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Understanding Derivatives And The Bailout
by Your Humble Servant
Washington, DC --
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
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
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, losing over 90% of the presumed value of
Her wine supplier also claims
bankruptcy, closing the doors on a family business that had endured for
Her beer supplier is taken
over by a competitor, who immediately closes the local plant and lays off
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
The funds required for this
bailout are obtained by new taxes levied on employed, middle-class,
nondrinkers who have never been in Heidi's bar.
Now, do you understand?
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