It’s A Beautiful World…

Cityman now has a house to live in, a good job, more income, therefore a loving wife and his kids are growing up. He starts thinking of retirement. So he saves up, and uses all that money to invest in MBSs, CDOs and CDSs that the bank is selling. He also buys some bank shares. He hopes to enjoy his retirement with the return from his investments.

The bank had some money initially, which it got by selling shares (to various City-dwellers). Bank lent this to Cityman to buy his house. Then Bank got that money back when it sold the CDSs. So what does Bank do with that money? Bank lends it to Cityman’s neighbour.

Bank manufactures even more CDOs and gets back that money too. Now they have a problem. Everyone in Cityman’s street has a nice home. So Bank cant lend to them anymore. What about Poorman living in Poor Street? But he is poor. He doesnt have a steady job. He cannot repay his loans. He has a poor “credit rating”. So no credit to Poorman.

Then one day, Banker took a walk down Poor street. “Shit, Poorman got so many friends. Maybe they got poor credit rating, but this is too huge a market to ignore.” So Bank told Poorman, “Look, I will give you money to buy house. But you have a credit rating that is below *prime*, so you have to pay me more interest than the average cityman.” This was the beginning of “sub prime” lending.

Everybody in the City started buying houses. There were not enough houses and real estate prices began to go up. You can build a house for 200 coins, so that’s what the house is worth. But when you sell it, suppose you ask for 250 coins. Do you think I will buy it? Of course, I will, because next month it will be worth 300 coins. Actually, this story can continue as long as everybody believes that prices will keep increasing, and soon houses were being sold at 600 coins.

Meanwhile, Bank securitised and sold Poorman’s mortgages too, but this time at higher prices. This is because Poorman is paying a much higher interest than Cityman.

Now what would you see, if you took a look around. Every Poorman, Cityman and Harry was buying houses. The price of those houses were also rising. Bank was getting more loan applications. Bank was selling more CDOs and they were earning more interest. Insurer was selling more Credit Default Swaps. Cityman retired and was living off the return from his investment in all these 3 letter words. What a beautiful world! Everybody seems to be happy.

Or so it seemed…

(To be continued…)