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« on: August 12, 2011, 02:36:26 PM »

Understanding Derivatives - A Primer

Helga 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.
Helga keeps track of the drinks consumed on a ledger (thereby 
 granting the customers' loans).
Word gets around about Helga's "drink now, pay later" marketing 
 strategy and, as a result, increasing numbers of customers flood 
 into Helga's bar. Soon she has the largest sales volume for any 
 bar in Detroit.
By providing her customers freedom from immediate payment demands, 
 Helga gets no resistance when, at regular intervals, she 
 substantially increases her prices for wine and beer, the most 
 consumed beverages.
Consequently, Helga'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 Helga'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 
These "securities" then are bundled and traded on international 
 securities markets.
Naive investors don't really understand that the securities being 
 sold to them as "AA" "Secured Bonds" really are 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 still are 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 Helga's 
 bar. He so informs Helga.
Helga then demands payment from her alcoholic patrons, but being 
 unemployed alcoholics they cannot pay back their drinking debts.
Since Helga cannot fulfill her loan obligations she is forced into 
 bankruptcy. The bar closes and Helga's 11 employees lose their jobs.
Overnight, DRINKBOND prices drop by 90%. The collapsed bond asset 
 value destroys the bank's liquidity and prevents it from issuing 
 new loans, thus freezing credit and economic activity in the 
The suppliers of Helga's bar had granted her generous payment 
 extensions and had invested their firms' pension funds in the 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 
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 multibillion 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, nondrinkers who have never been 
 in Helga's bar.
Now do you understand?

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