Understanding Derivatives
We've all heard that "derivatives" caused the financial system meltdown, but few understand what they are. Read this and you'll fully understand them, and the concept of "too big to fail."
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. She keeps track of the drinks consumed in 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 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, lays off 150 workers, and converts their full output to "Bud Light".
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 the drinkers are screwed, Heidi is screwed, her suppliers are screwed, her neighbors are screwed -- but the banks that caused the whole mess (and are now "too big to fail" are bailed out by the ever-more-screwed taxpayers.
Now do you understand how it all works?
