ultimately protect Main Street.
It was clear from the onset that Raulson and Buche, two unpopular men in Wasilla, were unable to instill confidence in the public for their proposal, and that they didn’t sufficiently convey the threat of a Fall Street collapse spreading to Main Street. Paul Nooman, a local merchant elaborated, “what we have here is a failure to communicate.” He continued, “Hank Raulson may have some fancy degree from Hartford Business School, but most residents I know ain’t about to see their tax dollars go to bail out some sleezy dog track owner with a mustache.” With a low level of public receptiveness to the proposal, members of the town council were ready to jump at the chance to bash Fall Street, “I am not going to sit here and bail out some corporate fat cats, while little boys are left with no ice cream. That is just not right, especially when I am getting ready to run for re-elect. I mean. Especially when it is hot out. Yeah.”
The ultimate rejection of the proposal has caused even further outrage among many, who consider the decision nothing more than political pandering. Another local resident explained, “Where were all the grownups during this crisis? Why was Countrywide allowed to get away with taking advantage of the kids? Why is a dog track running our town’s economy? Why is Frank “Moody” Mudinowski getting paid by the dog track to tell the public how safe the bets at the dog track are? Hank the Tank may look like Colonel Klink, but that doesn’t mean that he doesn’t know what he is doing when it comes to finance. These dopes in the city council who contributed to this problem from the start are now trying to block a solution that they probably don’t even understand. These guys couldn’t tell preferred stock from livestock from Woodstock from a tube sock.”
In the end, the crisis that has torn the sleepy little town apart (and may spillover into neighboring towns) has left many wondering how so many smart people were willing to back a financial system that hinged on a heat-wave that drove a temporary rise in ice cream values.
Local musician, Brian Adams expressed his frustration with the entire quagmire, “Oh looking back now, how did no one see that summer wouldn’t last forever?”