Understanding Derivatives – in laymans terms!

OK, so this topic is slightly different to the usual recruitment blurb but seeing as the euro crisis and economy seems to be affecting us all, we found this amusing explanation of what’s happening out there….see if you can derive the same conclusions that we did from this short story!

 

Sue is the proprietor of a bar in Sutton Coldfield…

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.

Sue keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Sues “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Sue’s bar. Soon she has the largest sales volume for any bar in Sutton.

By providing her customers freedom from immediate payment demands, Sue gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages.

Consequently, Sue’s gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognises that these customer debts constitute valuable future assets and increases Sue’s borrowing limit.

He sees no reason for any undue concern because 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 DRINKBONDS.

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 still are 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 Sue’s bar. He so informs Sue.

Sue then demands payment from her alcoholic patrons. But, being unemployed alcoholics — they cannot pay back their drinking debts.

Since Sue cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and Sue’s 11 employees lose their jobs.

Overnight, DRINKBOND 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 Sue’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 with losing 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, non-drinkers who have never been in Sue’s bar.

Now do you understand the EuroZone troubles?

Advertisements

One thought on “Understanding Derivatives – in laymans terms!

  1. Your analogy above is really an explanation of what CDOs were – but instead of drunks, it was homeowners. The eurozone debt crisis is nothing to do with CDOs, and everything to do with this:

    1. A Government provides public services, runs an army, funds local government, has a civil service, provides a health service, and various social security benefits

    2. The Government finds they don’t have enough tax revenue to
    pay for everything to they borrow what they need from banks by issuing Bonds, which repay the lender interest

    3. This keeps happening for years, and the amount of borrowing by governments such as Greece, UK & US reaches high levels

    4. The lenders, the banks, realise that the ability of a government such as Greece, to make interest payments on those bonds, cannot keep increasing, so increases the amount of interest on any *new* borrowing – thereby regulating supply and demand

    5. Eventually the prices for the governments to borrow, especially in Italiy, Greece, Portugal & Ireland (PIIGS) becomes so high (like 7% a year) that the Government can’t afford to borrow any more, and leads to the departure of Silvio Berlusconi

    6. As a result, the Bond Market forces governments to stop borrowing and *get real* with their budgets – you can’t spend what you don’t have – very simple rule

    7. End of story – if you borrow too much, eventually you can’t repay your debts – we’ve all been there.

    The bail-out you refer to above, isn’t why Greece and Italy are screwed, they didn’t bail out any banks, we in the UK did. At the moment our investment (bail out) in RBS will get paid back with interest, look it up.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s