One upon a time, there was a little girl named Heidi. She loved to cook and eventually opened a fancy restaurant in one of America’s largest cities. Things went well for some time but as the economy began to slow, people lost their jobs and she realized that her formerly wealthy customers could no longer afford to eat at her restaurant. In order to keep things going, she came up with the strategy of allowing her customers to eat now and pay later. This made having a fancy dinner appear cheaper than eating at home. Her customers loved the idea and she kept track of the meals they ate in a ledger (basically granting them numerous small loans).

Word of Heidi’s novel approach got around and new customers flocked in. Soon, it was the busiest place in town. Because Heidi’s customers didn’t have to pay immediately, none of them complained when she raised prices or added various fees to their accounts. All the costs just went into the ledger as part of the loans, so no one really cared and her sales grew and grew.

A dynamic young vice president at her local bank recognized that those customer debts constituted valuable future assets so he kept increasing Heidi’s borrowing limit. He saw no reason for any undue concern, since he had the debts of her unemployed patrons as collateral.

At the bank’s corporate headquarters, clever traders bundled all the small loans into pools of bonds, each of which could be sold. As the concept became more widely known, everyone could see it was a great idea with money to be made by all. Congress encouraged regulators to loosen lending standards so more restaurants could follow her lead and everyone could buy all the fancy meals they wanted. That made it easy for other banks to join the gold rush and create their own bonds.

Soon there were hundreds of such bonds available. A few bankers expressed concern, since it was possible that at least a few of the bills might never be paid. Some of the larger investment banks dealt with the issue by using the various bonds to guarantee each other. When the “new” bonds were presented to the rating agencies they took a look and decided that most were worthy of AAA ratings.

Naturally, the agencies collected significant fees from the banks who had hired them to provide the ratings. The various securities were sold country wide. Since CD rates were low, individual investors loved the bonds and they soon became the hottest-selling item in many brokerage firms’ inventories. Those investors didn’t realize that the securities being sold to them as AAA quality were really just the debts of various restaurants’ unemployed customers. Bond sales (and sales commissions) continued to rise along with underwriting and rating fees. Realizing there was money to be made, even more banks encouraged local restaurants to follow Heidi’s lead.

Although everything was still going smoothly, one day a wicked risk manager at the original bank decided that the time had come for Heidi to begin repaying her earliest loans. He told Heidi who in turn asked for payment from her patrons. Unfortunately, they were still unemployed and had no money to repay their debts for the fancy meals. Since Heidi couldn’t collect from them to fulfill her loan obligations, she was forced into bankruptcy which meant the restaurant had to close and all of her employees lost their jobs.

Almost overnight, the bonds created by the various banks and brokerage firms dropped in value by as much as 90%. That wiped out virtually all of the banks’ liquidity and prevented them from making new loans of any kind. The credit freeze halted economic activity in communities all over the country.

Heidi’s food suppliers had granted her generous payment terms and many had invested their own pension funds in the various AAA rated bonds. Not only did they have to write-off her bad debts but they also lost most of the money they had invested in the bonds. Her produce supplier also filed for bankruptcy, closing the doors on a third-generation family business. A competitor of her beer supplier received a government-guaranteed loan to take over its assets and, in order to return it to profitability, immediately closed the local plant and laid off 75 workers.

Since they were obviously too big to fail, most of the banks, brokerage houses and their respective executives were saved, bailed out by a multi-billion dollar infusion from the federal government. The money for the bailout was raised through new taxes levied on employed, middle-class, bill-paying citizens who had never heard of Heidi’s restaurant. Everyone (well, at least those at the top of the pyramid) lived happily ever after. And you thought things like this only happened in fairy tales.