Good Article

Some layman explanation for what happened to Lehmann Brothers. Even though we had been hearing these terms incessantly over the last many months, didn't really have a clue what was going on. In case you happened to be in the same boat, please read the article carried by TOI (Delhi Edition) in their 'Learning With The Times' section. Explains a lot. For starters what is prime and subprime:)
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.
Reports suggest that insurance major AIG (American Insurance Group) is also under severe pressure and has asked for a $40 bn bridge loan to tide over the crisis. If AIG also collapses, that would really test the entire financial sector.
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.
Financial Crises - A simplified versionSo let's go through it step-by-step, from the beginning until this weekend when the Government announced a $700 billion bailout of the financial services industry. It's our tax dollars that will be financing this bailout so I think it's important that we all understand how and why it happened.I. It all started in the housing and mortgage market:Basically, lenders were loaning money to whoever wanted to buy a home. Credit score, income and assets became irrelevant terms as brokers and local lenders rushed to issue new mortgages.It seemed like a relatively "low risk" strategy at the time to many banks. Reason being, they figured that even if people stopped paying their mortgages, the housing market was doing so well that folks could just sell the house for a profit and pay back the remainder of the mortgage.And that's really where the trouble started.II. Then the Investment Banks Got Involved:Mortgage Backed Securities (MBS) are nothing new on Wall Street. They're sort of like bonds, meaning there's a "principle amount" (the amount being loaned) and interest coupons (or payments) that would be paid monthly on the loan. However, MBS's aren't single loans.Instead, these loans were really thousands of individual mortgages all pooled together to create a single, tradable security.This is another reason why many lenders were happy to keep giving out mortgages to folks (even if they didn't qualify). Local lenders knew that they'd be able to package up all those mortgages and just sell them right to the big investment banks and not have to worry.The banks then turned around and would trade these Mortgage Backed Securities like they would a stock or a bond - trying to pocket profits in between each trade.III. BubblesThe basic assumption in this whole mess was that housing prices would continue to rise each year. In fact, that assumption turned out to be pretty accurate. According to the S&P Case-Schiller Index, home prices nearly doubled across the country from 2001 - 2006.That's because it was so easy to get a mortgage, everybody wanted to buy a home. Thus spurring demand and in turn driving up prices further. It sort of became a self fulfilling prophecy, which in turn became a full-fledged housing bubble.And just like any good bubble, it eventually had to pop!IV. The "After-Pop"So after the housing market finally started to tumble, the financial services industry went into a year-long death spiral. Here's the basic sequence of events:
1. People couldn't afford their mortgages anymore. 2. They couldn't sell their homes for more than they paid due to falling prices 3. So they defaulted on their loans - this happened to millions of people! 4. The big investment banks which now owned all the mortgages suddenly realized that these "assets" were virtually becoming worthless in a very short period of time.
5. So the banks had to take massive write-downs on these loans. The way this works is the banks were considering these baskets of mortgages as assets on their balance sheets. Once the assets went from being worth $100 to $1, the banks basically lost 99% of their value.
6. When that happened it made it very difficult for the banks to get loans themselves (imagine applying for a loan when all you have is a pack of bubble gum and the clothes on your back - it's not likely to happen).
7. When the banks couldn't get their own loans they were either going to be forced into bankruptcy (Lehman Brothers) or had to be swallowed up by healthier firms (Bear Stearns, Merrill Lynch, etc.)
V. How the Government Got InvolvedEver since Bear Stearns went under the government has played a fairly prominent role in this whole mess.But it wasn't until we almost saw the implosion of Fannie Mae and Freddie Mac that the government really made its presence felt.Fannie Mae and Freddie Mac are sort of like "buyers of last resort" in the mortgage market. They were established to maintain liquidity in these markets in the event of the large banks being unable to trade their Mortgage Backed Securities.So in the end, Freddie and Fannie were sitting on trillions of dollars in bad home loans.And while these companies were private organizations they were however government sponsored organizations. So if the government had let either one of these companies fail then it might've made it very difficult for the United States to keep selling debt to big foreign buyers, like China . Remember, it's our ability to sell our debt to other countries that has been funding our country's operations (e.g. wars, etc.) for the last several years.VI. How AIG and Insurance Fit InAIG came into the picture when it began selling "insurance" to the big banks.This technically wasn't insurance, but that was mainly due to clever wording on the part of AIG management. Because for all intents and purposes, they were basically insuring the mortgages held by the banks - this type of insurance was called a "Credit Default Swap", or a CDS.Basically, the banks would pay AIG a monthly fee and in turn AIG would promise to make the bank whole on any mortgages that defaulted (sure sounds like insurance to me).At the time I'm sure this sounded like a good idea because everybody assumed housing prices would continue to rise.Well we all know how that turned out and that's why in the end AIG was left holding the bag for billions of dollars in bad loans.VII. The BailoutSo that brings us to where we are today: On the eve of the largest government bailout of the private sector in the history of this country.The implications for these actions are vast and complex.On the one hand, the government has to do this; the alternatives are too disastrous to even comprehend. On the other hand, what type of message does this send to the banks going forward? That it's ok to engage in risky, reckless behavior and they'll always get bailed out in the end?
Article by Wayne Mulligan