I had German Measles when I was about 14. As such I had to take a few days off. It so happened that at that time Mr. Curwin, our Math teacher did the lesson on "financial instruments." When I came back I had absolutely no idea what anyone was talking about, and so I've always steered away from the subject. For any of you who have a similar problem here is an explanation on the truth of derivatives that even I can understand. It's worth reading through, and I'm grateful to my friend in England for sending it to me.
Congress decided that it's not fair that loans are not available to bars and taverns in poor areas whose customers are predominately unemployed alcoholics. They sent out an order that if banks do not raise their lending in these areas by 300%, they would face punitive sanctions. Therefore one day in Detoit a clever young thing noticed Heidi's bar and approached her with a suggestion.
They both realized that virtually all of Heidi's customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar.
To solve this problem, they come 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 her 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.
By now the clever young thing has become a young and dynamic vice-president of the bank and realises 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 DRINK BONDS.
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 "AAA 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 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 Heidi's 11 employees lose their jobs.
Overnight, DRINK BOND 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 community.
The suppliers of Heidi'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 lose 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 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 Heidi's bar.
Now do you understand? I think I finally do!