EDMOND — In 2008 the global financial system almost came to a standstill as banks, insurance companies and investment firms teetered on the edge of insolvency. Much of it was blamed on excess risk taken in the subprime lending markets. But that was just the beginning of the problem.

Most people had never even heard of subprime loans prior to that, but then we started to hear about something else that took the problem and accelerated it at warp speed — something called derivatives. Derivatives is a catch-all word used to describe a variety of investment instruments like options, futures, CDS’s (Credit Default Swaps), CDOs (Collateralized Debt Obligations) and a whole alphabet soup of other exotic acronyms.

When used properly, derivatives can be an effective tool to manage risk by a sophisticated portfolio manager. But when taken to extremes, they become like financial time-bombs waiting to go off. They eventually did. The problem was that hardly anyone really understood them and the general public certainly didn’t. To make matters worse, many of them were traded privately and were totally unregulated. These are what basically brought down AIG and a few other firms.

My guess is that probably less than 1 percent of investment managers could adequately explain to the lay person how these things work and what the risks were. So, in an effort to explain them in a manner that most of us “regular” people can understand, I discovered a great analogy. I don’t know who the author is, but it started floating around the Internet sometime last year. It’s a funny, but also sad, representation of the derivatives market. It also allows you to see just how outrageous this entire situation was. I hope you find it interesting and helpful.

“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. 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 securities markets. Naïve 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 11 employees lose their jobs.

“Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90 percent. 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 more than 90 percent 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 the government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers.”

Now, do you understand?



NICK MASSEY is a financial adviser and owner of Householder Group Financial Advisors in Edmond. Massey can be reached at www.nickmassey.com. Securities offered through Securities Service Network Inc., member FINRA/SIPC.