Apr 3, 2009

Deriviatives Explained

I try not to post jokes, however, outside of the obvious light hearted nature of this post, I think it does a good job of explaining the creation of a derivative security. 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 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 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 who collect enormous fees on their sales, pay extravagant bonuses to their sales force, and who in turn purchase exotic sports cars and multimillion dollar condominiums.

One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due 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 bank's 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.


  1. I think these are great ways to teach people about the market. we tend to over complicate it with jargon.

  2. Not just "middle-class" mate. Working-class lose their jobs, pay 20% VAT, see their health services come under attack and any savings they have become interest-free loans to the banks. Inflation reduces the value of their savings and wage packets and pensions are devalued. It was an absolutely brilliant article until to last sentence that seemed to suggest only the elitist "middle-class" however you define that as being the only ones picking up this tab.

  3. I just want to go a bit further. This article is spoilt by an elitist thread that runs right through it. It depicts the borrowers as drunks, alcoholics, unemployed winos and deadbeats while those who end up picking up the pieces are "middle-class" non-drinkers and the only victims of this mess, my heart bleeds.

    There are only two classes here, those who have coralled the world's wealth through unrestrained greed(and you do not belong to that class) and the rest of us (which class you do belong to). Understand that simple fact and you will be on the way to really knowing what is happening to you and me.

  4. Ken-The point is not that the borrowers are deadbeats, drunks, or part of a particular "class". The point is that the banks loaned and later collateralized debt backed by blatantly bad credits without personal repercussions. The banks were bailed out while the rest of society was left holding the bag in this dereliction of duty. In this particular story, which is meant to illustrate SOME of the causes of the banking crisis, there are six groups represented: individuals who borrowed more than their circumstances should allow; the merchant (not sure how to classify her); the vendors who relied upon the merchant and the bank to use good judgement when issuing credit; the unrepentant banker; the investors who didn't understand what they were buying; and the taxpayer.