Life is Like a Box of Jenga Blocks

September 3rd, 2009

In the game Jenga, players take turns removing blocks from a tower and balancing them on top, creating a progressively taller, but also increasingly more unstable, structure as the game goes on.  The gig is up when a player pulls out a final block and the whole structure collapses with a clatter of wooden bricks and screams of surprise.  While the comparison is slightly simplistic, there are numerous ways that Jenga is just like the world’s current economic crisis.

In the last few years, there have been many developments which in retrospect look like small blocks being pulled from the base of our economy, and placed on top to “help it grow.”  Some of them are now infamous: the growth of the housing bubble, the deregulation of the financial sector in the 1990s, and predatory lending by banks.  The last block, which left the tower in pieces, was likely the subprime mortgage crisis.  There is also one largely unknown factor: the system of international banking secrecy, which was yet another block pulled from the bottom of our world’s economic foundation.

Banking secrecy would not have brought down the tower alone.   But there were several other critical blocks that were placed around it and below it, and collectively the effect was catastrophic.  Permit me to explain.

Block One: Mortgage backed securities and tax havens. Mortgage backed securities are financial instruments that were thought to be risk-free because they were backed by house values.  So when housing prices went up and up, the value of these securities soared.  They were like magic Jenga blocks that could always make a tower taller, but whose removal would never make it fall.  Sound too good to be true?  It was.  Turns out, house prices can fall.  Actually, they did.  And the securities were pulled down with them.  Not so magic after all.

The crisis was, in large part, triggered by the systematic failure of these financial instruments.  The two subprime mortgage-backed Bear Stearns funds that collapsed in 2007, which precipitated the credit crisis, were both incorporated in a tax haven in the Caribbean Sea.

Can you guess which?  Here’s a hint: it’s not Jamaica and it’s definitely not Haiti (see answer below).

Block Two: Hedge funds and secrecy jurisdictions. Unlike banks, hedge funds and investment banks (e.g. Bear Sterns), are not heavily regulated by the government.  Since they do not accept deposits, they are not required to hold assets (cash) in proportion to their risk in liabilities (deposits).  Hedge funds have no such restrictions.  These institutions became dominating, unregulated, and risky entities in the financial system.  When they eventually came crashing down, their executives blinked and screamed in shock.  Then they asked the U.S. government to pick up the tab.

Tax havens, with their limited regulation and transparency, were like a wet Petri dish for hedge funds.  In fact, as many as seventy-five percent of the world’s hedge funds are located in one tiny Caribbean island.  Do you know which?  Here’s a clue.  It begins with a “C,” but the answer’s not Cuba.

Block Three: capital adequacy ratios, leverage, and offshore financial centers. Banks need to hold a certain amount of cash so that they are able to pay back their depositors, in case a bunch of their loans go sour.  When a bank assumes more risk (i.e. it has more liabilities in proportion to assets), it is increasing its “leverage.”  Think of it like a narrow, unsteady tower.  The higher the profits (and the tower) grow, the more risk it has of falling.  Right before the crisis, banks were highly leveraged, so when a lot of borrowers defaulted on their debt, the banks didn’t actually have the money to pay them.  That’s when Uncle Sam stepped in, threw some blocks on the base of our Jenga board, and kept the whole thing from splintering apart.

Offshore centers made this tower taller.  In the U.S., banks have Capital Adequacy Ratios (CARs) they must meet, which stipulate the amount of cash a bank must hold to prevent the banks from assuming to much risk.  Many offshore centers have no such ratios.  Also, banks were using structured investment vehicles (SIVs), which were complicated ways for banks to hide losses, leverage debt, and look great while they’re at it.  One country has become a leading destination for SIVs as a result of political stability, its laws, and the absence of any direct taxation or heavy regulation.  If you’re having trouble guessing which country it is, take a peek below.

There is no such thing as profit in exchange for zero risk.  Hiding losses does not make them cease to exist.  And tall, narrow towers—whether they are constructed of money, balance sheets, Jenga blocks, or global economies—are all inherently doomed to fall.


Block one: Cayman Islands; Block two: Cayman Islands; Block three: Cayman Islands

Written by Ann Hollingshead

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