Steve Royston

In Vino Veritas: Seeing Derivatives as They Are

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I don’t normally propagate stuff I receive via the internet, but a banker friend sent me this little nugget about derivatives, those nasty financial instruments that caused so many problems in 2008. It’s probably been pinging around inboxes around the world by now, but if you haven’t seen it, it’s a treat:

A Lesson in Economics:  Understanding ‘Derivatives.’

Heidi is the proprietor of a bar in Detroit .

She realises that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronise 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 recognises that these customer debts constitute valuable future assets and increases Heidi’s borrowing limit. He sees no reason for any undue concern because 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. 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 fulfil her loan obligations she is forced into bankruptcy. The bar closes and Heidi’s 11 employees lose their jobs.

Overnight, DRINKBOND 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 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 the 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.

Do you now understand?

I have no idea where this came from, but I suspect Detroit, which is the city most often quoted as the biggest casualty of the 2008 financial crisis. Still relevant today, I think.

6 Responses to In Vino Veritas: Seeing Derivatives as They Are

  1. JCWS 26/11/2011 at 9:00 PM

    The point I was making was economic – that we have been led into this dead end of derivatives by a political/economic model that lacks ambition. The issue with debt-driven economic growth is a) should you do it and b) how you invest that debt. With some objectivity, having worked directly for two leaders in the Arabic world and as part of local government in the UK, I can state that bureaucracy and lack of ambition do distinguish the modern esprit de corps of the UK and ‘New World’ economies (and I agree Singapore is a shining example – arguably the original model of course for the UAE). A ‘standing start’ is just that; Dubai, for example, could as easily been defined today by shanty towns! It isn’t so this point about standing starts seems somewhat a house of cards (sorry!!!!) It is interesting that no one has mentioned hubris which is the usual critique. In many ways that says everything about just how far the Emirates have come.
    It is a cliche applied to too many things these days, but the model at the heart of Middle East decision making carries the ‘if you build it, they will come’ philosophy at its core – and by definition that does NOT mean every shining example of ambition has to be about infrastructure and nor did I say that it was (or should be). In Europe, billions are poured into perception projects (especially through the structural fund); events, marketing and the like. So too in the Emirates – and again that shows the sophistication of the ‘new world’ leadership. The truth is less prosaic; if you build it and no one knows about it, they won’t come – and they won’t have a chance to appreciate it.
    I am very proud to be British, but if I had been born Emirati I would be proud of that too. I was speaking of economics and ambition, not nationalism. It is subjective, of course. But I do NOT think there is anything wrong intrinsically with growing economies through debt IF the investment is made with ambition to build the foundations for growth. In the UK, debt has to a much greater extent become a dirty word, and been used to stand still and protect entrenched positions and services where it has been used. It is not that there is no ambition, but too little. You can count the number of buildings that will stand the tests off time on one hand.
    In the UK the drivers for buildings are function, the drivers for tourism historical, the drivers for government fire-fighting. These are simplifications of course. In the Emirates, in distinction, the drivers are much more about creating history, not living in its past, about taking risk, not protecting positions, about making things happen, not bureaucracy. Ideas are celebrated, not critiqued and strangled at birth.
    In the UK we are investing in Capital Projects BUT to keep the roads free of potholes Where we do talk of new High Speed rail links between cities the ‘nimbies’ nearly always win – that’s if the (endless) bureaucrats and their years of ‘meetings about meetings’ have not already strangled innovation and passion before their first gasps of breath.
    Concorde may not have been financially viable, but its impacts spread across the world to create growth. It was a time of ‘everything possible’ – and industry and the private sector responded. If, as today, the only thing the private sector has aspire to is debt-fuelled pot hole repairs, repairing not redefining infrastructure and fear, little wonder our finances have ended up crashing! That’s the point I was making. In the UK, we have become an economy built on pieces of paper and promises shuffled between bankers and governments without ‘real world’ meaning. Even the bankers are bored! In Europe our thinking trades too much on our history, not our future and if we do not start to change we won’t only be left behind, but damaged. A million of our young people in the UK are today to waking up to unemployment and hopelessness. This did not have to be the case. And on that basis I make no apologies for praising the Emirates’ leadership or that of Qatar or the KSA and countless others who have a little more of the passion and courage that created the world, not left it ‘standing still.’

  2. Simone 24/11/2011 at 6:09 PM

    Off subject, but sort of derivative of the main point perhaps!

    Anyway, I think you are being a bit unfair Stephen. For all the hubris and yes misspending, after 40 years of independence, Dubai is a pretty shining example for other ‘frontier’ economies.Yes it has got itself into a pickle with way too much debt , but at least it did that building an infrastructure. It’s not money that has been siphoned off into some Swiss bank vault to the detriment of the people.

    That infrastructure is not going anywhere, and will stand the city in good stead as things turn around.

    Of course it’s far from perfect – property laws are still a joke – and the antics of Nakheel and its like are going to set the property market back another five years – but I would still say that you’d be hard pressed to find another city to have achieved so much in 4 decades.

    Finally, like Steve I too am so much happier to be English than Emirati. Difficult to generalise too much, but I really do worry about the younger generation of locals. Rather than the state worrying and fretting over their employment situation, it should simply remove their benefits. That way you remove the entitlement culture, and get a new generation who like their fathers wanted to make something of themselves.

    • Stephen 24/11/2011 at 9:30 PM

      Fine. We are all entitled to personal opinion. You admire it; I don’t. It makes the world go round.

      Where you are wrong is that like so many other celebrants of the great dream, you think the money went on infrastructure. The Palms, Dubai Waterfront, Sports City, Humanitarian City, Silicon Oasis, etc, the misspent billions through groups like Istithmar, the ridiculous racetrack complex; none of these represent infrastructure and that is where the cash went. I agree we have the Metro and some decent roads -terrific. Oh and I would say SIngapore has done pretty well in 47 years
      .

  3. Stephen 24/11/2011 at 5:43 PM

    This is off subject given the article points to a whimsical explanation of OTC derivatives, however, JCWS started it.

    Dubai may well have been one of the great experiments of modern times but clearly, with the evidence of recent years, one that has rightly been confined to the garbage heap. History will reflect poorly on the UAE’s ambitions and show them, in my opinion for what they are; shallow, unworthy, wasteful and above all, unmeasured. It depends on how one defines ambition? The original meaning, which related to soliciting votes, i.e a wish for a specific end, or what the UAE tuned it into, an ardent desire for fame or power at any cost.

    I would beg to offer that from an objective viewpoint, there is nothing inspirational nor special about the so called achievements of our local cities. I do not hail the West in some form of personal credo as a shining example of achievement but to throw up this region as somehow something to which other nations should aspire, is laughable.

    There was a blank canvas here. Financial, land and human resources were freely available as was the knowledge and the volition to develop the blueprint. The world was full of evidence of how NOT to do it and the result could have and should have been a near Utopia. The paucity of imagination in carrying out the plan and the greed that overtook all involved, however, put paid to that.

  4. Steve Royston 23/11/2011 at 1:07 AM

    I think it’s always easier to make a spectacular impact from a standing start, as has been the case with states like the UAE and Qatar. It also helps that both countries are led by determined and visionary oligarchs who will not let red tape and lengthy consensus-building get in the way of their visions.

    In the UK we have many more hrdles to overcome to make our dreams reality -planning regulations, availability of funds, the need to gain political support. But before we flaggellate ourselves for our lack of ambition, let’s remember that next year we have the Olympic Games – on time and within the (admittedly revised) budget – a project that is continuing the transformation of East London started with Canary Wharf.

    Leaving aside capital projects, we still achieve in education, the arts, science and technology, even if our politicians – as ever – leave much to be desired.

    With all due respect to the Emirates, I would still rather be British – for all our imperfections, than Emirati.

  5. JCWS 21/11/2011 at 3:20 PM

    In the UK the question has become so simple: pay back debt (austerity) or promote growth (jobs). The former requires taxing all those who can least afford it – the wisom is that taxing the rich a) will not produce enough revenue and b) will stifle their natural urge to inveest to create jobs. The latter belives that “if you build it, they will come.” Of course it’s the same old argument about the evils or oerwise of Yeynes, albeit with new ferocity.
    One of the great experiments of modern times is that of Dubai, investing, building in impossible dreams. Yes there are issue about the labour force, yes, about debt, rights – all the usual critiques. But, at least from here in the UK, there is something to admire about the building of great and ambitious things. The UK and France once built Concorde, how soon this has been forgotten. Dubai makes us remember that human being can do great things with some sorrow and nostalgia – I think we have forgotten ambition. So yes in the example, the banks lend to the drunks, the bankers laugh, tax payers cry and the business goes down the plug. But, and maybe it is a romantic thought. in the Middle East, the bar would have been built with ambition with something that stretched the human imagination, people would have come to visit from around the world, the drubks would have met people with vision, become sober and done something with their lives and the business would NOT have gone down the plug whole in the first place. It must be easy to forget just how SPECIAL and INSPIRATIONAL Dubai and Abu Dhabi (and the new cities being built in the Deserts of the KSA) really are. From the UK, some of us look on and just wish we had governments – and populations, that had even half the ambition. You are building it. They do come. And we in Europe learn that, just perhaps, there is some hope and narrative outside the desperate stories of drunks, bars, bankers and complacency that now characterise our lives and blight the future of our children.

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