Global Crisis- Part 4/4

So, where did we stop last time? Ah! Yeah! Everyone was making lots of money and was hoping to live happily ever after.

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.

What happens when the bank owes money to a lot of people (those who bought the CDOs), but does not get the money that people (homeowners) are supposed to pay it? The bank would go bankrupt, and that is what is happening.

There are other developments. According to law, a bank is supposed to lend out only a certain portion of its assets, and has to hold the rest as reserve. What happens when the bank has already lent out, but the value of its assets decrease. (Remember, the houses bank had as collateral are its assets.) It would have to find more money to keep as reserve, or it goes bust. This was why governments had to interfere and give money to banks.

What happens to the insurance companies who had insured against credit default? They now have to make payments they never anticipated, and are facing problems. Credit rating agencies are now threatening to downgrade the credit rating of insurance companies. This is equivalent to telling, “Dont trust these insurance companies. They are themselves in danger. So they cannot help you in need. They are incapable of insuring you against losses.”

What happens to the CDOs that were insured by these insurance companies? People refuse to buy them because they are not, in effect, insured. Price of CDOs plummet.

What happens to all the people who invested in CDOs and CDSs? They lose their money.

Who have invested in CDOs? Who all are affected? Financial institutions all over the world, including investment companies, pension funds, banks, mutual funds etc. When these financial institutions are affected, all those common people who invested their life’s savings in these companies are also affected.

What happens when financial institutions are affected? They start going bust. Now nobody knows who is going to go bust next. Which means that nobody would lend to each other. This is called a crisis of confidence. Remember Lesson 4, that all businesses depend on getting money on credit. It is impossible to run business without getting easy credit at reasonable interest rates. So businesses are getting affected.

When businesses are getting affected, people lose jobs. More people default on their loans, more people lose their homes and the problems multiply.

We have so far seen the formation of a price bubble in the housing market, we saw the bubble getting bigger and bigger, we saw it engulfing more and more of the world, and we just saw the bubble burst in everybody’s faces. Whose fault is it? Who are the culprits? Bankers? Borrowers? Investors? Governments??? Bah!! I am no more interested 🙂