Once upon a time there was a very important country in a very important continent. The country was called Chickistan and was populated by, yes, chickens. All 63 breeds of chicken with their local variations and feather configurations were represented there and fowl as diverse as Cornish chickens, Silver Montazahs and Silkie Bantams could be found.
Chickistan was noted for innovation. One of the greatest innovations of Chickistan, for instance, was to send most of the manufacturing of chicken houses, wire netting and the growing of pecking-corn overseas to countries far away. This was a stroke of genius, for it reduced the cost of goods to local consumers, and made the far-way countries very rich, powerful and eventually stroppy, bossy and aggressive. But never mind. Short-term profits went zooming up and share prices followed.
Now Chickistan had made itself primarily a service economy and gutted manufacturing, other ways of making money had to be found. The brightest and most highly educated brains in the land applied their high IQs to the problem. At a very high powered convention at the Chick-Inn, a favourite watering hole, one of the chickens at the very top of the pecking order spotted a dead-sure winner - -
For centuries chickens had been peckin’ around, depositing what chickens deposit and not thinking about it at all. Their priorities had been adequate food, getting onto the highest perch in the evenings and making up to the prettiest chicks. But this is never enough for some, and the idea of exploiting chicken droppings seemed a winner.
But chickens tend to be squeamish and the better-off chickens liked to think they were well-bred, educated and stylish. To sell the idea of chicken droppings didn’t seem quite nice. In fact, it was a non starter. So the great, the wise and the talented sat down and pondered and puzzled: how could they exploit the droppings that were wasted on the ground and made a mess of the most elegant of chicken feet. Of course, although they were the brightest chickens on the planet they nevertheless hired extremely expensive consultants in order to blame someone else in case they made the wrong decision. For weeks they debated the problem, when one extremely bright fowl came up with the idea:
Eureka! he cried, ‘Chicken derivatives!” (*see below)
So, the concept of chicken derivatives was created. It took off like a bat out of hell. Chicken droppings were gathered together in packages and traded in increasing quantities. At first the droppings were aggregated indiscriminately and changed hands rapidly, every trader charging a handsome fee, adding or subtracting another package, re-naming the whole and passing it on to a colleague. This chicken in turn would alter the contents a bit, re-label it once again and sell it, earning a huge commission.
Later, the trading became more sophisticated. The droppings of Appenzell Pointed Hood hens were traded exclusively as dropping-backed securities, and there were innumerable trades that included droppings from a variety of breeds. A mix of Hamburgs, Hollands and Houdans was popular, while Plymouth Rock and Wyandottes were thought highly of. But then as trading volumes increased, nobody made a note of which droppings were in which package or whether droppings from a Red Cap (only single-A) were mixed with Naked Neck chicken droppings (rated double A+). All the packaged chicken derivatives were promoted as having a quadruple-A rating. This is because the chickens who owned the derivatives also owned the rating agency.
This securitization of chicken derivatives became more and more popular. Everyone was making a fortune. But even a chicken of limited brainpower could perceive a certain amount of risk. Some had read about Tulip Mania and they wanted to insure their trades, just in case. This turned out to be no problem, owing to the omni-presence of the FIG (Fowl Insurance Group). FIG insured chickens against fowl pest, fleas, early death, comb-discoloration and feather-loss. They didn’t really understand this novel idea of trading droppings, but the top executives of FIG examined the matter and declared that they would underwrite it, owing to the indisputable fact that nobody would ever demand payment. So much was obvious.
Thus were born the chicken-waste default swaps that insured dropping-backed securities and that themselves were traded on the assumption that no one would notice that the chicken derivatives were totally worthless. If the reader is confused it is nothing compared to the incomprehension experienced by those who were hired to administer the betting.
Now the total GNP of Chickistan was 1.5 million pecks (a peck being a unit of currency equivalent to $25). Despite warnings about the un-wisdom of relying on chicken derivatives as a principal source of growth in the economy, the government of Chickistan, encouraged with an illicit supply of young hens of dubious virtue, obligingly removed all oversight and restraint on the financial sector. This resulted in a total free-for-all.
Then, one night on television, a noted economist was asked what he thought of the amazing success of the derivatives market and the astounding wealth it was creating. The total outstanding liabilities of the financial industry, he told the audience, had reached 750 million pecks as a result of the frenetic trading in these financial instruments. This, he pointed out, was 500 times the GNP of Chickistan. The industry was grossly over-leveraged. Moreover, look at the underlying asset values, he said. If left to its own devices chicken derivative simply dissolved in the rain and disappeared into the soil. Yes, it was a mild fertiliser but had no intrinsic value to the community of chickens - - any chickens. Chickistan could face total bankruptcy were confidence in the market to falter. What we are talking about, he concluded was, after all, a waste product.
The audience was astounded. A waste product? Nobody had spotted this fact. How could this be? The brightest minds from the very best universities had assured the public that Chickistan investments were the safest in the world. Chickens all over the country started to sell their shares and to stop spending. When asked whether they shouldn’t be moving into cash to protect their clients and investors, financial advisors, who made their living buying and selling shares demurred: “The underpinnings of the Chickistan economy are sound. This country has the highest productivity of any country in the world and derivatives are central to its success. This is just a blip.” One advisor, unable to adjust to the new paradigm, saw his clients” savings disappear altogether. In reply to a polite query as to why he hadn’t turned more chicken derivative certificates into cash, he said, “You should have told me if you thought it was better to be liquid. My job is to trade in derivatives.”
The talented sages of the financial industry were hoping to spin things out long enough to make themselves multi-millionaires. The industry was going through a period of excessive exuberance, they said. The self-correcting capitalist market couldn’t possibly be wrong. Leveraging was anyway what banks and financial institutions did.
Alas, some of the smarter financiers smelled a rat and demanded that FIG pay out on the chicken-waste default swaps. The trend became a flood and soon FIG had run out of cash to pay the insurance claims. The whole rickety system collapsed, leaving Chickistan a financial wreck. Frantic efforts were made by the government to restore confidence and to recapitalize the financial institutions. But alas, all they had left to use as capital was the huge pile of chicken droppings left over from the collapse.
The moral is that if you start with shit this is what you end with.
* Note the sophisticated education of said chicken. It is unlikely that a trader on Wall Street or merchant banker would cry “Eureka!” or know what it meant.