A simple (humorous) look at bank derivatives

A Banking Primer: Understanding 'Derivatives'

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 a new marketing strategy that allows her customers to drink now and pay later; keeping track of the drinks consumed on a ledger (thereby granting the customers 'loans').

Word gets around about Heidi's "drink now, pay later" marketing plan 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 her products. Consequently, her gross sales volume massively increases.

A young and dynamic vice-president at the local bank recognizes that these customer debts [accounts receivable assets] constitute valuable future assets and increases Heidi'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 transforming these customer loans into DRINKBONDS [aka securities] bundling and trading them 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 tell Heidi she must demand payment on the debts incurred by the drinkers at her bar. She 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, 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 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 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 multi-billion dollar no-strings attached cash infusion from the United States federal 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.

There in a nutshell is what’s going on in the banking industry called ‘derivatives.’

41 thoughts on “A simple (humorous) look at bank derivatives

  1. We have an 1800s former savings and loan with a simple policy:

    Mortgages require 20% down and decent looking credit record for the last six months. No escrow, you're an adult, pay your own bills.

    Funny how people with $20,000 of their own money on the line tend to reconsider walking away from an $80,000 debt. If they do, it's easier to sell for $80,000 than $100,000. Not to mention that saving for a deposit shows good spending sense on the part of the borrower.

  2. The plan: Find an unlimited block of losing debt, get some call letters for it. Buy naked bear put options on it cheap... after pumping it and painting it "Govt-backed. Drive the price down, resell the put contracts to the panicked hoodwinked for a 600 percent premium. Do it again.

  3. On purpose: Hedge funds needed an inexaustable supply of securities they could count on to fail. Their trillions have come largely from buying bushels of bear puts on a company or block of equities they have promoted and right after they have driven the price
    and all the players are awash in good news and bear put contracts are selling for a song, the Hedge funds load up on them and start selling off the stock with a cascade of negative news on the intrinsically sick security. Subsequently, huge demand for put contracts occurrs and put premiums skyrocket to 600 percent of what the hedge funds paid, back when the investment was perceived to to be worthy of securitization. Investing in underlying stock equity on hopes of twelve percent gains has lost it's appeal. Huge hedgers are scanning countries large and small for monster blocks of debt to securitize replete with unlimited option writing and purchasing of puts with short term leveraged money far beyond any former regulatory constraints. -All cradled in an ideology of free trade having some intrinsic holy factor that allows money to eventually seek it's own level as if it actually flowed like water. Barney Frank was ripe for hoodwinking. He understood derivatives in a vacuum. He couldn't know what they were capable of, in the hands of those who lobbied to set them free to supply Mr. Hedge with exponential returns in the stead of old school, dowdy, compounding interest. The cat is out of the bag. Its tail wags Wall Street. Who wouldn't sink their own boat if it could be insured for 50 times what it was actually worth? Don't we all want a bigger boat? Especially one that might sink...Create a powerful enough moral hazard/temptation with no proportional associated risk... and few people, given enough sustained exposure to such levels of commensrate gain - will have the fortitude to sit
    back and watch others collect all those chips.

  4. I have cut and pasted this to a Word document, and have passed it out to all three of the college classes that I teach. And, have also put it on my Facebook Wall. It certainly gets all the various aspects of what really went on. The moral of the story is that we should have nationalized the banks for their recklessness--not given them a blank check.
    Cherubim

  5. You forgot the best part where the cash gift to the bank is not used for banbk business, but only to guarantee paymentr of multi million dollar bonus of the bank ceo.

  6. I'm thinking that a loan is made with interest, The Principal Amount that goes into circulation. There is no currency in circulation to pay for the interest portion of the loan.

    Start with the very lst loan.

    THEREFORE, the loan can never be paid back.

  7. Come on, obo, lighten up! Picking on AA members is not the point.
    Direct your angst to our friendly bankers and members of U. S. Congress who have no common sense, or fundamental moral character .
    Hummm. Sounds like a good name for a new political party....."The Common Sense Coalition".
    As I have told my sons, "never think your banker is your friend".
    Go Blue!

  8. You still telling bears to stay short Adam, based on your proprietary Trade Triangle Technology (TM)? How's that working out for them, do you think?

  9. There's a good argument to be made that the good times we have all enjoyed for the last 80 years -- rising markets, rising real estate, better quality of living -- are actually the result of a drunken spree on our credit cards. See, for example, any chart of accumulating debt going back to 1930. The first dip in the chart occurs in 2008. Otherwise, it's uphill all the way.

    Looks like it's time to pay the bill!

  10. And now in desperation to blame someone else the US and its camp followers insist on taxing assets.
    Eg. your cash under the mattress,or even better assets deposited in Swiss banks.If Gustaf from Sweden
    who never set foot in America has a Swiss mutual fund and it contains a miniscule investment of of
    US stock,the IRS wants to investigate Gustaf his family the Swiss bank and sue for billions of $
    for 500 shares of DELTA airline that went bankrupt years ago.

  11. OK, if Heidi owed a billion $$, multiply the cash infusion by Uncle Sam by 16,000 . . . and there you have our national debt. Next year's deficit, another 2,000 billion $$$.

    Final chapter of the story . . . the rest of the nations of the world that have been using $$$ as the reserve currency and have been forced to accept $$$ in exchange for *real* goods, decide they are tired of accepting counterfeit money. OPEC included. Military protection arrangements are made and OPEC announces that baskets of currencies will now be accepted for oil . . . and the rest of the world no longer has to keep dollar reserves to buy oil.

    End result = Uncle Sam's credit is no longer good, either. No more cheap consumer goods on credit, sorry.

  12. How can we disseminate this to the OWSreeters? They can then see their problems come from the Gang of 3 in Washington- the Government, the Fed (controlled by the banks)and Wall Street Bankers with their highly paid lobbyists!

  13. Zicon...that's the problem with attending a demonstration: when you get hit over the head with a billy club, you'll probably spill your drink. 🙂

  14. Sounds like the music has turned off and the dumb suckers left standing without a chair to sit in are thrown out of the game and a chair is removed. The game continues until the last remaining chair. By then, there are no more suckers and it quickly escalates to an every-man-for-themselves type ending.

  15. Pass the kool aid!
    Heidi came up with a new marketing strategy? Hardly. Didn't her Uncle come up with the new strategy - her Uncle Sam, because he thought everyone should have a drink.
    It is absurd to think that Heidi had any choice in the matter - once Uncle instituted the new strategy in his bar named Fannie's, Heidi had no choice but to go along if she wanted to stay in business.
    The financial markets are supposed to be a zero sum game, where the "naieve investors" or maybe even greedy investors will always be handing their money over to the smart and sophisticated. But when Uncle Sam inserts himself and adjusts the rules of the game, the consequences belong to Uncle. Uncle learned that everyone cannot have a drink, and we paid for the education.

  16. Humans are a doomed species: stupid, rapacious, myopic.
    I'm glad I'm a squirrel.
    We'll all be happy when they're gone.

  17. Love it.....I hope they raise our taxes
    Good old Bank of America and JP MOrgan
    are dumping "trillions" of high risk derivatives
    into depository accounts so joe six-pack
    can pay for their losses.
    Where is the transparency promised
    by our "Leaders"?

  18. Good explanation, but it left out an important step and went in the wrong direction. The problem with banks and mortgage loans was that the Federal Government mandated that mortgage loans MUST BE made to "unworthy" individuals so everyone could live the American Dream and own a home. As a result basic credit qualifying was ignored and through Fannie Mae and Freddie Mac the government created a path "guarantying" these garbage loans. That made the loans "saleable" as derivatives and classified as "A" paper. Since the government (Barney Frank) created the requirement that banks and mortgage lenders make these very high risk mortgage loans an investment industry naturally was built up around it. Many people in the pipeline were destined to make a lot of money at the expense of the government guaranty because these risky loans were destined to fail. NEVER FORGET THAT IT WAS OUR GOVERNMENT, PUSHED ON BY BARNEY FRANK, THAT CREATED THIS PROBLEM. I CAN'T HELP BUT BELIEVE THAT IT WAS ON PURPOSE!

  19. So now i am left with only 2 choices for my future
    1- Unemployed alcoholic
    2- Unemployed Heidi ..... Excellent

  20. Tune in to "Gold Bug," Gerald Celente's utube channel(s) on this great big ponzi scheme directed by our masters. The trends forecaster has been predicting blood in the streets for a couple of years now, but says America's too soft, unlike the inventors of the guillotine, the French.

    We are owned by a tribe that looks out for one another, all us cattle be shook loose from our money.

  21. And the politicians got contributions from the banks, brokers, and the people who got rich, thus did not do anything to regulate it.

  22. Your little story is absolutely marvelous. I laughed and laughed! But coming back to reality, it accurately recounts the financial gymnastics of the last 9 years. The rich get rich ( thanks to the government, who pays them off with newly printed funny money), and the innocent middle class is stuck with the tab.

    What ever happened to the good old days, when a banker would not talk with you about a mortgage unless you had 10% down? The banker today no longer asseses risk. Risk is sold to the government (Fannie May and Freddie Mac), an institution that has no idea of what fiscal responsibility is.

    So, we have an inept government waltzing hand in hand with the sharks. What else is new?

  23. The example leaves out one VERY important item: The seriousness of the problem for America and how nobody is addressing it. Allow me to borrow from something I saw on the Net that puts the numbers in perspective.

    If we assume the US is an average family making $30,000 per year, then it is adding $16,000 of debt every year to a $164,000 debt that it already has. And the amount that the Republicans and Democrats are arguing about cutting is about $300.

    Like I said, nobody will take this seriously until there is blood in the streets from the vast unemployed who can no longer make ends meet, like we're seeing in the Middle East, Greece, London, Madrid, Rome, etc....Despite what the pundits say, these demonstrations are more about economics than democracy.

    As I've always said, "Political and religious ideology are the most important things in the world...until you can't afford to get the toilet fixed."

  24. Mr. H......I am not an investor or trader, but a 'wannabe' learning everything I can thru sites such as yours...I never understood 'derivatives' but what a cool illustration....I am gearing-up to order a Market Club Membership just so I can get specifics on 'trading' and eventually start using my small-cap-savings to Trade.....Thanks much for all you do, Robert

  25. Loved it! Great explanation, and it strips away all the "mystery" that Wall Street wraps themselves in.

  26. That is sort of a sad commentary on the reality we face... it really shows the absurdity of what we've allowed to happen. How about we go back to balanced books again? Thanks for the provocative thoughts.

  27. Great description! But you left out a couple of things. Heidi's husband invested in the bonds and when he learned that the bank "might" demand payment, he sold them for a tremendous profit. Also one of the brokers bought default swaps against the bonds from Loyd's of London. He became rich, too. How come you didn't know that?

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