I received this story to help explain how derivitives work. What do you think? Is this helpful or distorted?
Derivative markets explained. 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 wine 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, ALKIBONDS 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 soinforms Heidi. Heidi then demands payment from her alcoholic patrons, but being nemployed 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, ALKIBONDS 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 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 lies 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, and non-drinkers.
Now, do you understand?
I confess the way this story is told, you expect the poor taxed smooes to string up the brokerage execs in a public tar-and-feathering.
ReplyDeleteThat's an interesting analogy.
ReplyDeleteOne thing the analogy is missing is the beginning. Heidi didn't just extend generous credit because of her greed or (alternatively) because of the goodness of her heart. She got a letter from the Government saying "everyone has a right to a decent drink" and "Heidi's portfolio of customers under-represents the class of unemployed alcoholics". The government threatened to revoke her license unless she found a way to serve more unemployed alcoholics. ACORN actually took her to court for class profiling and under-serving this particular minority. Heidi gave into this pressure and finally figured out a way to satisfy the Government and ACORN - she could do so by letting them drink on credit.
And I would also add to the ending. To prevent Heidi and establishments like hers to fall in the same trap in the future, the Government is now proposing the Help for the Unemployed-Alcoholics Act, whereby the middle-class taxpayer is forced to pay for his irresponsible neighbors debt.
Other than those two things, I think the analogy is pretty apt.
I am not sure that is a completely accurate comparison although the author does explain the mortgage backed security market (MBS). However, even that is incomplete.
ReplyDeleteA derivative "derives" or is pulled from a different, larger investment. For example, a MBS is simply a pool of mortgages held by a mortgage company and securitized by an agency such as GNMA or the infamous Fannie or Freddie. It is analogous to an IPO since the mortgage company receives a cash infusion while the investors received a fixed rate of return based the average interest rate of the mortgages.
Traditionally, an MBS would be a pool of mortgages held by responsible borrowers with good credit and a solid history of making their payments. By comparison, Heidi's Alcoholic Backed Security (ABS) would be a pool of employed, white-collar alcoholics who were committed to their craft.
Of course, even a conservative investment like an MBS carries risk. The traditional risks were of course borrower default, prepayment or a market rise interest rates. Heidi's ABS carries the risk that some of her customers could lose their ability to purchase alcohol. Also, what happens if one of her customers attends AA and starts "converting" the other customers?
David, this story would work for the sub-prime MBS market. It is true that mortgage companies financed loans to borrowers with little or no documentation of income, savings or viable credit history. We then saw pools of these loans securitized and purchased by institutional investors. Boom!! Real estate bust happens, ARM loans adjust and we are off to the races!!
One more thought-the riskier MBS pools did carry a higher fixed payment. The market does price the risk into the security.
Finally, an MBS becomes a true derivative when the company sells a pool based on a portion of each loans. In other words, investors could buy a pool backed by loan principle or backed by the interest. Wall Street can also strip an MBS into tranches by separating the pool into several groups based on loan balance, property value, payment history, etc. This is a true derivative since Wall Street is turning a large investment into several smaller ones.
For example, Heidi could create derivatives by separating her customers into various pools. She could separate them by age, tolerance, salary, will to live, etc.
This may help or not.