Trap for Investors (5) - Derivatives Market

A friend had forwarded me a very interesting story that illustrates how the derivative markets created the bubbles. (I was told the author is an accountant, but don't know the author's name.)

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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 a new marketing plan that allows her customers to drink now, but pay later.

Heidi 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 figure a way to make huge commissions, and 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 so informs Heidi.

Heidi then 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 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 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 their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi's bar.

Now do you understand?

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And, one more IMPORTANT QUESTION is that:-

Is this was an Accident by mistake or an Intention by design?

There are other effects that the derivative markets have actually affected the traditional stock market operation. Such as:

1) Insiders Buying/Selling information used to be an excellent guide for predicting the short to mid-term price movement. By law, insiders must report their activities for buying or selling stocks. But, with derivatives, insiders can now using put or call options to make profits which need not to be reported. And not to forget that many derivatives such as options are higly leveraged. Therefore, Insiders Buying/Selling information is not so much useful as compare to the past.

2) As people are now able to use puts and calls to profit from the market, the classical Tape Reading Technique is no more as accurate as the past.

In real life, many of those who lack of money are not because that they don't know how to make money. They are lacking of money mainly because they don't spend their money wisely and more critically is that they do wrong investment with their money.

"The state of being rich is not how much money you had already

earned in the past, but how fast you can have it grown

against the inflation in the future."

-KH Tang