Then, one day, the inevitable happened. Poorman defaulted on his payment. Before you start to blame him, please go back a little. Do you remember that the Bank had first refused to lend to Poorman? Do you remember why? Because the bank thought he was incapable of repaying the loan at even the moderate interest paid by Cityman. Then what did the bank do after some time? The Bank lent to him at an even higher interest rate! So let us not act like we are surprised when Poorman defaulted.

This officially marked the beginning of the “sub prime crisis”, though nobody quite realised that at that time. Who all do you think would be affected if Poorman does not pay? First, it is the Bank which would not get back its money. Actually, it is not even Bank’s money anymore. Bank had sold it as Collateralised Debt Obligation, the CDO. Bank now has to pay interest on the CDOs it manufactured and sold. Cityman who retired and lives off the income from his investments in CDOs will now start crying. So Bank could ask the Insurer to pay. Remember that Insurer had guaranteed the CDOs against default. But it is not the Insurer who is going to pay, because Insurer had sold his liability as Credit Default Swap (CDS). So the ones who pay are those who bought the CDSs. By the way, do you know who all, other than Cityman, bought CDOs and CDSs and other 3 letter words? That include just about everyone in the world- from Singapore government and Japanese banks to European pensioners. It would seem like they would all be affected. Well actually, none of this happened. The Bank just “repossessed” Poorman’s house, sold it and paid everybody else. Except for Poorman who lost his house, everybody else was happy.

Then next day, two of Poorman’s friends defaulted. And then more followed. Bank started repossessing more homes. Now there are too many houses in the market to be sold. House prices started plummeting. Bank had lent 600 coins to buy a house. But now house is being sold at 450 coins, so Bank wont get back its money by repossessing. Everybody down the line was about to lose a lot of their money. That was when more interesting things happened. There was this guy, Cityman’s friend who bought a home for 600 coins two years ago. He paid back some, but still owes the bank 500 coins. He thought, “Why should I pay back the 500 coins, when this house is only worth 450. Let the bank take it.” This was something Bank did not even dream of. Cityman’s friends had good credit rating, not like Poorman’s friends!

Please also remember that a house is the most expensive thing most people buy, and most people buy a house. Try multiplying the price of a house to the number of people buying a house. So the numbers involved here, overall, are HUGE. Please note that the securitisation and reselling of debt obligations is not confined to the housing credit market. The banks have devised an amazing variety of three letter words out of most of the money it lent out to various businesses. That kind of brings us to what is going on today.

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…)

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…)

To over-simplify things, er, life is very simple! You use money(assets) to make more money(assets). For example, if you have some money, you can buy some machines, produce something, sell it and make more money. Then some smart people figured out that if you dont have money, you can borrow from your friend. You can tell the friend that I will earn money in the future, so I can repay you. Then use that to buy machines, produce something, sell it, make profit, use part of that to repay your friend, and keep the rest. This is called “business” and borrowing money like this is “credit”.

Some smarter people figured out that if you have money, you can just lend it out to someone who does work, then go to sleep, wake up in the evening and collect interest. This is called ‘banking’.

Another example. I just got a new job, so I dont earn enough to buy that cool mobile phone. But the problem with growing up in the city is that when I want something, I cant wait and I want it now. So I tell my bank, l will earn money in the future, so give me some credit. I buy my mobile phone using my “future money”.

We have so far learned four lessons-

Lesson 1) If you have money (or assets), you can make more money (or assets). This is “business”. Note that you can buy assets if you have money and you can get money if you sell assets. So, asset is the same as money, well almost. In fact they are the same only if everybody else believe they are the same.

Lesson 2) If you dont have money now, you can borrow money to make more money. This is credit and that is what banks sell.

Lesson 3) To get credit, you need some asset. “Future money” is also an asset.

Lesson 4) In the city these days, all people and all businesses depend on credit. (Of course, if I want to be more racist and less accurate, I could use certain place names instead of “city”.)

We need to learn a few more lessons before the story can begin.

Lesson 5) The bankers are lazy and would like to sleep all day without doing any work.

But bankers are more greedy than they are lazy. So they lose all their sleep trying to figure out who got “future money” so that they will get back all the money they lend. But this was too much work. So they asked some of the dumber bankers to do that while the smarter ones slept, or vacationed in Hawaii. Thus “credit rating” was born. Now, these people may be dumb, but they are also bankers and dont forget Lesson 5.

Lesson 6) “Credit rating” is telling the banks whether the borrower is likely to repay.

You might already have started thinking, “Hey, that’s not fair. Why should bankers have all the fun?” This is exactly what the businessmen thought. “I own this company with so many machines (assets). Can I convert them to money now?” So they wrote down on a piece of paper, “I am selling you all the machines I have”, put their signatures underneath, took thousand copies of it, kept 500 of those with him, and sold the remaining to 500 others. These papers are called “securities” and the process of converting assets into pieces for sale is called “securitisation”. In the case of a company, we call these pieces as “shares”. Just about anyone can buy and sell these securities.

Lesson 7) If you have an asset and you want to sell, say, half of it, you can cut it into small pieces by “securitisation”.

If you thought that was neat, where do you think they got the idea from? Of course, from the bankers. In fact these are the smartest (and wickedest) of the lot and are called “Investment Bankers”. They are a very small group of people who are over-paid for not doing any real work.

Lesson 8.) “Investment Bankers” help businessmen cut their assets to pieces and sell parts of it to others. Investment Bankers charge a 2% fees for that!

Now the stage is set, and the story can begin

(To be continued…)