An Understandable Explanation of Derivative Markets
Heidi is the proprietor of a bar in Detroit . She realizes
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 hercustomers 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 thelocal 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 not only having to write off her bad debt but also with losing over 90% of the presumed value of the bonds.. Her wine supplier claims bankruptcy, closing the doors on a family business that had endured for three generations, and 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.
The only thing I would add is an initiation point: Heidi doesn’t just decide to extend credit to bums out of the goodness of her heart. Congress mandates that Heidi and other bar owners like her extend credit to unemployed alcoholics who otherwise would not be able to afford to participate in a social activity readily available to others who can afford it.
Oh, and one last thing: When the banks and brokerage houses have paid back their multi-billion dollar “no-strings attached” cash infusion from their “cronies in the Government” (aka, the taxpayers), the President announces he’s going to implement a new punitive tax on banks and brokerage houses in order to pay back the taxpayer’s bailout of the bicycle industry that was forced into bankruptcy after building a 3 year supply of bikes that nobody wanted.
On this, the National Day of Prayer, I offer this supplication: “That our Congress will someday grasp the law of unintended consequences, let us pray to the Lord.”