Still confused about how AIG lost its shirt by going into the securities lending business big time? We understand. It’s terribly complex and full of words that make your eyes glaze over.
So we decided to break it down into the simplest terms Wall Street transactions can be explained: the two cows story.
You have two cows.
John Paulson borrows one cow so he can sell it for $100. He gives you $10 as collateral.
You buy your neighbours cow for $100, which you finance by taking out a $90 loan from the bank and use John’s $10 to make up the rest.
You brag to everyone about your financial health. You have assets–two cows you own, plus one Paulson owes you–worth $300, and liabilities of just $100.
A third of the country goes vegetarian.
You thought your two cows were worth $200 and now they are worth $140.
You express confidence in your financial health. Your assets are now worth only $200–your two cows plus the one John owes you–but your liabilities are still only $100. If necessary, you could sell the assets at this distressed price and pay off all your loans.
You hold onto your cows because you are sure the market is “dislocated.” Some day someone will want to eat beef again.
The rest of the country goes vegetarian. Your two cows are now worth $2 each to guys who want to make dog food.
John Paulson buys a cow in the market for $2 and he gives it to you as repayment of the loan. You now have three cows worth six bucks.
John wants his $10 back.
The bank calls. It wants its $90 back.
You call the Federal Reserve and ask for a bailout.