Lot of people have difficulty understanding Derivatives and the ripple effects they can cause. So here is an attempt to explain what they are and the ripple effects they can cause.
Understanding Derivatives
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.
Heidi 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 because he has the debts of
the unemployed alcoholics as collateral!
At the bank’s corporate headquarters, expert traders figure a way to
make huge commissions, and transform these customer loans into
DRINKBONDS.
These “securities” then are bundled and traded on international
securities markets.
Naive investors don’t really understand that the securities being sold
to them as “AAA Secured Bonds” really are 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 still are 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 Heidi’s 11 employees lose their jobs.
Overnight, DRINKBOND prices drop by 90%.
The collapsed bond asset value destroys the bank’s 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 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 multibillion
dollar no-strings attached cash infusion from the government.
The funds required for this bailout are obtained by newtaxes levied on
employed, middle-class, nondrinkers who have never been in Heidi’s
bar.
Now do you understand ?
