This was making the rounds on the net during the height of the crisis. It's worth reposting periodically.
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Easily Understood Explanation of our recent financial Crisis -particularly modern Derivative and related 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 to form CDOs , which are traded on international security markets. The rating agencies, motivated by the commissions a AAA rating brings and to busy to bother checking the credit worthiness of the unemployed alcoholics, rate the bonds AAA.
Naive investors don't really understand that the securities being sold to them as AAA secured bonds, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.
As time passes, the expert traders at the originating Bank’s headquarters, realize the risk involved and decide to protect themselves; so, while continuing to sell bundles DRINKBONDS, ALKIBONDS and PUKEBONDS to the unsuspecting buyers, they enter swap agreements with GAGA, the Insurance giant. The GAGA managers are so excited about the prospect of the large commissions they would receive that they don’t take time to check the validity of the AAA ratings of the bundles of bonds and issue the Swaps obligating GAGA to cover essentially any losses in the values of bonds. Since swaps aren’t subject to insurance regulations, GAGA’s management can write the Swaps (derivatives) without capital to cover losses in the event that payment is required.
One day, even though the bond prices are still climbing, a new risk manager is appointed at the original local bank and decides to check risk associated with all of the banks loans. He checks the ability of the drinkers at Heidi’s bar to pay and finds that very few have any money or property to back their loans. The word slips out and the value of the bundles of DRINKBONDS, ALKIBONDS and PUKEBONDS begin to tumble. The traders, at the Bank Headquarters, go to GAGA to cover the losses in Bond values. GAGA is slow to respond and the bond prices fall faster. It becomes clear that GAGA can’t meet its obligations and both GAGA and the Bank face insolvency.
The bank demands payment on the debts incurred by the drinkers at Heidi's bar. 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 bundles 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. Heidi’s 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.
Any questions? |
