The US $ 700 bailout package proposed by the US government is one of the most extensive government interventions in the financial markets since the great depression. The bailout plan is similar to the 1933 Home Owners' Loan Corporation of the post-depression era. Way back in 1933 it helped in stopping foreclosures and refinance defaulting mortgages , and increasing liquidity. That a similar proposal is being considered indicates the extent of damage caused to the banking and financial services systems all over the world.
But how did the banks and investment banks create this crisis? Let's cut through the financial jargon and understand in simple words how this problem was created in the first place. The root cause for the current crisis seems to be the excessive use of leverage.
But how did the banks and investment banks create this crisis? Let's cut through the financial jargon and understand in simple words how this problem was created in the first place. The root cause for the current crisis seems to be the excessive use of leverage.
Excessive leverage:
To take an example, a company with a net worth of US$ 25 billion borrowed 26 times its net worth and creates leveraged funds of US$ 650 billion to invest or lend them. When a small portion of the company's investments turns bad, as is the norm for the industry, the company's capital is under threat. To put things in perspective a 3.8 percent misjudgment in their books was enough to wipe out their shareholders' capital of $ US 25 billion.
Bad lending policies:
In 2005-07 the property markets were on a high growth path. The property prices kept increasing. A sense of complacency had set in the real estate markets . It was assumed that the residential property prices would keep increasing forever. Mortgage lenders relaxed lending standards. Billions of dollars of sub-prime loans were to given borrowers with the sketchiest credit histories on recommendations of mortgage brokers who were more interested in their commission. Loans were structured very innovatively. Some gave borrowers the ability to skip repayments and some had interest rates that rose over the life of the loan. Lenders were not worried about repayments as defaults if any, on loans, could be recouped from the property itself.
Contrary to this assumption, the property bubble burst leading to sharp depreciation in property prices. As loans were given to people who could not repay it in the best of time, mortgage repayments defaults kept increasing, triggering off a chain of events that led to the bankruptcies of the hallowed institutions of Wall Street.
Contrary to this assumption, the property bubble burst leading to sharp depreciation in property prices. As loans were given to people who could not repay it in the best of time, mortgage repayments defaults kept increasing, triggering off a chain of events that led to the bankruptcies of the hallowed institutions of Wall Street.
Financial engineering:
Now you may ask how investment banks of the Wall Street who generally deal in investments in stocks, bonds and commodities have anything to do with mortgage loans. To understand this we move into the realms of financial engineering. Wall Street investment banks purchased the mortgages from the banks. This freed up banks' funds to lend more and gave the investment banks an underlying asset to create their financial magic.
Using these assets as collateral, they created derivative instruments and sold them to various institutional investors like hedge funds, pension funds, mutual funds and banks in all parts of the globe, including Europe and Asia. The instruments were to be redeemed as and when mortgage payments were received from borrowers.
The mortgages were categorised according to their quality. The good ones were pooled together under one derivative instrument. After being highly rated by credit rating agencies and insured from insurance companies these instruments were sold to institutional investors. The second quality ones got lower ratings, but nevertheless could be sold off with higher interest rates. The investment banks decided to keep the junk quality ones with themselves under separate companies called special purpose vehicles (SPVs) paying them the highest interest rates.
In all there was approximately US$ 1 trillion invested in these securities. Things were cruising along as long as property prices were on an upward trajectory . Once the tide turned the echo of defaults were heard far and wide. The value of mortgage-backed securities fell sharply. All institutional investors that had bought these highly-rated bonds in large volumes expecting a good rate of return now faced complete erosion of capital.
Using these assets as collateral, they created derivative instruments and sold them to various institutional investors like hedge funds, pension funds, mutual funds and banks in all parts of the globe, including Europe and Asia. The instruments were to be redeemed as and when mortgage payments were received from borrowers.
The mortgages were categorised according to their quality. The good ones were pooled together under one derivative instrument. After being highly rated by credit rating agencies and insured from insurance companies these instruments were sold to institutional investors. The second quality ones got lower ratings, but nevertheless could be sold off with higher interest rates. The investment banks decided to keep the junk quality ones with themselves under separate companies called special purpose vehicles (SPVs) paying them the highest interest rates.
In all there was approximately US$ 1 trillion invested in these securities. Things were cruising along as long as property prices were on an upward trajectory . Once the tide turned the echo of defaults were heard far and wide. The value of mortgage-backed securities fell sharply. All institutional investors that had bought these highly-rated bonds in large volumes expecting a good rate of return now faced complete erosion of capital.
The jigsaw puzzle:
So, now, if we look at it as a giant jigsaw puzzle we have many independent pieces. One, a home owner who borrowed a loan; second , a mortgage lender who sold off his loans as income streams; third, an investment bank that purchased and re-engineered them; fourth, an insurer who through credit default swaps insured these debtbacked securities; and finally a bond holder who invested in these highlyrated instruments.
Now, due to defaults by homeowners all institutions up the chain are already bankrupt or facing bankruptcies.
Now, due to defaults by homeowners all institutions up the chain are already bankrupt or facing bankruptcies.
Bailout to the rescue:
This is where the bailout plan is expected to solve the problem. The US government wants to buy mortgages and bonds from these near bankrupt companies with taxpayers' money. The plan as of now seems to be, after acquiring them at steep discounts, to hold them till maturity.
If all mortgages are paid back in full, the government can earn a handsome return on the taxpayers' money. This move will also help banks remove these illiquid assets from their balance sheets and free up the funds to be lent again, hopefully to good borrowers.
While experts seem cautiously optimistic that this bailout will solve the credit crisis to a certain extent, questions remain on whether it can prevent more failures of banks and Wall Street firms.
If all mortgages are paid back in full, the government can earn a handsome return on the taxpayers' money. This move will also help banks remove these illiquid assets from their balance sheets and free up the funds to be lent again, hopefully to good borrowers.
While experts seem cautiously optimistic that this bailout will solve the credit crisis to a certain extent, questions remain on whether it can prevent more failures of banks and Wall Street firms.
