Decoding the world - through finance

Today at office we had a session on 'Sub Prime Lending'. While the topic sounded interesting, my previous experience at such sessions, made me think twice. Anyway, the presenter seemed to know a lot about this, and did a neat job of explaining it to the ones who didn't. If you're among the ones who has often wondered what the fuss about 'Sub Prime' is all about, and if the world is coming to and end because of this, you're pretty close - or at least thats what the presenter seemed to believe... Let me try to explain this as best as I can remember it, because, its a whole lot of mess to remember in 1 hour. And having finished 'Snapshots from Hell' just a day before, I can probably relate to what Peter Robinson was trying to say.

The players: Borrowers (the ones who started the rut), Sub-prime mortgage lenders (and these guys took it forward), the i-Banks (who decided to give it a new shape, and take it still ahead) and people again (after all, what goes comes, albeit to the wrong address).

So, how did it all start?

By the year 2003 or so, The grand old man of America 'Alan Greenspan' stabilized the market, lowered the interest (to as low as 1%) and took some decisions which succeeded in bringing the recession to an end, but which also probably set the wheels in motion for another likely recession. So, with the interest rates being so low, there was hardly any investment from the people.

What do the lenders do?

In order to get some business, they decide to give out loans to just about anyone who might be interested (including the NINJA's - 'No Job No Income' category). But you don't expect them to pay up huge EMI's rite. So the mortgagers come up with a scheme, where the borrower needs to pay a very low interest for the first 2 years (as low as 3% or so, which apparently even the jobless people could pay), and after the two years the interest rates shoot up to something like 10-11% (this is based on the LIBOR rates).

And the borrowers think...

Maybe I'll pay the interest for the two years, and then try and sell off the house at the end of the second year (the real estate market was on the rise) and pay off the loans. That way, I'll make a good profit with hardly any investment. In the worst case, the property would be taken over by the bank. Pretty smart thinking huh?

And then step in the mortgage lenders..

These guys are now having good business, but then they realize they're dealing with people who can't be totally trusted to pay the money. So, they decide to pass on the risk,and bring in the Investment banks. They create a financial instrument out of this called the 'Mortgage Based Security'. In simple terms, they got cash from the i-Banks, promising to pay them money which they expected to get from the NINJA group.

But hey, the i-banks can't possibly be that dumb right...

After all the pay a whole lot of money to recruit the best B-School grads from all over the world... So, they decide to pass on the risk... to just about anyone who wants to take it. They create another financial product out of it called the CDO (Centralized Debt Obligation). Hmm... , but it can't be just that simeple right??

In come the rating agencies...

The Investment banks creates an instrument, showing it to comprise 80% good loans, 10% mezzanine (loans which can't be totally trusted, but are pretty safe in any case) and 10% bad loans (loans given to the NINJA's). The rating agencies, who need business from the i-banks, tend to ignore the mezzanine and bad loans, and give it a high rating based on the good loans. So, now what u have is a very good looking and prospective financial instrument.

Ok, so far so good.. But what next??

A lot of these i-Banks have a hedge fund arm, which is a ready market to buy the CDO. And how is the price fixed for these? Its based on what the i-Bank decided to peg it at... And how do they do it? Based on the underlying - the loan (which is actually the bad loan that is worth nothing). And the hedge fund then sells it off to anyone who is willing to buy it. Then just to complicate matters further, there are some instruments called CDS (Credit Dwfault Swap), which is like an insurance for the loan, which is given out by the hedge fund company (which still makes sense). But then there are others who give insurance for this CDO (peopl who are in no way related to / own the CDO), and so on and so forth, derivates are created and recreated...

So, what brought the happy story crashing down??

Two things... 1) A majority of the bad loans were made out in the year 2005. So two years down in 2007, when they have to sell off the property,they realize the market is suddenly turning bad, and so a huge number of loan defaults surface.. 2) Morgan Stanley (or one of the cmpanies) realizes that something is going wrong here,and offloads a large amount of CDO's in the market... This creates a chain reaction, and suddenly there is no market for the CDO's, with practically millions of CDO's and CDS' floating around. Add to this, many small time insurance firms have insured products for which they have no money to pay. And so that matters don't go out of hand futher, the banks finance these insurance companies so that it looks hunky-dorey... But for how much longer? Banks are taking huge losses, and its just expected to get worse...

Did, u say its just the US?

There's a fire in the forest and u expect to be safe in ur cabin in the woods?? The European market has been equall badly hit, and the Indian market, while mainting its position thanks to strong fundamentals in the market, is beginning to feel the effect. With the dollar rate going down, the RBI has increased CRR rates, which mean fewer loans and has bought 35B worth of USD, to stabilize the rates... And the industries are just showing the effect...

Ok, thats a pretty long explanation. But thats a whole lot of mess too....