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