In his new movie Capitalism: A Love Story, Michael Moore searches for someone to explain derivatives to him. Michael, here is an easy explanation for you. If you need me to explain it further, I would be happy to do so.
All my best,
Thomas J. Powell
How Derivatives Helped Collapse the Economy
The following is a fictional example. It never happened, except for in my head.
Las Vegas, Nev.
There is and always has been stiff competition between Las Vegas casinos. Located miles from the strip, Sin and Tonic Casino relies on clever ideas from their owner, Dale, to increase profits. In the summer of 2005, Dale decided to unveil a ‘Play Now, Pay Later’ program to his loyal customers. Dale’s customers, most of whom rarely left the casino because they had no home or job to maintain, were allowed to gamble and drink while management kept tabs on how much money they were each blowing through.
The customers told all of their friends down by the river about Sin and Tonic’s new program and soon the casino was always filled to record numbers for the property.
Dale decided to lower the payouts on all of his table games and slot machines and also increase the price of alcoholic beverages. But, because his customers were not required to pay right away, no one seemed to complain. Dale’s sales blew through the roof and caught the attention of local banks. One bank referred to Dale’s customers’ debts as “valuable” and offered to increase Dale’s borrowing limit.
With Dale’s customers’ debts as collateral, the bank turned the debts into securities known as Sin-a-Bonds. Soon, the Sin-a-Bonds were being traded on security markets nationwide. Investors across the country, and soon across the entire world, never knew the AAA-rated Sin-a-Bonds were, in reality, the debts of homeless gambling addicts.
Sin-a-bonds dropped to near-worthless levels and investors lost their money. Plus, the bank that issued the Sin-a-Bonds saw its capital depleted and they were consequently unable to offer any more loans. The bank laid off all of their employees and closed.
Dale was unable to pay any of his bills and all the companies that granted him payment extensions had to take massive loses, as Dale was their largest customer. The carpet cleaning service was forced to downsize, the vending companies were left with handfuls of damaged machines that no one else was interested in and alcohol suppliers were left with large inventories that could not possibly be consumed without Dale’s heavy-drinking clientele.
The brokerage firms that sold the Sin-a-Bonds were in heavy distress. Eventually, the government stepped in to save them by creating a bailout package that was funded by tax payers from states where gambling is prohibited.
Dale retired from the casino business and is now rumored to be heavily involved in politics.
On Monday morning Dale and his employees were witness to the first day without customers in the casino’s history. Not one of the customers came in to make payments on their debts and the ones that stumbled around drunk in the parking lot claimed they “hadn’t got no money.” Dale told the bank he could not pay back any of the money they lent him and he quickly decided to claim bankruptcy.