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 and, 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 borrows enough to keep her afloat for awhile and 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, mostly unemployed alcoholics, 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. Government officials are praised by the happy alcoholics and, claiming the tabs of the alcoholics to be valuable assets, pressure the local bank to increase Heidi's borrowing limit. There is no reason for any undue concern, since the bank 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 those 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. Many of Heidi's suppliers were willing to extend her generous credit and themselves invested in the bond funds and rejoiced as their investments continued to grow and grow.
One day, even though the bond prices are still climbing, the bank's cash reserves are sinking too low, so a risk manager decides that the time has come to call in Heidi's loan. 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 the eleven employees lose their jobs.
With Heidi in default on her bank loan, 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.
With Heidi out of business, her suppliers are left holding bad debt and have lost 90% of their investments as well. 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 declared 'too big to fail' and are bailed out by a multi-billion dollar no-strings attached cash infusion from their cronies in Government. The government officials then look to cover the deficit created by the bailout with new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi's bar.
And the unemployed alcoholics? They are made eligible for a plethora of government relief programs and move on to a Chinese bar in the next block where the government officials urges the proprietor to extend them credit.
Now, do you understand?
