Understanding Derivatives

Bob owns a bar in Phoenix and his clientele are mostly people who are unemployed and have a drinking problem.  It doesn’t take long before business begins to slack off as the economic recovery struggles.

Soon Bob realizes that his customers can no longer afford to go to Bob’s bar.  In a marketing epiphany Bob devises a plan for his customers to run up tab that they can repay later when the economy recovers.

So Bob starts a ledger of the open bar tabs (in a way Bob is loaning his customers money).  It doesn’t take long before every dead beat in Phoenix has heard of the open tab policy at Bob’s and soon Bob’s is the busiest bar in Phoenix.

Since none of Bob’s patrons are actually paying for their drinks they could care less when Bob increases his prices, which he does every quarter.

Bob’s suppliers seeing an increase in volume, and being the greedy suckers they are, extend to Bob generous extensions on payment for supplies.

Lo and behold a young investment banker, lets call him Jim, stops by Bob’s bar one day and immediately see that the debts in the ledger constitutes substantial assets with large future value and offers Bob a line of credit, which Bob accepts since he still has bills to pay.

Note: This genius of an investment banker see no issue with the fact that the outstanding debts which are the collateral for the line of credit are owed by drunks that are unemployed.

At the headquarters for Jim’s bank, there are some investment professionals that see an opportunity to bundle the debts owed by Bob’s patrons and create Bar Bonds  and give them a triple A rating, which in turn are traded on the global securities markets making the investment guys very rich and Jim’s Bank even richer.

The average investor seizes the opportunity to by some triple A bonds and the value of the Bar Bonds continues to climb and the top brokerage houses globally are soon selling the hottest assets since sliced bread and the toaster.

Note:  The average investor doesn’t know that bonds are backed by drunks that are unemployed.

Bob’s suppliers seeing the opportunity purchase Bar Bonds for their pension fund.

A year or so later the Bar Bonds are still climbing in value and to lower the risk at Jim’s bank a Risk Manager tells Jim he needs to go and collect some of the money that Bob’s patrons owe.  Jim contacts Bob and Bob in turn begins to demand that his clients (you remember them the drunks that are unemployed) pay their tabs.  However since the patrons are unemployed they can not pay their tabs and Bob is forced into Bankruptcy.

Bob’s bar closes and all his employees are now out of work. (Most likely drinking at a bar down the road a block or two, that offers an open tab.)

The news that Bob can’t repay the line of credit spreads quickly and the Bar Bonds drop in value like a rock over night. With out the inflated value of the Bar Bond asset Jim’s bank develops liquidity problems and thus can not offer anyone else a loan, regardless of how good the collateral might be, which basically freezes credit across the community it serves.

Bob’s suppliers are now faced to write off the bad Bar Bond debt.  Some are forced into bankruptcy, some are taken over by a competitor, who consolidates the operations and closes the local plant and distributer putting hundreds of people out of work.

But as fate would have it the Federal Government steps in, and using billions of tax payer dollars, saves the Bank, save the Brokerage Houses and even finds a way that the executives of these institutions can get a pay raise out of the deal. (see Troubled Asset Relief Program (TARP))

How will the government recoup the TARP losses … by raising taxes on the people who are employed, mostly middle class, who have never been to Bob’s in their life.