Imagine a world where stools are a critical component to the economy. Stupendous Stool Store, Inc (SSS) is one of the five largest stool companies in the world. For years, SSS sold four legged stools with various degrees of quality to retail stores
worldwide. SSS sells its stools in bundles of 10, improving efficiency and lowering costs. They bundle together both high and low quality stools to give the retailer a nice mix to sell to consumers. For many years, this was a very profitable business.
One day, the SEC (Stool Exchange Commission) relaxed the capital requirement laws for companies like SSS. Before, they could only borrow 10 times their equity for the inventory needed to make the stools. Now they could borrow 40 times their equity to purchase and make stools for repackaging. SSS set up more lines of credit to purchase more raw materials to make more stools. In order to carry this new debt load, SSS needed to make lower cost stools. One highly paid executive at SSS decided that they could lower prices of the stools, by including a few three legged stools in their bundles. They modeled the use of the new stool by sending “Stool Samples” to various bars and pubs around the world. They quickly determined that the three legged stool is just as good as a four legged stool, but costs less to make and takes up less room. Buyers of the stools did not seem to mind at all.
SSS then sent the Stool Samples to their independent external rating agency, Dumb and Dumber, Inc. After speaking with the executives at SSS and reviewing their “Stool Samples”, those at Dumb and Dumber, Inc. concluded that the new stool bundles should receive the same AAA rating as before. Now SSS could sell both three and four legged stools in bundles for the same price as they sold a bundle of higher quality four legged stools. The executives and sales people at SSS pocketed the additional profits and were happy.
Then one of the highly paid commission sales persons at SSS came up with an even better idea. How about adding some 2 legged stools to the package? These stools would only be effective for sober customers with good balance. Since they are only going to put a few of these stools in each bundle, along with three and four legged stools, they were able to lower their costs yet again. They went to Dumb and Dumber, Inc. with their “Stool Samples” and explained that since 20% of the customers who buy stools were sober, the two legged stools really had no effect on the quality of the stool package. Those at Dumb and Dumber, Inc. agreed and rated the stools packages AAA yet again. SSS could sell its stool package at the same price as before, but with much lower costs and pocket a handsome profit.
In order to keep production going, SSS always maxed out its leverage so that it had plenty of Stool Bundles available for the market. Eventually however, the stools reached a saturation point in the market and sales began to decline. At the same time, people were getting hurt falling off the three and two legged stools. Some companies began to return their stool bundles and others simply stopped buying.
It was at this point that Dumb and Dumber decided to lower the rating of the Stool Packages from AAA to BBB. Now no one wanted to buy any stools from SSS. SSS was still holding forty times its equity in lower rated stool packages in its inventory. These Packages were now “marked to market” by SSS’s auditor, an arbitrary process used to kick you when you are down. When they are marked down just 4%, the entire equity of SSS is wiped out. It is about this time that the banks that lent money to SSS began calling in their loans. They wanted their money back. At the same time, giant hedge funds began shorting the SSS stock, hammering its value even further. Eventually SSS had to either declare bankruptcy, be forced into a shotgun marriage with a stronger company, be taken over by the government or, as an interim step, be converted to a bank to be taken over later.
Imagine now that there are two legged stools hidden in dark pubs around the globe. They are owned by various institutions who no longer want them and the stools cannot be valued. As you can see, the world would be in quite a pickle if we relied on stools as a major source of financial security.
I used the stool in this analogy for two reasons. First, for many years, banking decisions were made by analyzing the 4 “C’s” of lending. Think of these 4 “C’s” as the 4 legs of a stool. They are Character, Cash Flow, Credit and Collateral. In residential lending, character was eliminated some time ago when loans were securitized and borrowers and their ultimate lenders never met. That left a three legged stool that functioned pretty well through the 1990s. However, in the first few years of the new millennium
, new products were coming out that eliminated one of the remaining legs of the stool. No income verification loans, no down payment loans, and loans to people who exhibited poor credit decisions were created. Soon the three legged stools became two or even one legged stools. They were then packaged and sold and somehow obtained AAA ratings.Loose lending guidelines combined with leverage and poor regulation has been the recipe for an unprecedented financial meltdown in this country. The mortgage back securities created by these firms have filled our financial institutions with financial crap; the second reason for my “stool” analogy.
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