Chickenomics 1 – From Henhouse to Private Jet

22 11 2009

Category: Finance

For a little while – really a very little while – I accidentally found myself in the heart of the credit-boom. I got a job with the world’s leading law firm working on their hottest area, securitisation, in their boom market, Italy.

I was getting good money and was in an area with great prospects but I felt like I was in the madhouse so I quit to cycle around Milan and eat ice-cream for a while.

When I first started learning about securitisation I could see exactly why everyone got so excited about it and why it’s not going away anytime soon.

It’s alchemy. It really is; it realises value that didn’t previously exist. To try and convey how it works, and a few of the other credit boom phenomena I’ve tried to explain it using a farmyard tale. I’ll explain how the story relates to the real world in later posts. I’m not sure if this chicken parable is at all helpful but here it is…

I’m a chicken farmer and I need some money to build a new henhouse so I go to the bank.

The Bank

The bank manager says he’d love to lend me the money but, while the chicken business looks pretty good, my scarecrow manufacturing business isn’t doing so well and my farmhouse needs underpinning, my wife drinks and is about to divorce me, my kids are off the rails and, while he’s on the subject he thinks my eyes are too close together. I’m not a good risk. No loan; or a loan on horrible terms.

Free Money

Then I see an ad in the back of the paper: “Free Money!” it says, “Call NOW!” So I call and some guy comes along and says. This chicken business looks pretty good. Actually I don’t really care about the rest, so as long as we can make sure that the money I lend you is paid back by the chicken business and your wife and kids and the scarecrow business are kept away I’d be happy to get the money for you on much better terms than the bank would.

Why would they do that?

Well the chicken business is good; it’s all the other stuff that’s the problem and if you separate that out in business terms (even though it’s integrated into your farm and life) you’ve got a nice simple proposition. He knows people who want to get a better return than they could get at the bank; I can offer them that.

What’s the downside?

Well there’s always a risk the chicken coop will burn down but I can get insurance.

I don’t have to give any guarantees that the people who invest will get their money back – they take their chance on the valuation they get (the one I pay for).

But they can insure their risk anyway.

How do they know what it’s worth?

That’s OK – there are people who’ll organise that – there are people who’ll organise all of it. They all want lots of money but there’s so much to go round and I’ll be so much better off it’s fine.

More Money

The woman who values the business says I’m selling myself short. She says I can easily get the money for the new henhouse at a low interest rate, but I can also borrow lots more money from other people at much higher rates.

She gives me a nice smile and says she’ll certify the chicken business is good for it and the best bit is that there’s no downside for me; if the business can’t pay the rest of the farm is safe and it’s their look-out; I get to keep the money.

Why ask for money I don’t really need?

I don’t need money? Who doesn’t need money?

What next?

All the valuers and agents and lawyers and bankers get busy sorting it all out and I just wait for the money to come in.

Is that all?

Well actually it’s not. Local planning (zoning) rules mean my farm only has permission to house 100 chickens. That’s always been a bit annoying because they’re the profitable side of the business. Because this transaction is going to appear to be separate from me, those chickens don’t count towards the hundred. So I can get another hundred. And if those appear to be separate from me I can get another hundred. And on and on and on.

Does anyone need all those chickens?

Look all the finance people say it’s a great idea and they know what they’re talking about.

Where am I going to put them all?

Buy more land! I don’t have a mortgage on the farm and I’ve just been told the land value is going up 15% every year. The bank tells me they’re happy to lend me as much as I like to buy up the land all around.

Wow

Wow indeed – I started out wanting a henhouse and now I’m shopping for a private jet.

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