Derivative Markets-Bank Crisis Explained
Derivative markets .... an understandable explanation:
Heidi is the proprietor of a bar in Detroit. In
order to increase sales, she
decides to allow her loyal customers - most of
whom are unemployed alcoholics -
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
and soon she has the largest sale volume for any
bar in Detroit.
By providing her customers' freedom from
immediate payment demands,
Heidi gets no resistance when she substantially
increases her prices for
wine and beer, the most consumed beverages. Her sales
volume increases massively.
A young and dynamic vice-president at the local
bank recognizes these
customer debts as valuable future assets and
increases Heidi's borrowing limit.
He sees no reason for undue concern since he has
the debts of the alcoholics as collateral.
At the bank's corporate headquarters, expert
traders transform these customer
loans into DRINKBONDS, ALKIBONDS and PUKEBONDS.
These securities are then traded on security markets worldwide.
Naive investors don't really understand the
securities being sold to them as AAA secured bonds
are really the debts of unemployed alcoholics.
Nevertheless, their prices continuously climb,
and the securities become the
top-selling items for some of the nation's
leading brokerage houses.
One day, although the bond prices are still
climbing, a risk manager at the bank
(subsequently fired due to his negativity), decides
that the time has come to
demand payment on the debts incurred by the
drinkers at Heidi's bar.
Heidi demands payment from her alcoholic patrons,
but being unemployed
they they cannot pay back their drinking debts.
Therefore, Heidi cannot fulfill
her loan obligations and claims bankruptcy.
DRINKBOND and ALKIBOND drop in price by 90 %.
PUKEBOND performs
better, stabilizing in price after dropping by 80
%. The decreased bond asset
value destroys the banks liquidity and prevents
it from issuing new loans.
The suppliers of Heidi's bar, having granted
her generous payment
extensions and
having invested in the securities are faced with
writing off her debt and losing
over 80% on her bonds.
Her wine supplier claims bankruptcy, her beer
supplier is taken over by a competitor, who immediately
closes the local plant and lays off 50 workers.
The bank and brokerage houses are saved by the
Government following
dramatic round-the-clock negotiations by leaders
from both political parties.
The funds required for this bailout are obtained
by a tax levied on employed
middle-class non-drinkers.
