By Andrew Sheng
(Caijing.com.cn) One day, a clever monkey established the largest bank in an ancient kingdom by inventing the first banana derivatives market, using banana peels to represent bananas. Later, the Magic Monkey’s bank started to fail. So the Emperor summoned his ministers to help him decide what to do.
The Minister on the Left argued that Banana Bank had become too big, and that it must be closed or cut down to size. He thought the BanDo market (banana-backed securitization) had become too speculative and that the BanDS market (banana default swap) was downright dangerous. Although the bank’s losses were high, he said, closing down a bad bank is still cheaper than keeping it open.
"It is a well-known saying that a failed enterprise’s management that’s part of the problem cannot be part of the solution," the minister argued forcefully before the Emperor and his Queen.
"You are right," said the Emperor.
The Minister on the Right, on the other hand, said that since more than half the kingdom’s population had deposits in Banana Bank, closing it down would mean most depositors would lose their money. It would cause such panic that the kingdom’s reputation would plunge, and it would not survive. The only way out was to guarantee all deposits, take over some bad assets, and then lower interest rates so that banks could begin earning profits again.
The banana finance industry has become such an important industry, the rightist minister said, that it’s even more important than the business of growing and selling bananas. People in the banana finance industry earn higher salaries and bonuses than those who just growing bananas.
Indeed, the real problem was not bananas, but the fact that the Banana Bank had loaned a lot of money to a lot of poor people who could not repay. The minister said if Banana Bank had to foreclose on all these loans, more people would be homeless, and there would be a greater crisis.
"You are right," said the Emperor.
The Queen broke her silence. "But how can they both be right?" she asked the Emperor.
"You are also right," said the Emperor. "But we must make a decision. Since the banana finance industry contributes so much to the country, including our royal purse, we must save the industry. But since none of our ministers understand such a complex industry, what shall we do?"
The Minister on the Right, seeing his arguments had won the day, recommended that the retired CEO of Banana Bank be appointed person-in-charge of a rescue operation. After all, he knew how derivatives markets work. The Emperor remembered the old saying "poachers make good gamekeepers," and approved the appointment.
One year later, a miracle of miracles occurred: The stock market started booming again, Banana Bank reported good profits, and everyone was happy — except the Minister on the Left. He subsequently quit and became a monk, predicting the world would suffer another crisis because of human greed.
The Emperor was so delighted that he gave a private feast and invited the Magic Monkey to explain how this miracle was achieved.
"The first step was quite easy," said the monkey, his hair well-oiled and patting his latest Italian silk suit. "Once Your Majesty guaranteed all deposits, the Banana Bank was sure to make profits because deposit interest rates fell to zero, but lending rates did not decrease."
"But what about all your bad loans?" queried the Emperor.
"Your Majesty is very perceptive," the clever monkey said. "You see, under new international accounting standards, our assets and liabilities have to be marked to market. Since the Banana Insurance Group guaranteed a lot of our assets through credit insurance, our assets are now OK.
"But because our credit ratings fell and our bond prices dropped by more than 40 percent, according to the new standards, we can take the market decline in our liabilities as profit."
"You mean the more bankrupt the market thinks you are, the more profits you can report?" gasped the Emperor.
"Precisely. Of course, when our credit ratings improve, our profits will actually decline. But that," the monkey smirked, "is another day."
"So what’s the catch?" asked the disbelieving Queen. "How can we seem to make profits endlessly?"
The monkey answered with the serenity of a satisfied cat after a good meal. "Well, Your Majesties, as long as the kingdom continues to print money, the banking system will always make money, because the more credit we create, the more profits for the banking system and the better our bonuses.
"There is only one small catch," he said. "But no one notices such things anyway."
"What’s that?" asked the Queen.
"The 30-year interest rate swap spread between government bonds and the Banana Bank Inter-bank Offer has just turned negative, which has never happened before. This is highly technical, but what it means is that the market is telling us that the chance that your kingdom will default in 30 years is higher than that of the Banana Bank."
"But how can the credit rating of a bank be better than that of the sovereign?" she cried.
"Aha! The market believes Your Majesties spent so much money bailing out the banks that, in the short-run, the banks are healthier than your kingdom in 30 years. But you must not worry about such market indicators because, as you know, the market is not always right."