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Liquidity crisis on an uninhabited island

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December 23, 2008 – Comments (12)

The original source is in Russian, and it in turn sounds like an adaptation from a Western original, so the excerpt below could well be a reverse translation, but anyway...

Suppose the three of us - you (an Investor), myself (a Con Artist), and the third guy (a Banker) were sitting on a plane flying over the Pacific Ocean. While we were onboard, we got drunk, started a fistfight and toor off the lavatory door from its hinges, so they threw us off the plane through an emergency exit. We were lucky: right near where we landed was a tiny nameless unenhabited Polynesian island. Upon climbing ashore, we held council and decided to declare the island a new state called the UST (Unites States of Tequilla).

When they kicked us out, they naturally did not provide us with any luggage, so of all material and goodwill assets we only have the lavatory door which you somehow managed to hold on to. Moreover, even with all that tequilla, you still  turned out to be the most thrifty of us: by some stroke of luck you discovered a $100 bill stashed away in your wallet. And thus our UST has both hard assets (the door) and financial assets ($100). Since this is all that we have, you can also put it that way: we have a single hard asset - the door - secured by the $100 monetary base. In other words, our door is worth $100.

When the effect of tequilla wore off, we decided we need to have some kind of economy. The Banker proved the be the most dynamic of the three of us. He instantly announced that he is creating a bank and is ready to borrow the financial assets of the island's population at a 3% interest. Now, here's a man that does not let grass grow under his feet! You give him your $100, and he records it in his notebook ($100 debt against a $100 deposit). But I am not about to let you throw dust into my eyes. After all, financial schemes is my specialty. I know how to take possession of both your door and your $100. I set up an LLC and offer you a bond with a 5% coupon. I tear off a page from my notebook and write on it: "A $100 Bond with a 5% Coupon". You feel excited about this opportunity, so you withdraw the money from your account (making the Banker feel very sad) and give it to me in exchange for my bond. I take your $100 and deposit it with the Banker (who is now quite happy again).

You would think we might just call it a day and set about some serious business, for example, to shake a palm tree or pick some oysters or whatever. But you know me well enough - I am a financial genius, I can't be interested in such trifles as coconuts or oysters. While pacing back and forth about the island - 50 yards from the north to the south, 30 yards from the west to the east - I am plotting a shrewd scheme. I approach you again with a new offer: to boost your capital return by another percentage point. You can take a $100 loan from the Banker at 4% and buy another bond from my LLC for a 5% coupon yield. I immediately write a second bond on a sheet of paper, tear it off from my notebook and wave it in front of your face. Without much further thought, you rush to the Bank and apply for a $100 loan secured by my first bond. The bank has the money - I just deposited it an hour ago. You take the borrowed $100 bill, give it to me and put the second bond into your wallet - congratulations, now you hold $200 worth of bonds! And I put your $100 in the bank, so now I have $200 on my deposit. The Banker is now exhuberant: the loan business is thriving!

Do you imagine I'm going to stop at this point? Far from that: I have already written the third bond for you! Off you go to your bank to borrow money secured by the second bond! At the end of the day that we spent running about the island, exchanging the $100 bill and tearing off sheets of paper from our notebooks, we have the following picture. You own $5000 worth of my bonds, and I hold $5000 on a bank deposit. Now is the time for me to take possession of the door. I ask you to sell it to me for $100. But you decide to flex your pricing power: after all, this door is special, you can't find another one for love or money. You set your ask price at $1000. Well, $1000 is fine with me: I have $4000 more where they come from. I tear off the last page from my notebook, write a request to transfer $1000 to your account, and take your door. 

If an American with an MBA from Harvard could inspect our books, he would tell us that our United States of Tequilla has a $1000 worth of hard assets (the door) and $10,000 of financial assets (deposits and bonds). Thus our nominal GDP has grown by a factor of 110 while the consumer price index has increased tenfold, making the real GDP show a 1100% growth. Someone less sophisticated, or, perhaps, less educated, would say that we are just three idiots, that we have the same lavatory door and $100 that we had in the morning, and that it takes a special stupidity to spend the whole day tearing pages off one's notebook instead of getting off one's a..s to look for coconuts. Whatever view one might take, here is the mechanism of the housing bubble - whether in Europe, America, or Japan.

At the end of the year it will turn out that the Investor has no liquidity and cannot pay off his loans, and all his bonds will become the property of the Banker. But since the LLC that issued the bonds does not have liquidity either, the Bankers books will become one unmitigated disaster because the value of the bonds will now be identically equal to zero. The Bank will thus have a negative book value, forcing a bankruptcy, and the Con Artist will take over the bank, with its $5,000 debt to himself and with its last remaining asset - the $100 bill. As a result, we have a full-fledged liquidity crisis in the island economy, accompanied by a change of ownership of the only real asset on the island. In the final run, the bank folds and the Con Artist has both the door and the $100 bill.

What a good thing to be a con artist! 

P. S. The real picture was more complex than that. In a few hundred yards's distance from the island was another island inhabited by Polynesians. Our three travellers promptly used the door as a weapon, knocking the s..t out of the aborigenes and telling them that UST is rich and powerful, having a metallic door and $10000 worth of bonds and deposits, which the aborigenes would now have to accept as a payment for their fresh water, potatoes, coconuts, fried fish, and other commodities. That was the beginning of the meteoric rise of the United States of Tequilla as a global superpower.

12 Comments – Post Your Own

#1) On December 24, 2008 at 12:34 AM, RVAspeculator (29.68) wrote:

Here in the US we have a government that has done the same thing as the three people on the island (with Medicare, social security and the like)….but they have decided that they will bail out the banker on this island anyway and give them the $5000….   This whole thing gets more interesting when you add a government and a printing press to the story….   :)  Yet currently on the island the price of coconuts has dropped precipitously because of “fears of deflation”.  I don’t know about you but I want to be buying those coconuts with as many ponzi notes as I can.

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#2) On March 17, 2009 at 11:01 PM, lquadland10 (< 20) wrote:

Sadly True.

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#3) On March 19, 2009 at 1:08 AM, SolarisKing (< 20) wrote:

This is so pertinant to the Treasury Bond Scheme the feds pulled today, that i thought it was worth rereading

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#4) On May 07, 2009 at 10:27 AM, portefeuille (99.67) wrote:

making the real GDP show a 1100% growth

make that 1000%

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#5) On May 07, 2009 at 11:21 AM, kaskoosek (35.23) wrote:

Actually the growth is 900%

 

1000*(1+x)=10000

 

x=9 therefore growth =900%.

 

It increased by 9000$

initial is 1000$

growth=(final/initial)*100=900%

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#6) On May 07, 2009 at 11:28 AM, kaskoosek (35.23) wrote:

growth=change/initial

or

growth=final/initial-1

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#7) On May 07, 2009 at 11:33 AM, portefeuille (99.67) wrote:

... has a $1000 worth of hard assets (the door) and $10,000 of financial assets (deposits and bonds). Thus our nominal GDP has grown by a factor of 110 while the consumer price index has increased tenfold, making the real GDP show a 1100% growth.

He calculated $1000 + $10000 = $11000 (nominal) -> $1100 (real)

$100  -> $1100 is an increase by 1000%.

I think you missed the door ($1000).

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#8) On May 07, 2009 at 12:25 PM, UltraContrarian (31.60) wrote:

Nice post.  The problem of NINJA loans vividly illustrated.

Also don't forget that the nearby Polynesians have a built-in advantage when they start trading UST Bank: they are naturally both naked and short.

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#9) On May 07, 2009 at 12:31 PM, kaskoosek (35.23) wrote:

Actually

 

I missed the whole point. Didn't read anything. just saw two numbers 1000 and 10000.

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#10) On May 07, 2009 at 12:40 PM, kaskoosek (35.23) wrote:

By the way the original source is recursive.

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#11) On May 11, 2009 at 4:24 AM, alexxlea (42.32) wrote:

Rec'd, favorited, stored to memory. Also, wouldn't this, as an average, have to involve numbers more along the lines of 12.500+12.500-25.000 paper assets? Wow we're absolutely insane.

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#12) On May 11, 2009 at 4:45 AM, thisislabor (< 20) wrote:

oh thats whats wrong with our economy. it all makes so much sense now.

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