Sub Prime Crisis-Part 3:- Investment Banks/Bankers

The News channels and public, now scream at these guys as ‘Devils in disguise’, whom they unanimously hailed as the ‘Financial Messiahs’ a year back.  They were awarded by their bosses and markets for their Sheer Innovativeness in the financial markets. The last decade saw a wide range of products, tailored (Structured in their parlance) for every conditions or outcome of the market. Just imagine, what would have happened, if they see a vast, trillion dollar opportunity, lying untouched or handled the traditional way…yeah, what now we call as Subprime Crisis, is the financial reengineered child of these I bankers.

 

Step 1: Investment Banks purchase the Mortgage loans from Banks/Lenders

Step 2:  Segregate them into different types and rate them.

Step 3: Making these loans as underlying assets, created Derivatives

Step 4: Insure all the Instruments according to the rating, with an insurer

Step 5: The Insurer creates Credit Default Swaps (CDS) and sells it in the market.

Step 6: Investment Bank creates SPV’s (Special Purpose Vehicles) and holds all the unsold/high risky Sub Prime loans with them. These SPV’s will be their sister company, registered in Mauritius or some Island, where no questions are asked, and the parent company will invest its share capital/its clients money in the sister company.

Step 7: What else, every instrument created will be marketed well to the so called sophisticated Hedge funds, HNI’s, Corporate, Pension Funds, and even Banks in every nook and corner of the world, be it UK, Europe, Japan, and why not the conservative Indian Banks… (ICICI, SBI, AXIS bank  …)

 

Step8: All these papers a.k.a Sub Prime Mortgage Backed Securities/CDS are to be redeemed when the mortgage payments are received in full from the borrower. (If at all he pays…)

Subprime Crisis- part 2: Real Estate

As, George Soros once infamously said, “In Investing, We have a Herd Instinct.” Everyone was talking and writing about the great Real estate boom right from 2005 onwards. Everyone believed or made to believe that Real estate prices will be in upward trend forever. (Remember the same endemic stories in Chennai and other parts of India…). So, as every aspiring citizen wanted to buy a house of his own, the demand for the loans grew like anything and the mortgage lenders and brokers, who recommend  the customers to Banks made a killing by commissions. They did not bother about the credit worthiness of the clients they recommend. Their Client list included all classes of economy, Prime (Good customers, who have the asset backup to pay the loans back) and Sub-Prime (those who have only the desire to own a house and not the money/wish to payback).

To attract customers, the Banks designed various product offerings- Fixed, Floating, and even zero payment loans. (I.e. in 1^st year the subprime guy can pay 5 %, in 2^nd year he pays 8 %, 3^rd year he pays 15 % and the interest percent goes on and on.)

Everyone, the banker, Broker, mortgage lender and even the Customer believed that the real estate price will move upward and in worst case of repayment, they can simply refinance their houses/ the banks can acquire the property and sell it to someone, for a better price.

 

This was the first nail in the coffin of Financial Market crisis.

Sub PRime Crisis- Part 1:-Leverage

Leveraging is a process which is used to borrow capital through various financial instruments like Options, Futures, and Margin etc to increase the potential return of any investment.  For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Infosys, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10. But if there is a loss of 1$, we will suffer 500 times more. Many a time, we end up losing all our capital and fall into debts.

This is what happened in all the Investment Banks who have entered in leveraging their capital and invested in Sub Prime Mortgages.

For example,

Lehman bros- Share capital- $ 50 Billion

Leverage size- 20 times i.e 20*50 = $ 1000 billion

Invested in Sub Prime Mortgage Bonds and now if the Real estate price goes down and the value of the bonds goes down by say 10%, they will be losing $100 billion.

Value of bond = -10%

So loss = $100 Billion.

Capital in hand = $ 50 Billion

So now they have lost all their share capital, also in debt of $ 50 Billion + the interest charge for the leverage they took.

So, what other option they have, other than to file for Chapter 11???