Where did all the money go?

As usual, let us look at the few financial jargons involved in this crisis

     Leveraging and Deleveraging   :   Leveraging is synonymous to borrowing. A has put up some product for sale with a selling price of Rs. 100. B has Rs. 100 with him. 

    1) B invests Rs. 100 in this product. And sells the same for Rs. 11o to someone else in the future. Rate of return – 10%

    2) B Borrows Rs. 90 and adds it to Rs. 10 from his pocket. B invests Rs. 100 in this product. And sells the same for Rs. 11o to someone else in the future. Rate of return – 100%.  (Rs. 90 goes to the lender and Rs. 10 goes as profit.) . And the remaining Rs. 90 can go in for other investments. Hedge Funds generally do this.   

         Here B tries to leverage Rs. 10 to buy something worth Rs. 100. (meaning it has borrowed Rs. 90 showing its Rs 10).         Deleveraging in the company parlance is to reduce the debt in its balance sheet.

        Credit Default Swaps  :    It is like a debt insurance. I lend some money to someone. And I take an insurance for the debt. If the borrower fails to pay, the bank covers the amount for me.  But this instrument was used (misused) like the following

                   1) Banks, Hedge Funds and other financial instituitions provided Credit Default Swaps (Insurance) without posting adequate collateral (money to pay back) if it has to pay for the debt.

                   2) CDS was started for Corporate Debts and Bonds. But CDS was later extended to Mortgage loans as well. (as there was economic boom). The mortgage loans were divided into pieces called ‘Collateralized Debt Obligations’. (CDO) – in plain English Debt backed by money. You will get money for sure.

                    3)  CDS can be used to earn higher profits through speculation. Lets say ‘A’ is an entity. There is another Company ‘C’. A thinks (speculates) ’C’ will default (fail to pay) on its Debt. A need not hold any of the debt of ‘C’. But it can get a protection cover of Rs. 100,000 for ‘C’ at a premium, lets say, of Rs. 5000 per year. (Bank levy protection cover rates like LIC premiums). What do Banks get? Premium. What will ‘A’ get? If  ’C’ defaults (one time, the first time), A gets Rs. 1,00,000. Or Scenario 2 – the next annual results of  company ‘C’ is not encouraging. ‘A’ can sell this insurance for Rs. 10000 where ‘A’ has paid only Rs. 5000 for the first year.

    Sub-Prime Lending : Loans given to people with bad credit.

How things are connected? 

                     Post 1995,IT Boom and lot of economy boom all over the world. India and few other Asian countries opening their market. Things were looking great.  Lot of DotCom Companies mushroomed. Few unworthy companies also earned lot of money in this era. One fine day, the DotCom Boom saw its end.

                     There was a financial crisis looming big. In order to curb it or contain it, many monetary measures were taken. As a result, money was becoming available for free. (at a very less rate of interest.). So people started borrowing. They wanted to invest in something which can fetch them good rate of return. Home investments looked like a great investment arena. People believed that the house rates will keep on increasing.

                       People started investing. Home rates started increasing. Banks started lending. (Mortgage Loans). Brokers and Agents started giving money to people with bad credit. There was a bubble forming. In the similar vein, lot of Credit Default Swaps (CDS) were given to lot of mortgage loans. (AIG ws a big time invester in this.). People broke these mortgage loans into pieces and sold it to other firms, fund houses in US and abroad as well. (Heard China might be deeply affected).

     What is in there for Banks who give Mortgage Loans?   If the borrower does not pay the money back, the bank would sell the property (rate is ever rising) and cover the costs.

         What is in there for bad borrower?   Borrowers in general were leveraging. They had Rs. 10 and invested in a property worth Rs. 100 believing that it would rise to Rs. 110, when they can sell.

          What is there for Banks like AIG giving CDS?  Premiums. You remember that these banks were charging for giving the protection cost. They thought that the bubble will never burst. And they did not attach the adequate collateral required for the CDS they issued.

           What is in there for Banks which bough Collateralized Debt Objects?  High returns. They thought that since the Mortgage funds were protected through CDS, they will always get their money. They never checked the paying capacity of the CDS lender.

          One fine day, people found that the supply of homes were greater than the demand. So the cost of houses started coming down. So people were shocked. Bad borrowers started defaulting. Bank was not able to confiscate and sell the property as it would incur a loss. People were no more ready to buy the CDOs. And people who wanted to buy postponed their buy expecting the prices to decrease further.

          The world spiralled down. So where did the money go? The money went into the greed of human minds. So is it possible to avoid this in the future. With more regulations, people will be able to avoid these kind of issues. But it would take a different form to hit us. After all, we are human!!

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