Mary is the proprietor of a gourmet juice bar called “Melange”. Over a period of time, she realizes that many of her customers are unemployed and, as such, can no longer afford to patronize “Melange” on a cash payment basis. This is her only source of income in a township where there several other competitors. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, pay 25% of the drink value upfront and pay the balance later. She keeps track of the drinks consumed on a ledger – thus effectively granting loans to her customers. Mary's “Drink now! Pay later!” marketing strategy is highly successful and new customers flood into “Melange”. Soon, she has the largest sales volume in the area. Her competitors are very worried and some of them follow her example to protect their businesses. 

By providing her customers freedom from immediate full payment demands, Mary gets no resistance when, at regular intervals, she keeps increasing the sales prices. Consequently, Mary's gross sales volumes increase massively. A young, enthusiastic vice-president at the local bank where Mary has a Term Loan and a Working Capital limit, now reckons that these customer debts constitute valuable future assets and increase Mary's working capital borrowing limit. He sees no reason for undue concern, since he has the debts of the unemployed customers appearing on Mary’s sales ledger as collateral. At the bank's corporate headquarters, an expert bond trader figures a way to make huge commissions, and transform these customer loans into tradeable securities named MelangeBonds. These securities are then bundled and traded on the international securities markets as AAA rated bonds. 

The bank finds these trades very profitable. Naive investors far removed from the epicentre, do not really understand that the securities being sold to them as AAA secured bonds are really the dubious debts of unemployed patrons of “Melange”. The bond prices climb continuously and soon become one of the hottest-selling products for leading brokerage houses. One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at “Melange”. Consequently, the Head of the Credit Department of the bank informs Mary both, verbally and officially in writing. Mary then demands payment from her patrons, but being unemployed they cannot pay back their drinking debts which have ballooned sizeably. Dragging them to court or the debt recovery tribunal looks meaningless. Since Mary cannot fulfill her loan obligations, she is forced into bankruptcy. “Melange” closes and all fifteen employees lose their jobs. Overnight, MelangeBonds drop in price by 90% and are now effectively junk bonds. The collapsed bond asset value destroys the banks' liquidity position and prevents it from sanctioning new loans to other customers, thus freezing credit and economic activity in the community. The bank’s AssetLiability position becomes untenable and its ALCO is unable to function effectively. The bank capital comes under severe stress. Fears grow about a possible “run” on the bank by existing depositors. The central bank of the country subjects the bank to a fresh CAMELS appraisal with particular emphasis on “M” for Management. The gourmet juice supplier to “Melange” who had granted her a generous line of credit and had invested a part of the company’s pension funds in these securities, is now faced with having to write off her bad debt and losing over 90% of the presumed value of the bonds. The value of the pension fund has eroded by 30%. The supplier ultimately files for bankruptcy, lays off all 150 workers, and closes the doors on a family business that had endured for three generations. The local economy takes a very severe hit, leading to social unrest and a knock-on effect on all other areas of business and industry on account of a drop in money in circulation and spending power. The ripple effect spreads into other parts of the country’s economy which begins to shrink. Property prices weaken, unemployment rises and demand for goods and services witness a fall. Under the “Too big to fail” notion, the bank, the brokerage houses and their respective executives are saved and bailed out by multi-million cash infusions from the government. The funds required for this bailout are obtained by imposing new taxes on the employed, middle-class, taxpaying public who had never heard of “Melange”. This results in a political storm, and in the next general elections, the government collapses.

[Side note: While this hypothetical saga may have dark, humorous undertones, the fact is, that a chain of events such as this contributed to the Global Financial Crisis of 2008-9, as well as to other more recent instances of this nature. Public and investment banking memory is notoriously short!]

Assignment: 

a. Analyse the chain of events and indicate what were the causes, what went wrong, and why did the situation snowball to crisis proportions resulting in epic failures at every stage. 

b. Suggest actions that could have been taken at the outset to prevent the crisis from happening. 

c. Select any one of the main protagonists in the narrative viz. (a) Mary, (b) the bank’s vice president, (c) the bond dealer at the bank’s corporate head office, 

(d) the broker in the leading broking house, (e) the supplier to Melange, and (d) the government and take on their role. Briefly explain what you would have done in their place to avoid the disaster.

Answer rating: 100% (QA)

Answer A The causes of this crisis were 1 Marys lack of understanding of the risks associated with her Drink now pay later strategy 2 The banks vice p... View the full answer