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A Simple Analogy of the Housing Collapse

Big Jimmy's Liquor Store had been a fixture in Jonesville for over twenty years. Big Jimmy was as you might suspect, a rather robust, affable man, who never met a stranger. Small town life suited him just fine and he felt like he was friends with the entire town. One of his close friends, Clive, started up Clive's Liquor Store about ten years ago. There was plenty of business to go around, so business never got in the way of their friendship.

As we all will eventually, Big Jimmy passed on and "Lil" Jimmy took over the business. "Lil" Jimmy was a bright young man with big ideas and he was not satisfied with the status quo at the store. In fact, he had always resented Clive for opening another store and it now became his mission to drive Clive out of business. His plan was simple. He would start selling his liquor on credit in order to accomplish two goals. One, he wanted to give Clive's customers a reason to come to him. Two, he wanted everyone to use the credit and buy more liquor. He figured if he made it easy to buy more, they will drink more.

"Lil" Jimmy's plan worked like a charm. Most of the town began buying their alcohol from him on credit and sure enough, they all began to buy more than usual. As I have already mentioned, "Lil" Jimmy was pretty smart. He made his customers fill out credit forms and sign a contract promising to pay for their purchase by a specific future date. This caught the attention of Gabe, his best friend who ran The Bank. Gabe convinced "Lil" Jimmy to take out a large loan backed by the future revenues he would receive in his credit contracts. With all the money from the loan "Lil" Jimmy tripled the size of the store and created Big Jimmy's Liquor Emporium.

The Bank was happy because their loans were securely guaranteed. If "Lil" Jimmy could not pay up they would collect from the customer. Then Gabe got an even better idea; he sorted the contracts by their issue due date, issued bonds and sold them around the world. These liquor store bonds were deemed AAA safe and secure, so money began pouring in to buy them. Bond holders enthusiastically began re-packaging and selling these bonds to other investors. No one really knew what these bonds were all about, but they had an AAA rating and they were backed up by The Bank, so how could you lose? The value of these bonds continued to climb and there were no shortage of buyers.

Eventually the bonds would come due and The Bank needed to collect from either "Lil" Jimmy or his customers. Unfortunately, his customers had all become hopeless drunks and they could not pay "Lil" Jimmy anything. "Lil" Jimmy had to file bankruptcy, as did most of his customer's and suppliers.

In the end, the price of the bonds dropped by over 95% and The Bank was tipping towards insolvency. Just in the nick of time, it was rescued with the money of the town's non-drinkers.

Learn more about this author, Peter Latona.
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