You have two cows.
Your friend Jim Jones borrows one cow so he can sell it for £100. He gives
you £10 as collateral.
You buy your neighbour’s cow for £100, which you finance by taking out a £90
loan from the bank and use Jim’s £10 to make up the rest.
You brag to everyone about your financial health. You have assets–two cows
you own, plus one Jones owes you and you have assets worth £300, with
liabilities of just £100.
A third of the country goes vegetarian. You thought your two cows were worth
£200 but after the slump in beef they are now worth £140.
You express confidence in your financial health. Your assets are now worth
only £200 – your two cows plus the one Jim 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 and walk away from it all.
However, you think you are a banker so you hold onto your cows because you
are sure the market is “dislocated.” Some day someone will want to eat beef
again. But bad news, the rest of the country goes vegetarian. Your two cows
are now worth £2 each to Pedigree Pet food who wants to make dog food out of
them.
Jim Smith 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 quid.
Jim wants his £10 collateral back for the cow he borrowed off you.
The bank calls. It wants its £90 back.
You call Gordon Brown and ask for a bailout.