Guest Post: Explaining Derivative Markets

If you are like me, the whole bank bailout business confused the dickens out of you and it doesn't seem to quite make sense why billions of tax dollars had to be spent to bailout a few banks that misbehaved and didn't follow sound banking principles. Luckily, a dear reader of my blog, DJA, sent this explanation to me regarding how it works. Enjoy!

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 resistence 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 that 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 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 extentions
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.

Finally an explanation I understand ...