Below is a very creative metaphor to make clear how those financial instruments called "derivatives" work. There's nothing like a good metaphor to remind us of the sometimes devious world in which we live.
"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 a 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 substanially 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 the 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 the unemployed alcoholics.
Nevertheless, the bonds 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 obligation she is forced into bankrutcy. 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 bank's liquidity and prevents it from issuing new loans, thus freezing credit and economonic 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 bankrutcy, 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 executives are granted multi-million dollar bonuses and celebrate with a company paid junket to Las Vegas.
The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers."
"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 a 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 substanially 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 the 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 the unemployed alcoholics.
Nevertheless, the bonds 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 obligation she is forced into bankrutcy. 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 bank's liquidity and prevents it from issuing new loans, thus freezing credit and economonic 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 bankrutcy, 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 executives are granted multi-million dollar bonuses and celebrate with a company paid junket to Las Vegas.
The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers."
Shorter (albeit less poetic) version: Money is transferred from the responsible middle class to a few rapacious, extremely wealthy bankers. It is the largest upward transfer/concentration of wealth in U.S. history, and the current administration, elected to stop it, is facilitating it instead.
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