A Layman’s Explanation of The Derivatives Market and Crash

 

This was passed on to me by a good friend, and I found the analogy so compelling that I decided to share it:

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 proceed to transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international securities 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. But underwriting insurers have guaranteed them and so they must be as good as gold, having been rated “AAA”.

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 rising, 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 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 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 the Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers.

Now, do you understand? There is no such thing as a free drink, or a free lunch. Look at the European Union, pumping in $1 Trillion of fiat printed Euros in order to save Greece, and understand that the United States isn’t that far behind.

In 2009, the FDIC closed 140 banks – a rate of 11.66 banks per month. As of the end of May 2010, the FDIC has already closed 74 more banks – an increase to a 14.8 bank closure per month rate. And that, friends, is not some analogy. It’s FACT.

Are there too many Heidi’s Bars – or just too many really dumb bankers? Or perhaps – the Government is simply run by a cadre of unemployed alcoholics?