Explanation of Derivative Markets

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 a new marketing plan that allows her customers to drink now, but pay later.

Heidi 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 figure a way to make huge commissions, and 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.

Congress now mandates that the banks, Fannie Mae and Freddie Mac, extend credit in the name of affordable drinking. This affordable drinking mandate was wildly popular among their constituents, the alcoholics at Heidi's bar.

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 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.

Then to revive the economy once the credit crunch came, Congress went out and borrowed a trillion dollars in the name of a stimulus package so that all the alcoholics at Heidi bar could go out to dinner.

Now do you understand?

GREAT COMMENTS:

From: Armour, Ed edarmour@mac.com

There were a couple of videos produced that explain parts of thefinancial crisis (including aspects of this thread) visually. 0

If membership education is the goal, some parts of these two videos mightfacilitate discussion on the target you wish to discuss or enhanceincluding culpability and subsequent "fixes":

http://bit.ly/acKvvM The Crisis of Credit Visualized - Part 1

http://bit.ly/bveX8l The Crisis of Credit Visualized - Part 2

Ed Armour

From: Hill Robert roberthillnyc@gmail.com

Bob,

Nice try, but you left out the part where American International Group (AIG) wrote insurance policies backing up the DRINK-, ALKI-, and PUKEBONDS by "leveraging" their available capital.

I forget the actual numbers, but in my recollection it was a ratio something like 28::100. That is, $28 worth of assets was used to "secure" and "guarantee" $100" worth of BONDS. Ain't unregulated leverage a beautiful thing?

This explains why AIG was among the first the get the bailout money, because they had contracts guaranteeing the junk bonds.

I'll sign off with this: One of my tasks as a technical writer for Lemony Snickett (** not the real name, see below) in 2008-2009 was to write a user manual for trading software used by Lemony Snickett traders only (not the general public) to bundle up various instruments into sausages then slice the sausages and sell the slices.

It was assumed that the act of making the sausages eliminated all risk to the bank because of a feature of the software called "autohedge."

You see, the Quant people had decided that they understood risk well enough to model it with a formula. Granted, it was a very complicated formula, but it was something that the computer could calculate nonetheless.

Please see this Wired article about David Li's Gaussian copula function:
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all

Anyway, so long as the autohedge function was turned on, everything was supposedly hunkey dorey. No matter how risky any given deal was, it was assigned a risk factor of "X", say "27.3".

The autohedge feature automatically created a COUNTER DEAL that would have a risk factor exactly OPPOSITE the original deal, say "-X" or "-27.3".

By executing these deals in pairs, the net risk to Merrill Lynch was X/-X = 27.3/-27.3 = -1 = 100% certainty.

The customer purchasing either side of the deal might lose out, but with autohedge the bank would always theoretically do just fine.

As Sarah Palin might snap, "How's that auto-hedgy thing workin' out for ya?" ** (

I started to use the real name of the bank, but then had visions of their lawyers coming after me, so I'm using an alias name; the real investment bank in this scenario no longer exists, as it was acquired in a shotgun wedding which is still reverberating with criminal investigations and pending charges)

Robert Hill

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From: Stack, Barbara White bstack@usw.org

This analysis suffers from two important problems. One is that the bonds were not simply "sold as AAA-secured bonds." A rating agency deemed them to be AAA bonds -- good as cash.

The second problem is this: "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."

That is not what happened. Some people were paying their mortgages; some others, who would be called the unemployed alcoholics in this story, were not. The proprietors (banks) were getting some income. No one at a bank determined that it was time to demand payment.

What happened is that a rating agency determined that those mortgage bundles and other exotic financial instrucments based on the mortgate bundles were not, in fact, worth an AAA rating. Ratings were lowered. Panic ensued because the owners of these bonds suddenly were holding "toxic assets" not "good as cash."There's a step missing in the analysis as well.

The mortgages were bundled and sold. Then, when someone realized that some of the mortgages in the bundle were probably bad (because they were based on no-income-no-asset mortgages), they "traunched" (cut) the bundles and created new bundles, which were also sold.

These, somehow, were rated AAA, even though everyone knew that some portion of them were mortgages likely to default.

And, finally, organizations like AIG sold non-insurance on those. AIG was paid a fee to non-insure (because if it were insurance, it would be regulated, and AIG would be required to put up capital as security) the financial instrucments created from the traunches.

THEN, financial firms and private equity companies placed bets on whether that non-insurance would survive or fail. Those bets helped take down AIG, as well as banks calling for AIG to pay on the insurance on the bonds after the ratings dropped to junk.

Stack

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From: Daraio Robert bdaraio@yahoo.com

Thank you for the analysis and corrections, you have my vote for Secretary of Commerce.

Bob D