At last, here's what we've all been waiting for: an understandable explanation of derivative markets.Personally, I think we should not return to Congress or the Senate anyone who voted for TARP, Son of TARP, TALF, or PUKE. I'll go you one better. I think we should have term limits for both Congress and the Senate. Let's be fair. How about a maximum of one 4-year term for Congress and a maximum of one 6-year term for the Senate. That would return government to "we the people." What are we waiting for?
Heidi is the proprietor of a bar in Detroit. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - 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, and soon she has the largest sale volume for any bar in Detroit. By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume increases massively.
A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Heidi's borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral.
At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then traded on security markets worldwide.
Naive investors don't really understand the securities being sold to them as these AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, their prices continually climb, and the securities become the top-selling items for some of the nation's leading brokerage houses who collect enormous fees on their sales, pay extravagant bonuses to their sales force, and who in turn purchase exotic sports cars and multimillion dollar condominiums.
One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due his negativity), decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar.
So Heidi demands payment from her alcoholic patrons, but being unemployed, they cannot pay back their drinking debts. Therefore, Heidi cannot fulfill her loan obligations and claims bankruptcy.
DRINKBOND and ALKIBOND drop in price by 90 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. The decreased bond asset value destroys the bank's liquidity and prevents it from issuing new loans.
The suppliers of Heidi's bar, having granted her generous payment extensions and having invested in the securities, are faced with writing off her debt and losing over 80% on her bonds. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 50 workers.
Then the bank and brokerage houses are saved by the Government, following dramatic round-the-clock negotiations by leaders from both political parties.
Ultimately, the funds required for this bailout are obtained by a tax levied on the employed, middle-class non-drinkers.
If you say "it can't be done," then YOU are part of the reason why it can't be done. If you say "it shouldn't be done," then please explain your thinking in a comment.