'Derivative Markets' and how three
Derivative: A financial contract whose value is based on, or "derived" from, a traditional security (such as a stock or bond), an asset (such as a commodity), or a market index.
how it could happen, and how it effects us all:
Susan is the proprietor of a bar in Detroit. Susan 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 these 'special' customers unsecured financial loans).
Word gets around about Susan's "drink now, pay later" marketing strategy. As a result, an increasing number of customers flood into Susan's bar. Soon she has the largest sales volume for any bar in Detroit.
By providing her customers the freedom from immediate payment demands, Susan gets no resistance when, at regular intervals, she then substantially increases her prices for wine and beer, the most consumed beverages of 'the people'. Consequently, Susan's gross sales volume increases massively, and she hires more employees too.
A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Susan's borrowing limit. He sees no reason for any undue concern, since he has the debts of all these unemployed alcoholics as indirect collateral.
Financial institutions were pressured in the late 70's to promote high risk securities (bonds) and loans by the first president(1) who wishing to gain the votes of unemployed alcoholics. Promises of easy, unearned money garnered their votes as he was overwhelmingly elected by those hoping they could get some of this easy money. It was successful, he got elected as a representitive of 'the little people'.
At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS for all like bars, such as Susans. These securities are then bundled and traded on the 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. It is expanded to home loans for the alcoholics and included in the bundles. More tax advantages and benefits were promised to these big businesses as the second president(2) pushed the banks to promote these loans to bars all over the country, thereby garnering the votes of all the Bar Union members too. The practice was again pushed by expanding into the home loan market to gain votes for the second presidents(2) re-election, creating booms in the tech and housing markets.
In the mid 2000's, 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 unemployed drinkers at Susan's bar. Since interest rates were low, the banks weren't making as much money, so this was a way to grab some quick cash instead of trimming their overhead. So he informs Susan of the bad news.
Susan then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Susan cannot fulfill her small business loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.
Overnight, the 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 all of the economic activity in the community, including other small business and home loans. Many were also shut out from loans they really could qualify for and pay back, based on their sound financial practices.
The suppliers of Susan's bar had granted her generous payment extensions and had invested their firms' pension funds and sold 401Ks on these various BOND securities. They now find they are faced with having to write off her bad debt and thereby losing over 90% of the presumed value of the bonds.
It was not their money, no big deal, as they can pass the buck on to the stock, pension and retirement account holders. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations. Her beer supplier, and the suppliers are taken over by a competitor, who immediately closes the local plant and lays off a majority of the towns workers. 401K's around the country were gutted. The same happens to all the other bars all over the country. A domino effect impacts all financial institutions likewise. Panic insues.
Fortunately though for big businesses, the bank, the brokerage houses and their respective executives are saved by a huge bailout by a multi-billion dollar 'no-strings attached' cash infusion from the new president(3). The funds required for this bailout are obtained by new taxes levied on the newly unemployed, middle-class, lower class, and non-drinkers for generations to come. The money didn't go to the stockholders, though, but to the executives for contractual bonuses for making big business so much money with this 'bad paper'.
Susan made a bad business decision, and yet she is able to skate from her debt by declaring bankruptcy. The banks found a way to make money by creating bad securities, based on a poor business model, promoted by the two presidents(1)(2), but could sell it buried within good securities. They already made their money on the commissions, and passed the risk off on their buyers, so they were financially safe. The presidents already got elected, so they didn't care either.
The pension and bond funds bought the securities blindly, as the bad asset values in these bonds were deceitfully hidden. The bond managers already made their commissions and just wrote off the bad debt too, hitting their stockholders and 401K owners with the bill. All of Susan's suppliers had to take the loss of all the bad financial decision by the others, as did all of their employees and families for generations to come.
The two presidents(1)(2) and all the big businesses involved, the banks, security companies and brokerages knew exactly what they were doing, and yet these companies were rewarded with bailout money by the new president(3), on top of all the sales commissions they already made. The bailout money would not trickle down to the taxpayers, those voting in the new president(3), since all the surplus money was invested overseas as he neglected to place any strings on how it would be spent, or the peoples representitives, or by the people themselves for only electing him for their easy money and benefits to come, in his promise of 'change'.
The banks, to make up for their losses, increasing all their rates to those who had been paying their loans on time, and tightened the credit to uninvolved small businesses and the small towns that needed the capital to keep their businesses going, eliminating new jobs or expansion. More unemployed as they try and recover by sending many services to offshore countries as well, and subsequently more stocks and 401Ks were gutted.
All three presidents(1)(2)(3) already got their votes to gain power over the people, and the new president(1) elected by those not having a clue to what happened, now controls those big businesses he gave all the bailout money to. Detroit is now run by this new president(1), because the voters and unions from all the alcoholics nation-wide were promised a 'change' from the old government supporting big business, and continued to claim and that they would get more free and easy benefits to the taxpayers if elected. Other big businesses and organizations that helped the new president(1) get elected by promises of much of the bailout money, were also rewarded.
All the innocent taxpayers, the little people and those small businesses were now responsible for this huge debt by all three presidents(1)(2)(3) decision to help them out, but were only out to get their vote', are now taxing them, their children and grandchildren for this huge loss that they had nothing to do with, and all while they were playing by the rules. They get very little of the bailout money trickle down as most if it is actually being spent offshore, and in huge rewards to all those that actually caused the problem to begin with, the three presidents and the financial institutions that bowed to the government pressure, and all orchestrated by the banking industry (Federal Reserve Bank).
Now, do you understand?
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