Heidi's Bar (Understanding Derivatives):

HEIDI'S BAR (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 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 then are bundled and traded 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 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 Heidi's 11 employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS 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 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 multibillion 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.



PS:
This morning we hear Citi was leveraged 60:1 on the books in 2008, and 90:1 if you add-in their exempted obligatiions. But the Exec's say (with impunity) they thought it was safe. Jeez.....

Nice story!

Now where are my pitchforks?!



Edited 1 time(s). Last edit at 04/08/2010 02:03PM by MikeColangelo.

MikeColangelo Wrote:
-------------------------------------------------------
> Nice story!
>
> Now where are my pitchforks?!
>
>
>
> Edited 1 times. Last edit at Apr 8, 2010 by
> MikeColangelo.


Look behind the tar and feathers ...

---

As always IMHO

SEAN TENNIS KF7JJR
SEATTLE, WASHINGTON
SAAB 99, SAAB 850
SAAB V4, SAAB 99T

A few minor details to add/correct.

The story would be better if Heidi had 4 tranches of customers 1 tranche was unemployed as above, the next worked part time, the next full time and the last made very high incomes as managers at the beer supplier that later goes out of business and thus they can not pay.

The "bonds" were really securitized assets with triple AAA ratings on the first tranche and a blended BBB rate or like good rating on the strength of history that said the top three tranches always paid the money back, and the unemployed crappy tranche paid back more then 75% of the time by going and getting a new bar to pay off their debts at Heidi's bar in order to gain them as "paying" customers.

I think the share holders and exec's at the majority of failed banks such as Washington Mutual would disagree that they were saved by bail-outs. They are unemployed and lost 100% of their stock's value. Likewise share holders of AIG and others saw their investment wiped out or at least suffered major falls in value and the CEO's fired.

The government meanwhile did OK buy buying low and selling high to recapitalize banks. See story link....

U.S. set to make $8 billion from bailing out Citi http://www.realthinktank.com/2010/03/us-set-to-make-8-billion-from-bailing.html

So far as of April 2010 there are no new federal taxes on middle class non - drinkers or even the uber rich lushes. In 2013 I will start paying about .9% more income tax to help pay for health care but 95% of Americans will not get to pay this, the ONLY new income tax since well before Bush came to office.

Last but not least Charles Prince is no longer CEO of Citi (Fired), and there were lots of stings attached to the bail out funds, esp Citi who was the only bank to offer common shares to the government as it was in really bad shape.

So nice story but all wrong.

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In the long run reality always wins.



Edited 1 time(s). Last edit at 04/08/2010 03:33PM by derek.

No the story isn't all wrong.

It's a simple allegory about the chain of human greed at the heart of our man-made recession. Not a study in who-did-what. There's plenty of real world blame to go around. Diluted or lost life-savings, 10%-15% unemployment, and a probable decade needed for restabilization not withstanding.... the stagering cost has yet to be paid.

Simply put, improperly run American and International capitalism ran amuck. Our own economy was running on smoke and mirrors. About 30% of the "growth" during the past 6 or 7 years was bogus and the system crashed. Capitalism only works as it should when people are honest and take their lumps before their profits. Short of sufficient honesty, corporate self-regulation or government regulation can force prudent behavior. But our system failed. The leadership failed in both the private and public sectors; in the Board Rooms and Executives offices; in our elected Congress and Administration(s); and regulatory agencies. Too many people, in collusion, sucking the life blood out of the American future.

Our free enterprise system failed to protect itself.... from itself.

And it isn't fixed yet. The same public and private sector attitudes that caused the problem in the first place are not yet reformed. The dominant financial montra for economic recovery remains "growth"; while "stability" is still being shuffled off to the national debt.

No the story isn't all wrong. And it isn't over.

Rich Smith

The story is long from over.....

We are still wayyyy out in the woods, it is dark out and the Wolves are hungry.

Rich what role did Government play in requiring banks to make loans to those who had to have their own home?

Would the Banks have happily written loans to those who should never have qualified for loans which later (wow!) failed; if not for Government requiring that the loans be made?

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JohnLane

Overkill is consistently more fun

Are you saying that elected officials in DC don't know more about banking and making low risk/safe loans than thousands of lessons learned through thousands of years of banking/loaning history trial and error what worked and what did not ? Come come now that just can't be, surely people with little to no experience should make policy over the lessons history have taught!

---

As always IMHO

SEAN TENNIS KF7JJR
SEATTLE, WASHINGTON
SAAB 99, SAAB 850
SAAB V4, SAAB 99T

JohnLane Wrote:
-------------------------------------------------------
> Rich what role did Government play in requiring
> banks to make loans to those who had to have their
> own home?
>
> Would the Banks have happily written loans to
> those who should never have qualified for loans
> which later (wow!) failed; if not for Government
> requiring that the loans be made?
>
> JohnLane

John,

Barney Frank and his boyfriend should be in jail. Fanny Mae & Freddie Mac were not only primary triggers in the subprime fiasco, they signaled to lenders at all levels of that food chain that government regulators would turn a blind eye to hiding unreasonable risk. Then private lenders and bundle buyers, at all levels, willingly developed ever new ways to hide it, take the profit, and pass the unreasonable risks on to others. They could have said no. The politics of saying no would have been easy. It was literally a license to steal... and they knew it.

No shortage of blame anywhere in that process. Never trust a bank; an insurance company; or a politician.

Rich Smith

Sean,

Ha... yeah go figure.

Actually, I'm saying that both public and private interests knew exactly what they were doing and played their own parts. These folks are not stupid in the conventional sence. They knowingly created and feasted at a Mad Hatter's Tea Party.

Everyone gorged themselves and left the mess for "someone else" to clean up. Eventually they ran out of clean tables to move on to. And NOBODY knows how many dishes were broken.... or how many uninvited people it will take to pay the bills. At this point we only know they emptied the pantry.

Rich Smith

Rich,

I do not disagree about many of the things you said, I think the story should be reworked to remove the false claims and focus on the real true problems rather then try to over simplify and assert false factoids like the CEO's of bailed out firms kept their jobs.

There is good evidence to support the idea some banks, their lobbyist and politicians worked hard to create the environment that built growth on fluff and leverage in a scary alliance of greed. There are also clearly a few villains who willfully mislead for their own gain.

I agree 100% with your words here:
"But our system failed. The leadership failed in both the private and public sectors; in the Board Rooms and Executives offices; in our elected Congress and Administration(s); and regulatory agencies. Too many people, in collusion, sucking the life blood out of the American future.

Our free enterprise system failed to protect itself.... from itself.

And it isn't fixed yet. The same public and private sector attitudes that caused the problem in the first place are not yet reformed. The dominant financial montra for economic recovery remains "growth"; while "stability" is still being shuffled off to the national debt. "

I see no reason to embellish these ideas with a story full of errors in the details. I think it is a lot more powerful to say something like in the long run taxes will need to be raised to pay for the 2008 financial disaster rather then asserting falsely they already had.

I also think the story leads many to think capitalism should be thrown out in whole. I strongly disagree with that, I think cronyism should always be stamped out and I think the "Moral Hazard" that is embodied in Fanny and Freddy Mac must be removed but capitalism should stay, it is the best system and in the long run the system that will improve the lives of the most people.

---

In the long run reality always wins.

Rich Smith Wrote:
-------------------------------------------------------
> Sean,
>
> Ha... yeah go figure.
>
> Actually, I'm saying that both public and private
> interests knew exactly what they were doing and
> played their own parts. These folks are not stupid
> in the conventional sence. They knowingly created
> and feasted at a Mad Hatter's Tea Party.
>
> Everyone gorged themselves and left the mess for
> "someone else" to clean up. Eventually they ran
> out of clean tables to move on to. And NOBODY
> knows how many dishes were broken.... or how many
> uninvited people it will take to pay the bills. At
> this point we only know they emptied the pantry.
>
> Rich Smith
>
>

This because of loosening or dropping the regulations put in place from the lessons learned during the "Great Depression". Who'd of thought removing these regulations in placed due to financial melt down would create another financial melt down, let alone forcing lenders to commit bad loaning practices ... The word sabotage has to come to mind at some point !

---

As always IMHO

SEAN TENNIS KF7JJR
SEATTLE, WASHINGTON
SAAB 99, SAAB 850
SAAB V4, SAAB 99T

Commie crooks or robber baron crooks, they're all crook and oughtta hang the same way.

---

Jay Woodward
Snohomish, WA
'90 Mazdog Frankenprotege
Chronologically, 46...

All the nonsense about banks being "forced".
Banks own city/county/state/fed legislators simply due to the money they skim off and can throw around.
They have access to battalions of the most well paid lawyers in the world, they are virtually immune from the law, and yet YET why didn't they raise a stink about being "forced' to lend to all those "undesirables" which come on we know it's code words for niggers and mexicans and furriners...

Where were the news stories? Where were the complaints.

PRUDENT bankers would have raised endless howls, and the press would have been all over the story since the news media is100% beholden to any extremely rich and powerful entity???

Why did the stories of poooooor widdle innocent bankers being "forced " to make loans hit the national consciousness only AFTER the drug addled criminal mouthpiece of the RNC started spouting off about it?

It would be very interesting to see some of the boys here actually address these points, but.............

---

John Vanlandingham
Sleezattle, WA, USA

Vive le Prole-le-ralliat

www.rallyrace.net/jvab
CALL +1 206 431-9696
Remember! Pacific Standard Time
is 3 hours behind Eastern Standard Time.

I will tell you exactly why, Freddy and Fanny Mac told the banks they would buy the loans made to undesirables, and they did, so the banks (brokers) got the short term fees (profit) and sold all the risk and long term "profit" or loss to the government sponsored programs.

This was the system that the government came up with to avoid pissing off the banks when they created Fanny and Freddy who have a lower cost of raising capital and thus can lend at lower rates under-cutting the banks. No one gets a loan from Fanny May they get it from local banks (& brokers) down the street who then sells it to Fanny if it fits a FHA or HUD program.

The Moral Hazard here is Fanny and Freddy did not risk their own money, they had implicit access to the government budget, so they had no down side of taking on high risk, their cost of raising capital does not go up when they make risky loans. There for they do not make risk adjusted allocations of capital nor do they price risk correctly opening a market to loans priced well below a prudent safety margin.

---

In the long run reality always wins.

JVL how do you manage to turn loans made to those who are unable to prove their income or the rest of the usual rectal exam that goes with all the Mortgage loans I have had over my lifetime into a bullshit rant about anyone hating any group!!

The only person making any rascist bullshit comments is YOU. You add zero of value to the conversation with it.

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JohnLane

Overkill is consistently more fun