Thank You The Article really made the picture very clear. However I wonder why The FED rescued most of the other firms, but let Lehman one of the leading IB collapse?
Thanks & Regards, Swapnaj On Fri, Sep 26, 2008 at 10:11 PM, ekam ber <[EMAIL PROTECTED]> wrote: > > Why Did Lehman Go Bust And What Exactly Is Subprime? > > > Some layman explanation for wat happened to Lehmann Brothers... > > US mortgage crisis: A subprimer > > > Q: What is a sub-prime loan? > A: In the US, borrowers are rated either as 'prime' - indicating that they > have a good credit rating based on their track record - or as 'sub-prime', > meaning their track record in repaying loans has been below par. Loans > given to sub-prime borrowers, something banks would normally be reluctant > to do, are categorized as sub-prime loans. Typically, it is the poor and > the young who form the bulk of sub-prime borrowers. > > > Q: Why loans were given? > A: In roughly five years leading up to 2007, many banks started giving > loans to sub-prime borrowers, typically through subsidiaries. They did so > because they believed that the real estate boom, which had more than > doubled home prices in the US since 1997, would allow even people with > dodgy credit backgrounds to repay on the loans they were taking to buy or > build homes. Government also encouraged lenders to lend to sub-prime > borrowers, arguing that this would help even the poor and young to buy > houses. > With stock markets booming and the system flush with liquidity, many big > fund investors like hedge funds and mutual funds saw sub-prime loan > portfolios as attractive investment opportunities. Hence, they bought such > portfolios from the original lenders. This in turn meant the lenders had > fresh funds to lend. The subprime loan market thus became a fast growing > segment. > > Q: What was the interest rate on sub-prime loans? > A: Since the risk of default on such loans was higher, the interest rate > charged on sub-prime loans was typically about two percentage points higher > than the interest on prime loans. This, of course, only added to the risk > of sub-prime borrowers defaulting. The repayment capacity of sub-prime > borrowers was in any case doubtful. The higher interest rate additionally > meant substantially higher EMIs than for prime borrowers, further raising > the risk of default. Further, lenders devised new instruments to reach out > to more sub-prime borrowers. Being flush with funds they were willing to > compromise on prudential norms. In one of the instruments they devised, > they asked the borrowers to pay only the interest portion to begin with. > The repayment of the principal portion was to start after two years. > > Q: How did this turn into a crisis? > A: The housing boom in the US started petering out in 2007. One major > reason was that the boom had led to a massive increase in the supply of > housing. Thus house prices started falling. This increased the default rate > among subprime borrowers, many of whom were no longer able or willing to > pay through their nose to buy a house that was declining in value. Since in > home loans in the US, the collateral is typically the home being bought, > this increased the supply of houses for sale while lowering the demand, > thereby lowering prices even further and setting off a vicious cycle. That > this coincided with a slowdown in the US economy only made matters worse. > Estimates are that US housing prices have dropped by almost 50% from their > peak in 2006 in some cases. The declining value of the collateral means > that lenders are left with less than the value of their loans and hence > have to book losses. > > > Q: How did this become a systemic crisis? > A: One major reason is that the original lenders had further sold their > portfolios to other players in the market. There were also complex > derivatives developed based on the loan portfolios, which were also sold to > other players, some of whom then sold it on further and so on. > As a result, nobody is absolutely sure what the size of the losses will > be when the dust ultimately settles down. Nobody is also very sure exactly > who will take how much of a hit. It is also important to realise that the > crisis has not affected only reckless lenders. For instance, Freddie Mac > and Fannie Mae, which owned or guaranteed more than half of the roughly $12 > trillion outstanding in home mortgages in the US, were widely perceived as > being more prudent than most in their lending practices. However, the > housing bust meant that they too had to suffer losses - $14 billion > combined in the last four quarters - because of declining prices for their > collateral and increased default rates. > The forced retreat of these two mortgage giants from the market, of > course, only adds to every other player's woes. > > > Q: What has been the impact of the crisis? > A: Global banks and brokerages have had to write off an estimated $512 > billion in sub-prime losses so far, with the largest hits taken by > Citigroup ($55.1 bn) and Merrill Lynch ($52.2 bn). A little more than half > of these losses, or $260 bn, have been suffered by US-based firms, $227 > billion by European firms and a relatively modest $24 bn by Asian ones. > Despite efforts by the US Federal Reserve to offer some financial > assistance to the beleaguered financial sector, it has led to the collapse > of Bear Sterns, one of the world's largest investment banks and securities > trading firm. Bear Sterns was bought out by JP Morgan Chase with some help > from the Fed. > The crisis has also seen Lehman Brothers - the fourth largest investment > bank in the US - file for bankruptcy. Merrill Lynch has been bought out by > Bank of America. Freddie Mac and Fannie Mae have effectively been > nationalized to prevent them from going under. > > Q: How is the rest of the world affected? > A: Apart from the fact that banks based in other parts of the world also > suffered losses from the subprime market, there are two major ways in which > the effect is felt across the globe. First, the US is the biggest borrower > in the world since most countries hold their foreign exchange reserves in > dollars and invest them in US securities. > Thus, any crisis in the US has a direct bearing on other countries, > particularly those with large reserves like Japan, China and - to a lesser > extent - India. Also, since global equity markets are closely interlinked > through institutional investors, any crisis affecting these investors sees > a contagion effect throughout the world. > > > > > > > --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups "Kences1" group. To post to this group, send email to [email protected] To unsubscribe from this group, send email to [EMAIL PROTECTED] For more options, visit this group at http://groups.google.com/group/kences1?hl=en -~----------~----~----~----~------~----~------~--~---
