Sunday, March 28, 2010

An Easily Understandable Explanation of Derivative Markets

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Thanks Pat Corley for putting it in a way that most of us can understand...not sure who wrote it. But I pontificated something along these lines here. Thousand variations on a theme...enjoy...

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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 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.

1 comment:

Paul said...

Moral of the story- Don't be an employed non-drinker, you're gonna get screwed by the Man!