A friend of mine, Rob Slee has written what I consider the best explanation of the credit crisis I've read. Below is the entire post. Enjoy.
If you’re interested in getting more information from Rob, click on this link to go to his website.
How We Got Here
My Uncle Harry is the proprietor of a bar in Toledo. He realizes that virtually all of his customers are unemployed alcoholics and, as such, can no longer afford to patronize his bar. To solve this problem, Harry comes up with a new marketing plan that allows his customers to drink now, but pay later. He keeps track of the drinks consumed on a ledger (thereby granting the customers loans).
Word gets around about Harry’s "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Harry’s bar. Soon he has the largest sales volume for any bar in Toledo – which is saying something.
By providing his customers freedom from immediate payment demands, Harry gets no resistance when, at regular intervals, he substantially increases his prices for wine and beer, the most consumed beverages. Consequently, Harry’s gross sales volume increases massively. A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Harry’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 a way to make huge commissions, and transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the 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 are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Harry’s bar. He so informs Harry.
Harry then demands payment from his alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Harry cannot fulfill his loan obligations he is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.
Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks' liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.
The suppliers of Harry’s bar had granted him generous payment extensions and had invested their firms' pension funds in the various BOND securities. They find they are now faced with having to write-off his bad debt and with losing over 90% of the presumed value of the bonds. His wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations; his beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.
Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion, no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who had never been in Harry’s bar.
But something funny happened on the way to the bailouts. The Government finally ran out of money because it had been spending money it didn’t have for more than 10 years. So the Fed printed-up a few trillion dollars; the whole time saying that inflation would not ultimately reign supreme. The world shrugged and started buying gold.
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