It’s A Beautiful World…

It all started with the Big-City-Man who wants to buy a house. And since he grew up in the city, he wants it NOW. But the bank is not sure if Cityman can repay. Everyone tries to avoid “risk”, right? The bank checked his “credit rating” and found him ok. The bank told Cityman, “Look, I will give you money, you can buy home. But home belongs to bank until you repay. If you default on repayment, you lose your house.” This is called a “mortgage”. Since Cityman grew up in the city, and wants to have whatever he wants RIGHT NOW, he agreed.

Now Cityman has a house to live in, and a “liability” to keep paying the bank for the next 20 years. What about the bank? The bank will keep getting money for the next twenty years, or else, they get a house which they can sell to get back the money. This is definitely “future money”. This is an “asset”. “This can definitely be sold!!”, the smart bankers got thinking. They pooled all the “future money” together, then chopped it all again into smaller asset pieces to be sold. This process is called “securitisation”, and what they created are called “Mortgage Backed Securities” (MBS) or “Collateralised Debt Obligations” (CDO). It all looked risk free, but still people did not buy. They asked, “what if the people don’t repay? what if Cityman defaults on his credit?”

In comes more finance wizards called insurers. “Give me a percentage of the EMI. In return, in case Cityman dont pay, I guarantee that I will swap places with him, I will pay.”, the Insurer said. Suddenly, the CDO looked like a nice, debt free investment and people started buying them. But let us now come back to our Insurer. He has a steady stream of income, the insurance premium, which is a percentage of the EMI Cityman repays. That is an asset. What about the Insurer’s liability? What if Cityman defaults his repayment? Well, that is unlikely, Cityman has a good credit rating. So the Insurer decided to “securitise” his asset and sell it. He created the “Credit Default Swap” (CDS)!!!

If you thought things have become complex, please wait before you jump to early conclusions.

(To be continued…)