Uncle Roy's Guidelines No 6

Understanding Derivatives

My friend Helen used to run a popular wine bar in Clifton, Bristol ...

She realized that virtually all of her customers were unemployed alcoholics and, as such, they could no longer afford to patronise her bar.
To overcome this problem, she came up with a new marketing plan that allowed her customers to drink now, but pay later.
Helen kept a record of the drinks they consumed, in effect granting the customers loans to be repaid at a later date.
Word got around about Helen's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flooded into her bar. Soon she had by far the largest sales volume for any bar in Clifton.
By providing her customers freedom from immediate payment demands, Helen got no resistance when, at regular intervals, she substantially increased her prices for cider, wine and beer, the most popular drinks.
Consequently, Helen's gross sales volume increased massively.
A young and dynamic local bank manager recognised that these customer debts constituted valuable future assets and, to encourage her, regularly increased Helen's borrowing limit.
He saw no reason for concern because he has the debts of the unemployed alcoholics as collateral!
At the bank's corporate headquarters, expert traders figured a way to make huge commissions, and transformed these customer loans into a security called DRINKBONDS.
These securities were then bundled and sold on international securities markets.

It didn't seem to matter that investors didn't really understand that the securities being sold to them as "AAA Secured Bonds" really are debts of unemployed alcoholics in Clifton, Bristol. The demand for Drinkbonds continued to rise and the securities soon became a recommended purchase for some of the nation's leading finance brokerage houses.
One day, even though the bond prices still were climbing, a risk manager at the original local bank decided that the time had come to request payment on the debts incurred by the drinkers at Helen's bar. He informed Helen.
She in turn, demanded payment from her loyal patrons. But, being unemployed alcoholics, they were not able to clear their debts.

Since Helen could not fulfil her loan obligations, she was forced into bankruptcy. The bar closed and Helen's 11 employees lose their jobs.
Overnight, DRINKBOND prices dropped 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 Helen's bar had granted her generous payment extensions and had invested their firms' pension funds in the BOND securities.
They found they were 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 claimed bankruptcy, closing the doors on a family business that had endured for three generations. Her cider and beer supplier was taken over by a competitor, who immediately closed the local plant and laid off 150 workers.
Fortunately though, the bank, the brokerage houses and their respective executives were saved by a multi-billion pound no-strings attached cash infusion from the government.
The funds required for this bailout were obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Helen's premises.

Now do you understand?