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 An Easily Understandable Explanation of Derivative Markets:
  
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 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 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 the Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers.

Now, do you understand?
 

Creation date: Jul 16, 2009 9:18 am     Last modified date: Jul 16, 2009 9:58 am   Last visit date: Nov 30, 2016 8:10 am     link & embed ?...
3 / 1000 comments
Jul 16, 2009  ( 1 comment )  
Jul 11, 2011  ( 1 comment )  
7/11/2011
7:06 pm
Robert Carr (robert)

Ah... the step that is skipped over is that the lax goverment regulation of the 'expert traders' at Wall Street, and lax government regulation of the rating agencies that slapped the AAA on.

 

Soooo....   why don't we get some more support for tighter regulation of this silly behavior by Wall Street?

Jul 12, 2011  ( 1 comment )  
7/12/2011
10:55 am
Julie Carr (beekielou)

Also want to mention that it was our elected government who gave banks and others "the multi-billion dollar no-strings attached cash infusion", in the first place. There is a difference though.

The mortgage mess started with government regulation - forcing banks to give home loans to folks who couldn't afford it in the first place through Fannie Mae.

Heidi, on the other hand, decided to go down this risky path herself, making her own bed.  she could've gone into a catering business, divercified into another way to make a living.

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