Derivatives
In this tough economic climate with all the abbreviations being used to label the bailouts, here is a way to explain the Derivative markets in a more simplified fashion
Charlie is the proprietor of a bar in Detroit . In order to increase sales, he decides to allow his loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. He keeps track of the drinks consumed on a ledger (thiseby granting the customers loans).
Word gets around about Charlie’s drink-now-pay-later marketing strategy and as a result, increasing numbers of customers flood into Charlie’s bar and soon he has the largest sale volume for any bar in Detroit.
By providing his customers' freedom from immediate payment demands, Charlie gets no resistance when he substantially increases his prices for wine and beer, the most consumed beverages. His sales volume increases massively.
A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Charlie'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 Charlie's bar. Charlie demands payment from his alcoholic patrons, but being unemployed, they cannot pay back their drinking debts. This creates a bigger problem and Charlie cannot fulfill his 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 bank's liquidity and prevents it from issuing new loans.
The suppliers of Charlie's bar, having granted his generous payment extensions and also having invested in the securities are faced with writing off his debt and losing over 80% on his bonds. His wine supplier claims bankruptcy, his 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.
And this simplified version describes what happened with the subprime mortgage fiasco.
Charlie is the proprietor of a bar in Detroit . In order to increase sales, he decides to allow his loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. He keeps track of the drinks consumed on a ledger (thiseby granting the customers loans).
Word gets around about Charlie’s drink-now-pay-later marketing strategy and as a result, increasing numbers of customers flood into Charlie’s bar and soon he has the largest sale volume for any bar in Detroit.
By providing his customers' freedom from immediate payment demands, Charlie gets no resistance when he substantially increases his prices for wine and beer, the most consumed beverages. His sales volume increases massively.
A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Charlie'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 Charlie's bar. Charlie demands payment from his alcoholic patrons, but being unemployed, they cannot pay back their drinking debts. This creates a bigger problem and Charlie cannot fulfill his 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 bank's liquidity and prevents it from issuing new loans.
The suppliers of Charlie's bar, having granted his generous payment extensions and also having invested in the securities are faced with writing off his debt and losing over 80% on his bonds. His wine supplier claims bankruptcy, his 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.
And this simplified version describes what happened with the subprime mortgage fiasco.
posted by Anonymous at 5:38 AM
2 Comments:
Well said but I would add that because the fed. gov. believes everyone has the right to eat, drink, and be happy and the unemployed are disadvantaged in fulfilling this right, it steps in and through the fed. bank makes sure there is plenty of inexpensive money to reach this goal. Then when it fails and everyone is depressed and needs a drink, the Fed. does it again.
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