Sunday, June 14, 2009

An Easily Understandable Explanation of Derivative Markets:


Heidi is the proprietor of a bar in Detroit. She realizes that virtually

all of her customers are unemployed alcoholics and, as such, can no

longer afford to patronize her bar. To solve this problem, she comes up

with a new marketing plan that allows her customers to drink now, but pay

later.

She keeps track of the drinks consumed on a ledger (thereby granting the

customers loans).

Word gets around about Heidi's "drink now, pay later" marketing strategy

and, as a result, increasing numbers of customers flood into Heidi's

bar. Soon she has the largest sales volume for any bar in Detroit .

By providing her customers freedom from immediate payment demands,

Heidi gets no resistance when, at regular intervals, she substantially

increases her prices for wine and beer, the most consumed beverages.

Consequently, Heidi's gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that

these customer debts constitute valuable future assets and increases

Heidi's borrowing limit. He sees no reason for any undue concern, since

he has the debts of the unemployed alcoholics as collateral.

At the bank's corporate headquarters, expert traders transform these

customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These

securities are then bundled and traded on international security

markets. Naive investors don't really understand that the securities

being sold to them as AAA secured bonds are the debts of

unemployed alcoholics.

Nevertheless, the bond prices continuously climb, and the securities

soon become the hottest-selling items for some of the nation's leading

brokerage houses.

One day, even though the bond prices are still climbing, a risk manager

at the original local bank decides that the time has come to demand

payment on the debts incurred by the drinkers at Heidi's bar. He so

informs Heidi.

Heidi then demands payment from her alcoholic patrons. Being

unemployed alcoholics, they cannot pay back their drinking debts. Since

Heidi cannot fulfill her loan obligations, she is forced into bankruptcy.

The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%.

The collapsed bond asset value destroys the banks liquidity and prevents

it from issuing new loans, thus freezing credit and economic activity in

the community.

The suppliers of Heidi's bar had granted her generous payment extensions

and had invested their firms' pension funds in the various BOND

securities. They find they are now faced with having to write off her

bad debt and with losing over 90% of the presumed value of the bonds.

Her wine supplier also claims bankruptcy, closing the doors on a family

business that had endured for three generations. Her beer supplier is

taken over by a competitor, who immediately closes the local plant and

lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective

executives are saved and bailed out by a multi-billion dollar no-strings

attached cash infusion from the Government. The funds required for this

bailout are obtained by new taxes levied on employed, middle-class,

non-drinkers.

Now, do you understand?

1 comment:

Frances M. said...

Absolutely wonderful picture explanation of a term that no dictionary would clearly explain. Thanks for providing it. I'll bookmark it and reread it every time I come onto a sentence referring to this sham activity.

Thank you.