that anybody SHOULD be able to understand:



Subject: An easy to understand explanation of Derivatives Markets

This is a short but educational read (and funny)!!

Derivative markets .... an understandable explanation:
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,
ALKIBONDSand PUKEBONDS. These
securities are then traded on security markets worldwide.
Niave 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 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
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 banks 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.

And there you have an explanation that most SHOULD understand.

The sequel:

The non-drinking taxpayers who have to fund the bailout the government (e.g., the politicians) has put in place are so depressed with the loss of their investments and the increased taxes they will have to pay, have turned to alcohol to fog their depression. As a result, Heidi has opened up another bar - cash and credit card only - to handle this clientele. This allows Heidi to collect bailout money from one failed business, profit from the second, and vacation in Aruba (thanks mainly to the bailout money which has no accountability).

You did a decent job of giving an example of an asset-backed bond. But that security is NOT a derivative, as the term is currently used--as in "credit default swaps".

See if you can come up with a story that describes a real derivative. They amount to two or three times the amount if the "toxic loans" and asset-backed securities (mortgage-backed bonds) that are presenting the world with financial indigestion.

Because derivatives really are a huge part of the problem--the biggest part, really--maybe the readership here would appreciate your simplified example of what they are and how they work.

Originally Posted by Villages Kahuna

You did a decent job of giving an example of an asset-backed bond. But that security is NOT a derivative, as the term is currently used--as in "credit default swaps".

See if you can come up with a story that describes a real derivative. They amount to two or three times the amount if the "toxic loans" and asset-backed securities (mortgage-backed bonds) that are presenting the world with financial indigestion.

Because derivatives really are a huge part of the problem--the biggest part, really--maybe the readership here would appreciate your simplified example of what they are and how they work.

......The problem is they did work! Right up to the point that someone with a little common sense said: "Are you people crazy?" (And then the fight started...)