Understanding Derivatives or an Economic Primer!

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 came 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 of 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, which constitute the majority of her sales.

Consequently, Heidi’s gross sales volume increases greatly.

A young ambitious 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 by converting these customer loans into DRINKBONDS.

These “securities” were 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” really were the debts of unemployed alcoholics. Nevertheless, the bond prices continued to climb, and the securities soon become the hottest-selling items for most of the nation’s leading financial brokerage houses.

One day, even though the these bond prices were still soaring, a risk manager at the original local bank decided that the time had come to demand payment on the debts incurred by the drinkers at Heidi’s bar. He so informed Heidi.

Heidi then demanded payment from her alcoholic patrons. But, being unemployed alcoholics, they could not pay back their drinking debts.

Since Heidi could not fulfill her loan obligations she was forced into bankruptcy. The bar closed, and Heidi’s 11 employees lost their jobs.

Overnight, DRINKBOND prices drop by 90%.

The collapsed bond asset value wiped out the bank’s liquidity, and prevented it from issuing new loans, thus freezing credit and economic activity in the entire local community.

The suppliers of Heidi’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the DRINKBOND securities

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 claimed bankruptcy, closing the doors of a family business that had endured for three generations, her beer supplier was taken over by a competitor, who immediately closed the local plant, and laid off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved by being bailed out by a multibillion dollar no-strings attached cash infusion from the government.

The funds required for this bailout were obtained by new taxes levied on employed, middle-class, non-drinkers who have never even been in Heidi’s bar.

So, now do you understand derivatives!

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About geneb527

Retired, but still spending an inordinant amount of time thinking about all things big and small. I am proud to be a strong constitutional conservative. I am also proud to have been married over 56 years to my wonderful wife, Louise. I continue to be amazed that she has put up with me for such a long time, but have been happy that she decided to do so. "The democracy will cease to exist when you take away from those who are willing to work and give to those who would not," warned Thomas Jefferson.
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