Wednesday, January 27, 2010

Econ 101

An Easily Understandable Explanation of Derivative Markets

Heidi is the proprietor of a bar in Detroit . She realizes that virtually all of her customers are unemployed alcoholics, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with new marketing plan that allows her customers 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.

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 increases massively.

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, since he has the debts of the unemployed alcoholics as collateral.

At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. 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, 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 are still 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 and 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 the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%.

The collapsed bond asset value destroys the banks 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 various BOND securities. They find 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 claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class,

non-drinkers who have never been in Heidi's bar.

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SteveinTX said...

Ah, it is good to be a banksta !!!

Moonfairy said...

I like how you explained that, well done!

Dr. Φ said...

Moonfairy: you are too kind. The entire post came from an unsourced chain mail I received yesterday. I guess I should have done a blockquote . . .

Anonymous said...

your metaphor is close enough to be useful even though it strays in a few areas.

Real estate is never worth nothing. People who buy houses (for the most part) have money and jobs and the loans are based on that. You can of course argue that the trisky bankers permitted unqualified people to buy houses, which they did, but I can't picture anyone buying houses with no money down and no means of paying it back (even if fraudulently stated).

The booze distributors (house builders, realtors, closing agents and tax collectors) would not go out of business due to the closing of one bar, but only lose that sector of their business that was going to unemployed alcoholics buying on credit. In fact, they had record breaking profits. Many of them were also alcoholics and spent their profits, but they are still in business, even while doing less business and having fewer employes.

But still a useful illustration.

Anonymous said...

Magnificent post. I think your illustration still works besides Professor Hale's points, largely due to a "successful" model being replicated on a whole industry.

Who knows how many bars would have replicated Heidi's model. And if the chain establishments, i.e. TGI Fridays, also adopt the Heidi model, the booze distributors would definitely feel the pinch.

Great stuff.