Fenil's Library

The financial biggies sold investments in other parts of the world to make up for the losses suffered in the US

Having downed fourteen cups of coffee during the course of the day, I just couldn’t sleep. The thought that diabetes would kill me one day did not help either.

It was at around four in the morning when I saw her call coming through. With sleep alluding me, and nothing better to do, I took the call of the lady I had explained the subprime crisis just a couple of days back.

“You know I have been thinking and have come to the conclusion that you did not explain the entire thing to me the other day,” the voice on the other end said.

“You have been thinking? I did not know I was so good that I could make the female of the species think,” I replied.

“Cut the crap, dumbo. You explained the entire thing about the US subprime crisis, but you did not tell me whether it led to the Indian stock market falling.”

“Oh. Why don’t you first explain to me, what the US sub prime crisis is? Let me see if you have really been thinking.”

“In mid 2003, interest rates in the United States fell to as low as 1%. People used this as an opportunity to take home loans to buy property. Since demand far exceeded supply, this ensured that real estate prices started to rise. Bankers saw lower interest rates as a chance to expand the market. They started to give out home loans to even those who would not have got home loans in the normal scheme of things. This market came to be known as the subprime market.”

“But I told you all that. You haven’t done any research of your own?” I asked.

“I have. These loans were adjustable rate home loans (ARLs) of two types. Interest-only ARLs involved paying only the interest for the first few years. This period could vary anywhere from 3 to 10 years. Only after that did the principal repayment kick in. The other kind was the payment option ARL. In this, a low interest rate was charged in the first year. Once the first year was over, the interest applicable on normal home loans was applicable. However, there were no free lunches. The unpaid interest - or, the difference between the interest rate that a sub prime borrower paid on the payment option ARL and the real rate of interest on other home loans — kept getting added to the principal outstanding.”

“I am impressed,” I said.

“Don’t interrupt. Let me continue,” the lady retorted. “So initially a lower interest rate was charged. What this meant was that the borrower had to pay a lower equated monthly installment (EMI) and this ensured that individuals borrowed. The higher EMI kicked in only after some time. The borrower thought that since real estate prices were on the rise, he would sell out before the higher EMI kicked in. However, that did not happen. Real estate prices became very high and after a certain point, people just stopped buying. What this meant was that subprime borrowers looking to sell out could not find any buyers. When they could not sell out, and a higher EMI kicked in, the only remaining option was to just stop repaying the EMI.”

“But that still does not explain why so many financial institutions went bust?” I asked.

“Oh, that’s simple. All the banks who had given out home loans securitised their loans. What they did was issue financial securities and sold them off to Wall Street firms. Every time the borrower repaid the EMI, a major portion of it was passed onto these firms. This ensured that the banks giving out the home loans did not face any risk of default. But once the home loan borrowers started defaulting big time, the Wall Street firms that had bought the financial securities ended up holding just pieces of paper,” she explained.

“Good. Now let me explain how the Wall Street crisis impacted us,” I said. “Wall Street firms invest all across the world. Because subprime borrowers started to default, these firms started to face losses. In order to make good these losses, the firms had to sell out their profitable positions in markets like India and China. When they decided to sell, there were not many buyers and so the stock markets fell.”

“And what is this leverage thing I have been hearing about?” she asked.

“Leverage is a term that finance has borrowed from physics. In physics, leverage refers to a situation where in force applied at one point is converted into a greater force at some other point. Let us say you have one thousand rupees and you invest it for a period of one year and earn a return of 15% on the investment. So your investment has grown to Rs 1,150 (Rs 1,000 +15% of Rs 1,000). Now let us say you have Rs 1,000 and you borrow Rs 9,000 from me and invest Rs 10,000 in total. At the end of one year if you earn a return of 15%, your investment has grown to Rs 11,500 (Rs 10,000 + 15% of Rs 10,000). If I do not charge any interest from you, you just return the Rs 9,000 I had given you. Now that leaves you with Rs 2,500 (Rs 11,500 - Rs 9,000). Of this Rs 1,000 was your investment and so that leaves you with a profit of Rs 1,500 (Rs 2,500 -Rs 1,000). That means a return of a whopping 150%. And that’s what we call financial leverage. Nevertheless, this can work the other way as well. You invest Rs 10,000 by borrowing Rs 9,000 from me. What happens if you lose 15%? Your total investment of Rs 10,000 comes down to Rs 8,500 (Rs 10,000 - 15% of Rs 10,000). So your investment of Rs 1,000 has gone down the drain totally and from the Rs 9,000 I had given you, only Rs 8,500 is remaining.”

“But how is all this connected to the Wall Street?”

“You still don’t get it? Now we know who is a dumbo! Well, in order to spice up their returns from financial securities issued on subprime loans, Wall Street firms borrowed money, but unlike you they obviously had to pay interest on the borrowed money. But the interest they had to pay was much lower than the returns expected from investing in the financial securities. Once the sub prime borrowers started defaulting on their EMIs, the money stopped coming in. And the Wall Street firms ended up in the same situation you did in the second part of the example I gave you. Also, the lenders who had given money to these Wall Street firms wanted their money back. One of the ways to give the lenders their money back was to sell these financial securities, but by then the word had gone out and no one wanted to buy these securities. So, in order to repay these lenders, the firms had to sell their investments in other parts of the world, which led to the stock market in countries like India also going down. And those who could not repay their lenders simply went bust or were bought out at throw-away prices.”

“Hmmm. So that explains it,” she said. “You know what, let me take you out for a cup of coffee right now, and before you have a chance to say no, let me tell you, I am waiting right outside your door,” she said.

Diabetes will definitely hit me soon!

(The example is hypothetical)k_vivek@dnaindia.net

Here’s an explanation forthe current financial crisis in the US

It’s well past midnight and I am suddenly woken up by the ringing of my mobile phone. Today is one of those rare days when I have forgotten to put my phone on ‘silent’ mode.

“Why is the Wall Street going bust?” the rather feminine voice on the other end asks.

It takes me a few seconds to realise who is on the line.

“Mam. It is 2.30 am. Can we discuss this at a more appropriate time?”

“I am a ship that passes only at night. I thought you know that,” she says.

“Excuse me?” I question.

“Well. I understand things much better after midnight, is what I meant. So I will be highly obliged if you could explain.”

“Okay. This is a rather complicated question. Where do we start? You remember in the year 2000, the dotcom bubble went bust. In the aftermath of that, the US Federal Reserve started to cut interest rates.”

“Let me interrupt. What is the US Federal Reserve,” she asks.

“The US Federal Reserve is similar to the Reserve Bank of India. It is the central bank of the country and one of its tasks is to set interest rates. Therefore, after the dotcom bubble went bust, the Federal Reserve started to cut interest rates to ensure that the economy did not go into recession. By cutting interest rates it wanted to ensure that people continue to borrow and consume and hence the economy continues to grow.”

“Interesting. But don’t you think you are deviating from the point. I want to know about Wall Street not the US Fed.”

“Patience, my dear. The long-term interest rate was reduced to 1% by the middle of 2003. That is where it stayed for around the next twelve months. With the interest rates at such low levels, people started to borrow to buy homes. The idea behind this was very simple. The rate of increase in the value of the house would be more than the interest rate to be paid on the loans that had been taken. As more and more people started to believe in this, the home prices in the US started to rise at a very fast pace.”

“Where is this heading yaar. First you talk about the Fed, now you are talking about homes. I want to know about the Wall Street,” she screams on the phone.

“Don’t interrupt. Let me continue. Low interest rates, combined with the belief in the idea that house prices will continue to go up, fuelled another bubble. Banks and other financial institutions that gave out home loans decided that it was a good opportunity to expand the market. So they decided to give home loans even to those individuals who were not creditworthy enough and would not get a loan in the normal scheme of things,” I explain.

“Hmmm. This is getting interesting, though we are still nowhere near Wall Street.”

“In a way the home loan lenders themselves believed in the bubble and hence gave out home loans to individuals who were not creditworthy. Such borrowers are referred to as the sub-prime borrowers. In order to attract these borrowers, banks offered home loans with teaser rates. The interest rates would be lower in the first couple of years. This would mean a lower equated monthly instalment (EMI) to pay off the loan. In the later years, a higher interest rate would kick in and that would mean a higher EMI. The borrower was completely sold out to the idea of housing prices continuing to go up and he planned to sell the house to make a profit before the higher EMI kicked in.”

“But by following this strategy, weren’t banks taking in a huge amount of risk?”

“Yes and no. One the face of it, yes it was a risky strategy. But banks and other financial institutions giving out home loans were smart enough to get out of these loans very quickly by securitising them,” I reply.

“Wait a minute. What is this securitising thing you are talking about,” she asks.

“What they essentially did in case of securitisation was bundle similar kinds of home loans together and make financial securities out of it. These financial securities were then sold to savvy financial investors, most of whom were based out of Wall Street in New York. By selling the financial securities, the bank or the financial institution giving out the home loan did not continue to carry any risk. At the same time, it freed up the money and the bank could lend again. A major part of the EMI paid by the borrower was passed on to the financial institution that bought these securities.” “But why did Wall Street financial institutions buy these securities,” she questions.

“They bought it because these securities offered higher returns than other modes of investment available. But they were just investors. They failed to realise the true risk of these securities. The bank or the financial institution giving the loan was best placed to assess how risky a particular loan was. But since it was in a position to securitise the loan, it was only interested in giving out more and more loans, and not assessing the risk involved. Other than this, documents of a lot of sub-prime borrowers were fudged to give them loans that were well beyond their capacity to repay. Initially, with low interest rates, these borrowers continued to repay, but once the teaser rates were over and higher interest rates set in, they simply could not repay and started to default. Once the borrowers realised that they wouldn’t be able to continue to repay, they started to sell the property. But, with a lot of selling hitting the market at the same time, there were not enough buyers and this ensured that housing prices started to fall,” came my long wielding explanation.

“Ah. Now I seem to get it. With higher interest rates setting in, sub-prime borrowers started to default. Once this happened, all the Wall Street financial institutions that had invested in these securities stopped getting their money back. And once more and more borrowers started to default these hallowed institutions went bust. Wow, in hindsight, everything seems so explainable,” she exults over the phone.

“Yes Mam. Now that you have understood, why don’t you think about it and I’ll go back to sleep.”

(The example is hypothetical) k_vivek@dnaindia.net