What just happened??

[A layman’s view to understanding the present US Financial Crisis]

 

Before we get into the events, it is important to understand certain basic terminology and mechanisms.

Mortgage backed securities – Banks have two primary functions. Accept deposit and lend loans. When a borrower approaches a bank for a loan, the bank (after due diligence of the creditworthiness of the borrower) lends him money from the funds it has accepted as deposits. The bank charges a rate of interest for the time the borrower takes to repay the loan.

Given this simple mechanism, the bank may face a problem when the market rate of interest fluctuates or when it may run out of funds for further lending at a certain point. 

In order to solve these problems the concept of mortgage backed securities was introduced. In this system, the bank issues bonds against the loan and sells it to investors at a rate of interest that is equal to the interest payable by the borrower on the loans.

For e.g, say X borrows $1,000 for a home loan at 8% interest p.a from Bank of America. The bank may sell 100 bonds worth $10 each to an investor promising an interest of 8% on the amount. This way the interest payable and receivable are cancelled out by the borrower and the investor. So basically whatever the borrower pays as interest goes to the investor as his return on investment. The problem arises when X defaults his interest payment.

Subprime lending crisis – Check out my earlier post, Crash, boom, bang!

Credit crunch – A situation in which there is a sudden reduction in the availability of loans or increase in the cost of lending by banks and financial institutions. This is usually caused when banks and institutions have suffered losses in lending and have bad debts.

Bankruptcy – A legally declared inability or impairment of ability of an individual or organization to pay their creditors. This is also known as Chapter 13 in financial circles.

Bailout – A situation where a bankrupt or nearly bankrupt entity, such as a corporation or a bank, is given a fresh injection of liquidity, in order to meet its short term obligations. Often bailouts are by governments, or by consortia of investors who demand control over the entity as the price for injecting funds. 

Housing Bubble – Is a type of economic bubble that occurs periodically in local or global real estate markets. It is characterized by rapid increases in valuations of real property until they reach unsustainable levels relative to incomes and other economic elements.

Foreclosure – Is the legal proceeding in which a mortgagee, or other lienholder, usually a lender, obtains a court ordered termination of a mortgagor’s equitable right of redemption.

 

So… what just happened?

7th September 2008 – Fannie Mae and Freddie Mac takeover

Fannie and Freddie are two very large mortgage companies that are sponsored (but not run) by the Federal Government. Their primary business is to guarantee the mortgage bonds to the investor in case payments are missed by borrowers. They also create a fund(as in insurance) to make up for losses in cases of default. This fund is created by taking a certain percentage of the payments or from sale of the house.

Since Fannie and Freddie, the Government backed institutions provided guarantee, the mortgage securities industry flourished.

When the subprime crisis started in 2007, all the defaults, bad credits and foreclosures largely affected Fannie/Freddie’s business. The two have more than $5 trillion in outstanding mortgage backed securities. The share prices hit rock bottom.

The Government had no option left but to take over the two companies and infuse money from the treasury to clean up the mess.

14th September 2008 – Bank of America acquired Merrill Lynch

ML is a large investment banking and financial firm that incurred billions (app. $51billion) in losses due to investing in mortgage backed securities that went bad during the subprime crisis. The company was recently acquired by its rival, Bank of America.

15th September 2008 – Lehman Brothers bankruptcy

Lehman Brothers is a 158 year old global financial services and investment banking company. It had ventured into mortgage backed securities and during the subprime crisis, one of its firms was closed. The company lost huge sums in the form of goodwill and its share prices tumbled. Neither Bank of America nor Barclays who were called for deals to buy the Lehman, made a bid. The Government also refused to bailout the company from bankruptcy.

16th September 2008 – AIG bailed out

AIG, the largest insurance company in the world is being bailed out by the Government. The problem is the same; loss due to subprime crisis resulting in bankruptcy. AIG’s main line of business is insurance services but the company had diversified and entered other areas including mortgage backed securities.

The Government decided to bailout AIG due to its enormous funds (trillions), public stake, global ties across industries.

 17th September 2008 – WaMu Auction

Washington Mutual or WaMu is a former mutual fund company which later became the third largest mortgage lender. In 2007, the company suffered huge losses in its home loan divisions due to the subprime crisis which resulted in layoffs and affected stock prices. Now the company has hired Goldman Sachs to take care of its auction.

 

Why this happened?

As you would have noticed by now, the answer to the ‘why’ is quite clearly the subprime crisis. Let us drill down further.

In the early years of this decade, in order to remove the sluggish nature of the economy, the Federal Reserve lowered the mortgage interest rates. This resulted in a trend of rising housing prices. Unlike traditional loan diligence, the borrowers were given loans without looking at their creditworthiness. Instead, people who were lower on their creditworthiness rating were charged a higher rate of mortgage interest. Because of the housing bubble and the high demand for loans, banks and financial companies didn’t waste their chance to make a quick profit out of the situation. Loans were endlessly given out. Very high rates were charged. These loans were in turn sold as mortgage backed securities to investors. This business picked up across companies in the financial industry and everything seemed to go well until the bubble burst.

When the interest rates reached a level where it was too high to afford by many borrowers, lot of the loans went bad. This in turn had an impact on the investments in mortgage backed securities. The demand for Fannie and Freddie guaranteed securities decreased. Foreclosures increased, house prices plummeted, and lenders incurred huge losses unable to value assets resulting in liquidation.

A major argument and an increasing realization is that there was very less regulation imposed on the financial instruments by the Federal Reserve/ Government.

 

Who gets affected?  

The real estate crisis infected the financial markets. This led to enormous job losses and money losses. The financial institutions were unable to lend money to business that really needed it to grow. This is leading to a snowball effect and is slowly hitting every industry one by one. This, coupled with the rising and highly fluctuating gas prices is resulting in a huge economic recession instead of what was hoped to be only a slowdown in the US.

Thats not all. Most of the afore-mentioned companies operate globally. They have presence in all continents. And in this global economy, a financial meltdown in the US market is bound to have far reaching impact on world markets.

 

Solutions?

The current Wall Street crisis is touted to be the biggest since the Great Depression that hit the US economy in the 1930s. It has been a chain reaction with people across industries suffering. Though the Government has been working on immediate short term relief like the economic stimulus package, it is very obvious that the economy needs a long term sustainable solution to get out of this mess.

The 2008 Presidential Elections will certainly be one of the most important of its kind in a very long time. And the policies, ideas, determination and resolve of the next President will be the crucial factors determining this election.

references

www.wikipedia.org ; www.nytimes.com ; www.spiked-online.com  

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Crash, boom, bang!

It has been a while since I posted. Just like our stock market, I crashed! The reason being the market itself. I spent few days finding out the possible reasons and how worse it could get and guess what, I am still as optimistic as ever.

The sensex is down more than 5000 points compared to the highest level it attained towards the end of 2007. Evidently it is a big blow to the traders, investors, funds, IPO’s and most of all to the tempo in the country. The Finance Minister has been trying hard to keep the optimism levels from going down far too much by assuring that our growth rate for the coming FY08-09 is posed at a very promising rate of 8.75% (There has been many statements with a different rate each time, but this one seems to be the final projection).

Now, what really happened?
Recession in the US which is caused by words declared as used the most number of times last year – “subprime crisis”, lies at the root of the problems. In simple terms, ‘subprime’ means loan given to a person who is not eligible for it, because of his low creditworthiness, income or any other unhealthy financial situation. Ironically these loans are given to the same person at a rate higher than the market(reasoning- risk involved). Since US real estate valuations were blown out of proportion and were simply not affordable by subprimes, there developed a crisis. This in turn created lot of pressure in the banking industry that indulged in a lot of subprime borrowing and did not have enough funds to lend to businesses and other consumers who needed them for growth. So slowly the economy began to dip and then crashed. Businesses didnt do well and large number of employees were laid off. Incomes and consumer demand fell and since many countries in the world depend a lot upon the US, exports being the main share of their GDP, those economies also crashed. India was among the least affected as our exports to the US are comparatively less.

There is a reason why our stock market took some time to take the hit. Towards the end of 07, there was a lot of optimism in the our market due to large purchases by institutional buyers, foreign investors, excellent performances by some large cap and mid cap companies, promises and prospects reflected by the Government and a lot of hype. This lead to an illogical overvaluation of stock prices; illogical because they were high not as a result of the company doing well but as a result of speculation. It was like a bubble that had to burst at some point in time. After the Subprime, lot of American investors started pulling away their investments from other countries. This, in hand with the rising oil prices and blow to the software industry, in terms of declining projects, employee lay off and rupee value appreciation paved way to a much needed correction.

This is more or less like a world correction and a lot of people including me are still optimistic because our nation has all eyes focussed on development and stability. This is an opportunity to buy shares of promising companies.
Corrections like these are just nature’s way of telling us not to get carried away but to focus and do things the right way!

(to read more about subprime crisis check http://en.wikipedia.org/wiki/Subprime_Crisis )