Surfboards to Spark Plugs

Feast your eyes on an extract from Bankers Town, an explanation of correlation that everyone can understand.

It all begins with a bunch of Australians buying surf-boards. Not any old surf-board, though. Designer surf-boards, hand-made, by local artisans from organic materials at thousands of dollars a go. Sounds crazy, but all of a sudden it’s the next big thing, because some genius has come up with the idea that they’re a great investment, and while they’re waiting to become millionaires the investors can actually have fun falling off them and getting eaten by sharks. And you can’t do that with a share certificate.
An ambitious bank from New Zealand sees a chance to grow. The bank sends out thousands of fliers and makes tens of thousands of calls to Australians offering them loans to buy their boards. They’ll finance at 100%, low interest: why not? Surf boards are a sure thing, everyone knows that. The price of a good board can only go one way.
But as wiser heads have predicted (or claim to have predicted, conveniently, some time after the crash), the boom is over before it’s even begun. The shark community hears about all the novice surfers taking to the water and decides to party on delicious human flesh. Surfers panic, stay at home, sell their boards. Suddenly ten thousand-dollar surfboards are worth nine thousand, eight thousand, five thousand. The investors sell their boards but still can’t pay their loans. The New Zealand bank starts to shake, rattle and roll.

So do its lenders. The Kiwis have loans in the hundreds of millions from big Japanese banks – the same money they’ve been using to fund their surf-board experiment in the first place. But they’re not stupid, the Japanese. They’re not ones to take crazy risks on surf-boards. So when they saw their client going surf-crazy, they took out an enormous insurance policy – a credit default swap – against the Kiwi bank going bust.

And bust it goes.

OK, say the Japanese. We’ve got some of our money back from the Kiwis. But for the rest, they turn to the guys who wrote them the CDS, a bunch of smart ex-traders working out of a small office in Frankfurt. Hermann Hedge-Fund, we’ll call them. Hermann Hedge-Fund pays out, as it has to, and suddenly has a massive hole in its own finances. Which is unfortunate, as it tends to borrow short-term, and just three days later is due to repay a loan of, I don’t know, eight hundred million euros, to a small Dutch bank.

Payment day comes. The money does not. Hermann Hedge-Fund is nowhere to be found. The Dutch are sitting around in their beautiful glass-walled offices wondering what the hell’s gone wrong.
“What do you mean the companiesh not there?” asks one.
“It’sh jusht not there,” says another. “No one ish anshwering the phonesh.”
“They can’t jusht elope with our Eurosh!” screams the first. “Thish ishn’t a Charlotte Bronte novel!”
He means Jane Austen, of course. But Charlotte Bronte had a thing about the low countries.
What do the Dutch do? They’re not having a fantastic year themselves. They’re not exactly bust, but now they haven’t been repaid, they’ll probably end up breaching their capital ratios, which means their regulator – and their shareholders – will be very angry indeed.
But there is a solution. Do what bankers always do in a crisis (at least, on TV they do). Pick up the nearest phone – doesn’t matter whose phone it is or who’s on the other end – and scream “Sell!” at the top of your voice. The Dutch bankers sell anything that comes to hand – say, local commercial mortgage loans and obscure CDOs which no one really knows how to value. And because they’re desperate, they sell dirt cheap to a bunch of smug bastards who worked for Hermann Hedge-Fund until three days ago and who probably think they’ve got the deal of the century.

But the thing about these commercial mortgages and CDOs is that, although they’re everywhere, they’re not usually traded in quite these quantities. And because of an interesting accounting device called “mark-to-market”, a lot of the other banks and funds sitting on a pile of the same things now have to value their own holdings at these new, ultra-low prices. Suddenly, there are banks everywhere making losses. The giant Bank De Gauloises in Paris has made what it thought was a shrewd strategic move into Dutch commercial real estate. Not looking so shrewd now, mes amis. The rating agencies are straight on the phone with the bad news: the Bank De Gauloises is being downgraded.
This is an A-grade disaster for the Bank De Gauloises. It’s written lots of credit default swaps, interest rate swaps, currency swaps, with other banks and institutions all over the world. Now it’s been downgraded, they’re all on the phone at once, demanding more collateral in case it can’t pay what it’s supposed to. After valiantly fighting on all fronts for four, maybe five minutes, the Bank De Gauloises surrenders, throws all its assets at the problem and hopes it’ll go away.
The thing is, how much collateral is enough to solve the problem? They’ve given away billions, maybe tens of billions, in all kinds of bonds and smart financial instruments, but it’s up to everyone else to decide how much it’s all worth. And the answer comes back: “Please sir, can I have some more?” Scrambling around behind the sofa, the French find some US treasury bills to solve their own problem, but the big damage has been done – all the other financial instruments it’s handed over as collateral have to be revalued – by everyone else who holds them – at the new, low, “marks”.

“Golly.” “Gosh.” “My word.”
The management of the Bank of St-John Farquhar Farquharson, one of London’s most venerable institutions, are in session. They’ve just been through their books and seen to their horror that all those clever thingies with names they don’t understand that their smarter friends in hedge funds and other banks told them to buy, all those thingies are suddenly worthless. Oh dear. Tomorrow there should be some money coming in, because one of their biggest clients, a car-parts manufacturer in Westumberlandshire called “Aye Oop Exhausts”, is due to repay its own three hundred million pound loan. The trouble is, there’s been a handshake, an understanding, don’t you know, and it’s assumed that The Bank (they call themselves “The Bank”: what other Bank is there?) will lend all the money straight back to them. Aye Oop haven’t even bothered trying to scramble the funds together. Now, The Bank needs the money itself.
A short-term cash crisis. A delicate situation. What are they to do? Times like these call for the gentleman’s touch and the old school tie, and the Board adjourns while a few discreet calls are made to a few old friends. “Hello old chap, long time no see, how’s the wife, how are the horses? It’s terribly embarrassing, but I don’t suppose you could scrape together a little, erm, a little loan for us at The Bank, could you?”
A few hours later, the Board reconvenes. Shaken heads. Looks of disappointment. “How could they let us down? Don’t they realise who we are?”

There’s nothing for it. Aye Oop’s finance director is informed that The Bank will need its money back tomorrow after all. The poor FD tells the rest of the board, who respond calmly and reasonably by firing him on the spot. Aye Oop calls up its parent company in the Good Ol’ US of A, who rise magnificently to the challenge and put together an emergency package consisting of a statement that “in difficult economic times, difficult decisions have to be made, and it is with great reluctance that we announce the imminent closure of Aye Oop Exhausts, our British aircraft engines business.”

And if you’re working on the assembly line, that’s you out of a job. From surf-boards to spark plugs. Everything is correlated.