A Lesson in Understanding Derivatives and Their 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.
Heidi 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 figure a way to make huge
commissions, and 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 really 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, but 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 their cronies in Government.. The funds required
for this bailout are obtained by new taxes levied on employed, middle-class,
non-drinkers who have never been in Heidi's bar.
So now do you understand?
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This site was last updated
04/25/10
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