Basic Trading Apples -how the financial sector was saved-
Imagine you buy and sell apples for a living. One day you come across a large shipment of cheap, bad apples, nevertheless you gamble that they are good enough to sell and make a large surplus above your normal necessaries. You request a bank loan amount 20 times the total amount of everything you own, your car, your house, your savings and future anticipated profits. The bank looks at your proposal and determines that your risk is within limits and provides you a loan 20 times of all the assets you have.
This is for us common people unfortunately not possible, but the SEC thinks these risks are fine for large institutions. A mortgage loan is maxed at 5 times your annual income, however, oil futures (Commodity Futures Trading Commission regulation) can be bought with a “leverage” of 1:16.
You buy the bad apples and start selling them. The first apples are sold in no time and although you sold only a fraction of your total amount of stock of apples, you return to the same bank, and propose to them to sell your whole loan agreement plus a share in the profit back to the bank, for a new loan amount 14 times the amount that you initially loaned.
Let’s say your total assets are $1000, your initial loan is 20 * $1000 = $20,000. You sell that loan back to the bank, for a loan amount 14 times the initial loan, 14 * $20,000 = $280,000. Your total loan amount is now 280 times the amount of all your combined assets.
You keep on buying more and more bad apples and at one moment the apples start to rot causing the price of your apples to decline. As the price of your rotting apples is going down, the apple stock value goes down. Instead of selling the apples for a lower price you return to the bank and refinance your $280,000 loan for a larger loan amount, 10% more at $308,000 to purchase more apples to increase the stock of bad apples. This to uphold the value of the total apple stock. Because your bonus is dependent on the apple-stock-value.
The rotting apples start to smell, and people wonder what is going on in your warehouse and start asking questions. To show investors that you’re doing great your return to the same bank and refinance your apple stock amount by another 10% and buy more bad apples. Your entire loan is now $338,800, a massive 338 times your assets.
At the time the apples start to leak, and apple juice drains under the doors of your warehouse. You are hard-pressed to sell but you do not accept any offer below the threshold that values the total stock $1000 lower than you originally bought it for. Because if you did you are bankrupt, you only have $1000 in assets.
People from China want to buy some juice, and people in the Middle East like some juice but you refuse to sell because accepting their offer will bankrupt you. Then you receive a margin call from your lender. A margin call requires a client to add funds to its account if the value of an asset drops below a specified level. If the client can’t pay up the bank can step in and dump the shares on the client’s behalf. On this decision day, you must make interest payments, and you know it is done you have no money to pay interest on the loans and you can’t sell your apples with a loss. You know you are dead, done, homeless, credit card less, friendless…
The good ending
…however, the representatives of the socialistic republic of the United States, appear for you, like superman, and say: “hey you rotten apple trader, how much money do you need, we the representatives of the people will provide you with all the cash you need”. You smile and request an amount twice the total loan amount, to cover your late car and house payments and to start a venture capital company.