Saturday, February 28, 2009

Financial Crisis - Beautifully explained

I came across this interesting article by an IIT Bombay student. This explains the financial crisis in terms which anyone can understand and also manages to put the whole picture together. You can read the whole article at http://rahuldash.blogspot.com/2008/10/financial-crisis-101.html Am reproducing the post here for easy reference.


The Fall of the Wall


After every major newspaper and publication in the world has used every possible adjective to describe an occurrence, with every single person having read at least a part of it, what new, is a student newsletter of a technical institute going to offer?

Well, very frankly, nothing. This article is about the worst financial crisis to have hit the global markets, not to mention the most complex one too. It has been written by a group of undergraduates who are majoring in a discipline as different from finance as Ridley Scott is from Kanti Shah. Yet, we thought we should write this, not because we know more, but because it would help us put forward our grossly simplified thoughts on this highly complicated problem and through discussion with our readers, would help us to better our level of understanding.

If anyone finds anything unclear (even after googling :P), please feel free to contact me on my email id

So you wake up every day, pick up the newspaper and read almost the same headline that you read the day before. A carefully structured juxtaposition of the words “Wall Street crisis”, “Subprime Mortgage”. “Credit Crunch”, “Lehman Brothers”, “Fed, Treasury” and recently, “Bailout, $750 Billion”. And it makes one wonder, what the hell is all of this? And how did things get so bad?

Why the housing sector?

In the US, owning a house is considered to be the best investment a person can make. The US government encourages people to buy their own house by providing incentive in the form of tax cuts on the mortgages paid by them. Further, a person can use his house as an “ATM card”, drawing credit based on the value of his house. Now post the dot com crash, in 2001, Alan Greenspan, then Chairman of the US Federal reserve bank, slashed the interest rates (down to 1%) This, combined with the encouragement provided by the US government to buy houses, made people in the US borrow a lot of money (in the form of loans, with a very low interest rate) Mortgage institutions also took advantage of this huge demand of loans by providing a large number of the now notorious “subprime mortgage loans”


Wait! Subprime what?


Usually, when you take a loan from a bank, you need to show your credit history, whether you have defaulted in the past or not. You also need to provide something known as collateral (an asset that can be taken over by the bank in case you default) You also need to show that you have a job with a steady income. A subprime loan is a loan that is given to a person with a bad credit history, with nothing to show as collateral (except the house that the person would buy with the money) and in many cases, with no job too. Now why would an institution give such a risky loan? Two reasons. Firstly, during the period 2002 to 2005, the US housing market was undergoing a tremendous boom. This means that a house that was bought for $100,000 today would be worth, say $150,000 in a year’s time. Hence a mortgage institution could always take control of the house, in case the person defaulted, and could sell it at a profit. Secondly, the banks would charge a higher interest rate on a subprime loan. Note that the incredible numbers of subprime loans were made based on this one assumption: The price of houses would keep on increasing.

Sounds good…

But wait, it gets better. The loans that were made by the mortgage lenders were further bought by two giant institutions; the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) These are private institutions with a high level of government backing. Normally, if a mortgage institution gives a loan of $100,000, it would recover back an amount of say $150,000 after a period of say 20 years, via monthly payments made by the borrower. But the institution’s money would be “stuck” for 20 years. Enter Fannie and Freddie. They buy these loans from the institutions for say $120,000 and then recover the amount of $150,000 themselves, earning a profit of $30000 in the process. And these giants need not worry that their capital gets “stuck” for a long period of time, since they sell what are known as “ Mortgage Backed Securities” ( similar to stocks) to the common investors. A part of the $30,000 profit that they earn is given away as dividend to these investors.

Cool. But how do investment banks come into the picture? And what are these CDOs we keep hearing about?

Now comes the most “beautiful” part of it all. Seeing a nice opportunity to earn some large amount of money, the large Wall Street investment banks also got into the picture. These I banks bought the risky subprime loans that were made by the mortgage institutions. They then made packets of these loans (securities) that could be traded. Now, securities are rated by rating agencies according to the chances that the underlying assets will be defaulted upon. U.S. Treasury bonds, for example, get AAA+ ratings because of the negligible amount of risk associated. Enter a special type of security called the Collateralized Debt Obligation (CDO) A CDO takes these subprime loans and slices them up into “tranches” (like layers) The upper layer consists of loans that are least likely to be defaulted upon and so on. These upper layers got AA+ ratings from the rating agencies; the lowermost layers got BB-. Investors who wanted lesser risk (and were ok with lesser returns) went for the AA+ rated parts, the risk takers went for the high returns yielding BB- parts. Thus, the I banks were able to form AA+ securities from absolutely risky, subprime loans. Brilliant! Further, investors bought insurance on these securities. The insurance companies (like AIG) were more than happy to sell a large number of insurance products to people to protect them against possible losses due to the securities failing. Insurance companies kept on making out these insurances far beyond their covering capacity. Companies started insuring any kind of big loan with the guarantee of coughing up the cash should the loaner default. Just like mortgage-backed securities, these instruments (technically called Credit Default Swaps or CDS) were being bought and sold on the market at high premiums and companies who were dealing in them were raking in the profits. And what was the risk involved in these transactions? A CDO could not fail unless there was a total collapse of the system, which could happen only if a large number of the loans could not be recovered, which could happen only if the underlying collateral also failed, giving the mortgage lenders no option but to give up. And that wasn’t supposed to happen…since the assumption that “the price of houses in the US would keep on increasing” still held ground.

Fabulous! So why didn’t this romance last forever?

All this was fine till the day the housing market went crashing. Thousands of people began to default on their loans. The insurance companies and the buyers of credit default swaps, needless to say, did not have the cash to cover the claims. The investment banks—the Bears Stearns and the Lehman Brothers of the world had gone deep into mortgage-backed securities or the credit default swap markets. As a result of years of high-paying lobbying initiatives, the investment banks had made sure that they operated under the minimum of controls and oversight, freeing them to take unreasonable risks while investing. Now, when the system went bust, the only way these banks could have survived was by borrowing a lot of cash from the market and getting rid of their obligations based on CDOs and CDSs. However, Wall Street firms refused to trust one another. Banks had become extremely tight when it came to credit. No money was available. The great, 158 year old Lehman Brothers filed for bankruptcy. Bear Stearns narrowly avoided that by getting bought out by JP Morgan, along with the Fed’s backing.

Merrill Lynch was bought by Bank of America. Fannie Mae and Freddie Mac as well as AIG were deemed too important to be allowed to collapse, and were rescued (and nationalized) by the US Treasury. Morgan Stanley and Goldman Sachs ditched their sole I banking existence and adopted the consumer banking + I banking model. Washington Mutual, an US bank, collapsed, resulting in the largest banking failure in US history. Citigroup, UBS and others had losses amounting to billions of dollars.

Wall Street had changed, forever.

After spending around a trillion dollars of American tax-payer’s money to bail out some of the above mentioned organizations, the US Treasury came up with a plan, asking for $700 billion to buy the underlying “toxic” bad loans and attack the problem at its root. After much political deliberation, the plan has been accepted by the US government. It remains a huge question whether this plan would help, or will we be pushed into an extended period of financial mayhem. It is unfortunately a question too difficult (and risky) to answer.

-Rahul Dash


P.S. Some major institutions that fell and their effect on the job scenario, especially in India :

Lehman Brothers

Filed for bankruptcy due to unavailability of funds to continue daily market operations.US ops sold to Barclays. Indian ops to Nomura Asst Mgmt, a Japanese co. Most employees expected to be retained. Top talent to be retained on existing payscale.


Merrill Lynch

Sold to Bank of America for $50 billion. 600 Indian employees. Future uncertain but not many layoffs expected due to non-overlap of BoA and Merrill’s ops.

Bear Stearns: Sold to JPMorgan


Fannie Mae and Freddie Mac
nationalized

AIG nationalized


Washington Mutual
sold to JPMorgan in the largest banking failure in US history


Wachovia
sale caught in a legal battle between Citigroup and Wells Fargo

3 comments:

chachi said...

Check this one out too:

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=1

chachi said...

booga

abhinav said...

thanks chachi..

http://crisisofcredit.com/

is another link. This is a video.