This I found on the web. Sorry I can’t acknowedge the writer. Others seem to have put it on their websites too. I asked a meeting of 35 people in New Plymouth the other day how many people know what a derivative is and only one person put up her hand. It is worrying that the shadow economy of at least $700 trillion is at least ten times as big as the real economy yet so few understand the shadow economy.
A financial reporter in Australia said in 2009 all banks are exposed to toxic derivatives. If 1% of these contracts default because third parties get into trouble, the whole shareholder wealth would be wiped out and the banks could be broke.
So here is the derivatives for dummies piece. Nice and easy.
Derivatives for Dummies
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 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 substantially increases her prices for whiskey 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, ALCOBONDS 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.
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, ALCOBONDS 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 whiskey 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 the Government.
The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-alcoholics.