USA Finance 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 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 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.

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.

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 the Government. The funds required for this
bailout are obtained by new taxes levied on employed, middle-class, non-drinkers.

Now, do you understand ?