Home Politics Derivative Markets – An Understandable Explanation:
Derivative Markets – An Understandable Explanation: PDF Print E-mail
Written by David M. Voth   
Thursday, 16 April 2009 10:57

Heidi is the proprietor of a bar in Detroit. In order to increase sales, she decides to allow her loyal customers–most of whom are unemployed alcoholics–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 and soon she has the largest sale volume for any bar in Detroit.


By providing her customers’ freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume increases massively.


The local community bank advises Heidi that her current practice is unsustainable and asked Heidi to repay the loan she took out. Heidi then goes to the local branch of one of those mega-banks, which immediately grants her a new loan.


A young and dynamic vice-president at the mega-bank recognizes these customer debts as valuable future assets and increases Heidi’s borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral.


The bank regulators who have been ordered to enforce the recent “Be Kind to Alcoholics” federal legislation penalize the local bank for demanding that Heidi repay the loan.


The mega-bank gets a gold star.


At the mega-bank’s corporate headquarters, expert traders transform these customer loans into DRINK BONDS, ALKIBOND, and PUKE BONDS.


These securities are then traded on security markets worldwide. Naïve investors don’t really understand the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics.


Nevertheless, their prices continuously climb, and the securities become the top-selling items for some of the nation’s leading brokerage houses.


One day, although the bond prices are still climbing, a risk manager at the mega-bank (subsequently fired due his negativity) decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar. Heidi demands payment from her alcoholic patrons, but being unemployed they cannot pay back their drinking debts. Therefore, Heidi cannot fulfill her loan obligations and claims bankruptcy.


DRINKBOND and ALKIBOND drop in price by 90%. PUKEBOND performs better, stabilizing in price after dropping by 80%. The decreased bond asset value destroys the banks liquidity and prevents it from issuing new loans.


The suppliers of Heidi’s bar, having granted her generous payment extensions and having invested in the securities are faced with writing off her debt and losing over 80% on her bonds. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 50 workers.


The Senate and House conduct an investigation to determine why a bank would have been so irresponsible as to make loans to unemployed.


The Government, following dramatic round-the-clock negotiations by leaders from both political parties who congratulate each other on a job well done, saves the bank and brokerage houses. The funds required for this bailout are obtained by a tax levied on employed middle-class non-drinkers.


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