Very good Info on what went wrong and who is responsible
While some blame the greed of Wall Street investment bankers and the
dangers of a totally unregulated system for the current financial crisis,
what can't be denied is that lives, and lifestyles, have been suddenly
changed across the social spectrum and careers built up over a lifetime have
vanished in an instant.
*Flashback to year 2003:*
Rohit (name changed to protect identity), a good friend of mine and
someone who was officially considered to be a genius with an IQ of 150+,
graduated from one of the leading IIMs. Rohit managed to make it into the
New York Headquarters of the most sought after firm that had arrived on
campus for the first time - Lehman Brothers - a top U.S. Investment Bank
(then). On joining, he was assigned to Lehman's mortgage securities desk
that dealt with Collateralised Debt obligations (or CDOs).
Following is an extracted transcript of a chat session I had with Rohit
back in 2004:
Me: So man, you must feel like you are on top of the world.
Rohit: Yes dude, the job here is amazing, I get to interact with people
around the world, investment managers who want to invest millions of dollars
Me: Great...so tell me something interesting. What's your job all about?
Rohit: You know there is a great demand for American home loans, which
we buy from the U.S. banks. We then convert these into what is called as
CDOs (Collateralised Debt Obligations) . In plain English, this refers to
buying home loans that banks had already issued to customers, cutting them
into smaller pieces, packaging the pieces based on return (interest rate),
value, tenure (duration of the loans) and selling them to investors across
the world after giving it a fancy name, such as "High Grade Structured
Credit Enhanced Leverage Fund".
Me: Wow! I would've never guessed that boring home loans could transform
into something that sounds so cool!
Rohit: Hahaha...actually we create multiple funds categorised based on
the nature of the CDO packages they contain and investors can buy shares in
any of these funds (almost like mutual funds...but called
Structured Investment Vehicles or SIVs)
Me: Dude, you make your job sound like a meat shop...chopping and
packaging. So, in effect when an investor purchases the CDOs (or the fund
containing the CDOs), he is expected to receive a share of the monthly EMI
paid by the actual guys who have taken the underlying home loans?
Rohit: Exactly, the banks from whom we purchased these home loans send
us a monthly cheque, which we in turn distribute to the investors in our
funds
Me: Why do the banks sell these home loans to you guys?
Rohit: Because we allow them to keep a significant portion of the
interest rate charged on the home loans and we pay them upfront cash, which
they can use to issue more home loans. Otherwise home loans go on for 20-30
years and it would take a long time for the bank to recover its money.
Me: And, why does Lehman buy these loans?
Rohit: Because we get a fat commission when we convert the loans into
CDOs and sell it to investors.
Me: Who are these investors?
Rohit: They include everyone from pension funds in Japan to Life
Insurance companies in Finland.
Me: But tell me, why are these funds so interested in purchasing
American home loans?
Rohit: Well, these guys are typically interested in U.S. Govt. bonds
(considered to be the safest in the world). But unfortunately, Mr. Alan
Greenspan (head of Federal Reserve Bank, similar to RBI in India) has
reduced the interest rate to nearly 1 per cent to perk up the economy after
the dotcom crash 9/11attacks. This has left many funds looking for
alternative investments that can give them higher returns. Home loans are
ideal because they offer 4-6 per cent interest rate.
Me: Wait, aren't home loans more risky than U.S Bonds?
Rohit: We have made home loans less risky now. In fact they have become
as safe as U.S Govt. bonds.
Me: What are you saying, man? What if the people who have taken these
underlying home loans default? Then the investors would stop getting the
EMIs, and their returns would take a hit. Wouldn't it?
Rohit: Boss, may be some will default, but not definitely more than 2-3
per cent. Moreover, we have convinced AIG (a leading insurance company) to
insure our CDOs. This means that even if there were big defaults, the
insurance company would compensate the investors.
Me: that's amazing. What are these insurances called?
Rohit: Credit Default Swaps.
Me: Definitely you guys are the most creative when it comes to naming.
Rohit: Thanks.
Me: And why has this AIG guy insured millions of home loans?
Rohit: See man, the logic is simple.. Home prices in the U.S always go
up. In fact over the last three years alone they have doubled. So even if
someone defaults paying the EMI, the home can be seized and sold for a much
higher price. So there is no risk. Insurance companies are actually
competing to insure this, because they can earn risk-free premiums.
Me: No wonder investment managers from all over the world want to put
money in your CDOs.
*A global financial cobweb started getting built around the American
dream of purchasing a home and it rested on the assumption that "home prices
will keep rising". As demand for the CDOs started growing across the global
investment community, the investment bankers (like Lehman) who were meant to
sell these instruments also started investing a significant portion of their
own capital in these. I guess after selling the story to the whole world,
they themselves got sold on the seemingly foolproof concept. Gradually the
markets for CDOs and Credit Default Swaps started expanding with traders and
investors buying and selling these as if they were shares of a company,
happily forgetting the underlying people behind these products who took the
home loans in the first place and on whose capacity to repay the loans, the
safety of these products depended.
As Wall Street firms like Lehman were churning more and more home loans
into CDOs and selling them or investing their own money, there was a
pressure on the banks to issue more loans so that they can be sold to the
Wall Street firms in return for a commission. Slowly banks started lowering
the credit quality (qualification criteria) for availing a home loan and
aggressively used agents to source new loans. This slippery slope went to
such an extent that in 2005, almost anyone in the U.S could buy a home worth
$100,000 (45 lakhs INR) or more without income proof, without other assets,
without credit history, sometimes even without a proper job. These loans
were called NINA - "no income no assets".
The U.S. housing market went into a classic speculative bubble. Home
loans were easy to get, so more and more people were buying houses.
The increased demand for houses caused the price to increase. The rising
prices created even more demand, as people started to look at homes as
investments - investments that never went down in value.
When I touched base with my friend Rohit in late 2005, he was on cloud
nine. During the previous one year, he managed to buy a home in Long Island
(a posh area near New York City) worth almost a million dollars, and got
himself a Mercedes. All this was interesting to hear, but what shocked me
was that although he was earning close to $20,000 a month (that is what CEOs
in India make) he was not able to save anything because his lifestyle
expenses where growing faster than his salary.
*Unheeded signals**
*
In late 2006, Mortgage lenders noticed something that they'd almost
never seen before. People would choose a house, sign all the mortgage
papers, and then default on their very first payment. Although no one could
really hear it, that was probably the moment when one of the biggest
speculative bubbles in American history popped.
Another factor that lead to the burst of the housing bubble was the rise in
interest rates from 2004-2006. Many people had taken variable rate home
loans that started getting reset to higher rates, which in turn meant higher
EMIs that borrowers had not planned for.
The problem was that once property values starting going down, it set
off a reverse chain reaction, the opposite of what had been happening in the
bubble. As more people defaulted, more houses came on the market. With no
buyers, prices went even further down.
In early 2007, as prices began their plunge, alarm bells started going
off across mortgage-backed securities desks all over Wall Street. The people
on Wall Street, like Rohit, started getting call from investors about not
getting their interest payments that were due. Wall Street firms stopped
buying home loans from the local banks.
This had a devastating effect on particularly the small banks and finance
companies, which had borrowed money from larger banks to issue more home
loans thinking they could sell these loans to Wall Street firms like Lehman
and make money.
Everyone got into a mad scramble to seize and sell the homes in order to
get back at least some of the money. But there were just not enough buyers.
The guys who had insured these loans thinking they had near zero risk (e.g.
AIG) could not fulfil the unexpectedly huge number of claims. The best part
was that since these insurance policies (credit default swaps) could
themselves be traded, multiple people had bought and sold them, and it
became so tough to even trace who was supposed to compensate for the loss.
The global financial cobweb built around mortgages is on the brink of
collapse. Firms, large and small, some young some as old as a 100 years have
crumbled as a result of suing each other over the dwindling asset values.
Lehman's India operations, that employed over a thousand staff, is up for
sale and many of the employees have been asked to leave. The Indian stock
market has crashed almost 50 per cent from its high (and so have markets
around the world) as the
Wall Street giants sold their investments in the country in an effort to
salvage whatever is good in order to make up for the mortgage related loss.
Hedge funds, pension funds, insurance companies all over the world have lost
billions in investor's money.
Many Indian B-School graduates with PPOs (pre-placement offers) in the
financial sector (India and abroad) have either received an annulment or
indefinite postponement of joining dates. IT firms that built and maintained
software for the U..S. mortgage industry or the related Investment Banks,
have shut down their business units, laid-off people or transferred them to
other verticals.
*Fragile system**
*
For all the hoopla over the sharp and sophisticated people on Wall
Street, the current financial crisis has exposed the fragility of the
system. Wall Street is blaming the entire episode on people who could not
repay their home loans. But the reality seems to point towards the stupidity
of people who lent all this money, financial institutions that built fancy
derivative packages and in effect facilitated billions in trading and
investments in these fragile low quality loans.
The U.S. Govt is planning to grant 700 billion dollars to the Wall
Street firms to compensate the financial speculators for the money that they
have lost. Isn't this like rewarding greed and stupidity? The head of a
leading Investment Bank has stated, "This is necessary to sustain financial
ingenuity. We don't want to spend this money on ourselves. We just want this
money to go into the market so that we can carry on trading complex
securities, borrowing and lending money."
(Yeah...right, so that one can act as if nothing had happened without
analyzing too much into it). The real question is: Who is going to
compensate the common investors across the world who have lost their wealth
in the resultant market meltdown? (either directly or through pension
funds).
After being unreachable for a month now, finally I heard back from my
pal, Rohit, saying he is back in India to take a break from the roller
coaster ride that he had lived through. After Lehman's collapse he has lost
his job and probably the house that he had bought by taking a hefty loan. I
really don't know whether to feel happy for him, for getting an opportunity
to learn a lesson or two from the experience or to feel sad for him for
losing his job. Maybe I'll get a better sense of things once I meet him.
*Now I know why /*_Warren Buffet calls derivatives, the financial
instruments of mass destruction! !!!!!!!!_ */*
--
Cheers,
Shuaib
--
Cheers,
Balasubramanian.
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