What's wrong with the Intl. banks?

Status
Not open for further replies.

iMav

The Devil's Advocate
Well, as the question says ... I have no idea why are all the banks from US to UK going kaput? Anyone with info in simple terms?
 

karmanya

Journeyman
Basically, they all f*cked up.
It started with mortages- they were doing so well, they gave loans to people who had 0 hope of paying them back. Now they realize "Oh ****! where did all our money go?"
 

victor_rambo

हॉर्न ओके प्लीज़
Then there is also 'credit crunch'- people used credit cards and other means to avail credit but now are not in a position to repay them.
 

Pathik

Google Bot
They extended too much credit to many people most of whom defaulted on their loans. The securities on most of the loans were their house mortgages whose bonds were sold to investment banks and the generated credit was used in creating more credit. More people defaulted on their loans and all the real estate mortgaged was left in the hands of the banks with almost no buyers pushing its prices further down. This resulted in a credit crunch which screwed the whole US economy. Also with almost no liquidity, all the FIIs started withdrawing their investments in global markets as well resulting in a global market fall. Damn!
 

esumitkumar

Call me Sumit
READ THIS :D

*specials.rediff.com/money/2008/sep/25slid1.htm

What is subprime crisis? How it caused financial mayhem?

September 25, 2008



Text: Rediff Business Desk

The current upheaval in the global financial markets has caused more mayhem in a fortnight than the world has seen in its entire economic history.

Although there are many reasons responsible for bringing the world to the doorstep of financial doom, the main cause of this financial disaster is said to be the �sub-prime loan.'

So what is this sub-prime loan? And why has it caused global panic? If it is related to the American housing sector, why should it affect Indian and other markets?

A sub-prime loan

Sub-prime mortgage loans (or housing loans or junk loans) are very risky. But since profits are high where the risk is high, a lot of lenders get into this business to try and make a quick buck.

Sub-prime loans are dicey as they are given to people with unstable incomes or low creditworthiness. These individuals are not financially sound enough to be given a loan when judged under the strict standards that should normally be followed by a bank or lending institution.

However, there's more to it. Let us simplify this issue to understand better how sub-prime loans work and how they brought the world down to its knees. Read on. . .



It all begins with an American wanting to live the famed American dream.

So he seeks a housing loan to give shape to his dream home. But there is a slight problem. He doesn't have good credit rating. This means that he is unable to clear all the stringent conditions that a bank imposes on an individual before it sanctions a loan.

Since his credit is not good enough, no bank will give him a home loan as there is a fear that the chances of a default by him are high. Banks don't like customers who default on their payments.

But lo!, before the American dream can fade away, there enters a second American -- usually a robust financial institution -- who has good credit rating and is willing to take on some amount of risk.



Given his good credit rating, the bank is willing to give the second American a loan. The bank gives the loan at a certain rate of interest.

The second American then divides this loan into a lot of small portions and gives them out as home loans to lots of other Americans -- like the first American -- who do not have a great credit rating and to whom the bank would not have given a home loan in the first place.

The second American gives out these loans at a rate of interest that is much higher rate than the rate at which he borrowed money from the bank. This higher rate is referred to as the sub-prime rate and this home loan market is referred to as the sub-prime home loan market.



Also by giving out a home loan to lots of individuals, the second American is trying to hedge his bets. He feels that even if a few of his borrowers default, his overall position would not be affected much, and he will end up making a neat profit.

Now if this home loan market is sub-prime, what is prime? The prime home loan market refers to individuals who have good credit ratings and to whom the banks lend directly.

Now let's get back to the sub-prime market. The institution giving out loans in the sub-prime market does not stop here. It does not wait for the principal and the interest on the sub-prime home loans to be repaid, so that it can repay its loan to the bank (the prime lender), which has given it the loan.



So what does the institution do?

It goes ahead and �securitises' these loans. Securitisation means converting these home loans into financial securities, which promise to pay a certain rate of interest. These financial securities are then sold to big institutional investors.

Many investment banks (or institutions like the �second American' in our story) sold complicated securities that were backed by debt which was very risky.

And how are these investors repaid? The interest and the principal that is repaid by the sub-prime borrowers through equated monthly installments (EMIs) is passed onto these institutional investors.



The institution giving out the sub-prime loans takes the money that it gets by selling the financial securities and passes it on to the bank he had taken the loan from, thereby repaying the loan. And everybody lives happily ever after. Or so it would have seemed.

The sub-prime home loans were given out as floating rate home loans. A floating rate home loan as the name suggests is not fixed. As interest rates go up, the interest rate on floating rate home loans also go up. As interest rates to be paid on floating rate home loans go up, the EMIs that need to be paid to service these loans go up as well.



With US interest rising, the EMIs too increased. Higher EMIs hit the sub-prime borrowers hard. A lot of them in the first place had unstable incomes and poor credit rating.

They, thus, defaulted. Once more and more sub-prime borrowers started defaulting, payments to the institutional investors who had bought the financial securities stopped, leading to huge losses.

The problem primarily began with the United States keeping its interest rates very low for a very long time, thus encouraging Americans to go in for housing loans, or mortgages. Lower interest rates led to buyers wanting to take on bigger loans, and thus bigger and better homes.



But life was fine. With the American economy doing well at that time and housing prices soaring on the back of huge demand for real estate and bigger and better homes, financial institutions saw a mouthwatering opportunity in the mortgage market.

In their zeal to make a quick buck, these institutions relaxed the strict regulatory procedures before extending housing loans to people with unstable jobs and weak credit standing.

Few controls were put in place to handle the situation in case the housing �bubble' burst. And when the US economy began to slow down, the house of cards began to fall.

The crisis began with the bursting of the United States housing bubble.



A slowing US economy, high interest rates, unrealistic real estate prices, high inflation and rising oil tags together led to a fall in stock markets, growth stagnation, job losses, lack of consumer spending, a virtual halt to new jobs, and foreclosures and defaults.

Sub-prime homeowners began to default as they could no longer afford to pay their EMIs. A deluge of such defaults inundated these institutions and banks, wiping out their net worth. Their mortgage-backed securities were almost worthless as real estate prices crashed.

The moment it was found out that these institutions had failed to manage the risk, panic spread. Investors realised that they could hardly put any value on the securities that these institutions were selling. This caused many a Wall Street pillar to crumble.



As defaults kept rising, these institutions could not service their loans that they had taken from banks. So they turned to other financial firms to help them out, but after a while these firms too stopped extending credit realizing that the collateral backing this credit would soon lose value in the falling real estate market.

Now burdened with tons of debt and no money to pay it back, the back of these financial entities broke, leading to the current meltdown.



The problem worsened because institutions giving out sub-prime home loans could easily securitise it. Once an institution securitises a loan, it does not remain on the books of the institution.

Hence that institution does not take the risk of the loan going bad. The risk is passed onto the investors who buy the financial securities issued for securitising the home loan.

Another advantage of securitisation, which has now become a disadvantage, is that money keeps coming in.

Once an institution securitises the first lot of home loans and repays the bank it has borrowed from, it can borrow again to give out loans. The bank having been repaid and made its money does not have any inhibitions in lending out money again.



Given the fact that institutions giving out the loan did not take the risk, their incentive was in just giving out the loan. Whether the individual taking the home loan had the capacity to repay the loan or not, wasn't their problem.

Thus proper due diligence to give out the home loan was not done and loans were extended to individuals who are more likely to default.

Other than this, greater the amount of loan that the institution gave out, greater was the amount it could securitise and, hence, greater the amount of money it could earn.

After borrowers started defaulting, it came to light that institutions giving out loans in the sub-prime market had been inflating the incomes of borrowers, so that they could give out greater amount of home loans.

By giving out greater amounts of home loan, they were able to securitise more, issue more financial securities and earn more money. Quite a vicious cycle, eh?



And so the story continued, till the day borrowers stop repaying. Investors who bought the financial securities could be serviced.

Well, that still does not explain, why stock markets in India, fell? Here's why. . .

Institutional investors who had invested in securitised paper from the sub-prime home loan market in the US, saw their investments turning into losses. Most big investors have a certain fixed proportion of their total investments invested in various parts of the world. So...



Once investments in the US turned bad, more money had to be invested in the US, to maintain that fixed proportion.

In order to invest more money in the US, money had to come in from somewhere. To make up their losses in the sub-prime market in the United States, they went out to sell their investments in emerging markets like India where their investments have been doing well.

So these big institutional investors, to make good of their losses in the sub-prime market, began to sell their investments in India and other markets around the world. Since the amount of selling in the market is much higher than the amount of buying, the Sensex began to tumble.

The flight of capital from the Indian markets also led to a fall in the value of the rupee against the US dollar.
 

dheeraj_kumar

Legen-wait for it-dary!
^^ That is a really good article. I knew nothing about finances and stuff, and I understood what it was trying to say!
 

NucleusKore

TheSaint
Yes, very good. It's cleared up things. Thanks iMav for raising the question.

Those who bought those securities must be farting now.
 
Last edited:

esumitkumar

Call me Sumit
Thnx Dheeraj and Nucleus...Today a 700 billion $ bailout plan is being voted by US senate..lets seee wat happens

PS: off topic Dheeraj does ur HD contains so much porn as said by siggy ;););)
 

Pathik

Google Bot
I hope that bailout plan gets approved with proper regulation. A slight boost to the market and I am out.
 

esumitkumar

Call me Sumit
FYI : House defeats $700 bn financial mkts bailout :(

jaane kya hoga raaama re
jaane kya hoga maula reeeeeeeeeeee...........
 

dreamcatcher

Rockin g33k
It wont be approved.the US Senate is more interested in keeping the money to themselves and let the dollar rise than do anything about it. Rupee has fallen beloe 47 that has resulted in resing infaltion..
Also banks such as JPMorgan which has taken over as the No 1 bank in the US is giving out stocks and not bailing out any loans at the moment.The money is eing kept to themselves that has resulted a greater demand for fr the dollar.

The wold bank should step into the matter now.
 

karmanya

Journeyman
Dude, The world bank is meant for development.
There is very little it can do to help the credit crunch. To quote Bush, the government is the best institution to bail us out of this crisis.
 
Status
Not open for further replies.
Top Bottom