Financial crisis - the ticking timebomb...

This post is an advanced version of one of my earlier post, How the Bubble burst.

What is the credit crisis?

It's a financial fiasco including:

• Sub-prime mortgages
• Collateralized debt obligations (CDO)
• Frozen credit markets
• Credit default swaps (CDS)

The credit crisis brings two groups together, Home owners and Investors. There is common place for either of these groups to suffice their respective needs - a bunch of financial institutions commonly known as Banks.

It is these banks which actually initiate the process of creating this time bomb.

How does it actually work?

1. Let's say, a family A wants to buy a house and needs some money. 

There is another group called Z who is financially well off and has stash of money which it would like to invest.

2. Now, A goes to this bank B in need of money and the bank B lends them in return of an agreement to pay EMI (equated monthly income). A is happy because he knows the house that he bought at x amount is appreciating in terms of value and doesn't mind paying the EMI. B lends mortgage to many such home owners.

3. People from group Z would like to invest their money and want to become richer so they go to bank B for deposit, but, bank B pays a very low interest rate. So, not all investors from group Z are happy. In fact, very few park their money at low interest rate in the bank B.

This is observed by another investment bank 'IB' (probably of higher magnitude) and approaches small bank B. IB buys out these mortgages from B at a very good price and B is happy as it sold off its risk at better price! 

4. IB collects many of these mortgages and bundles them in one box. This box receives EMI monthly from all these mortgages. Now, IB does financial analysis and splits this box into three parts viz, Safe, Ok and Risky. This is called, 'Collateralize debt obligations' (CDO). A CDO works like cascade with Safe block at the top, when the money flows in, it first fills in the Safe block, then in the Ok, and finally in the Risky block. This means, in case if there is some family which defaults to pay their EMI then, first it will impact the lower most i.e Risky block.

To compensate this, the bottom block has the highest rate of return and the top most block has the lowest but still better rate of return as compared to bank B.

To make the top most block more safer IB will take a small fee usually called, 'Credit Default Swap' (CDS). Usually the CDS fee is charged by the insurance firms to protect the investor. Credit rating agencies will give the rating AAA on it. Credit rating firms have nothing to lose and they get money to rate the risky CDOs as AAA.

(Credit rating AAA is considered as the safest investment area)

Thus, Group Z investors are interested in these top block of safe CDOs which pays of better than normal bank B deposits.

IB sells of the rest of the CDO blocks to other high risk taking institutions like hedge funds, etc... thus, IB sold it risks and makes millions and is obviously happy!

Everyone is happy, in fact the Z group investors are so happy with the return on their investment that they demand for more of such safe CDOs. So, IB calls up bank B and asks for more mortgages. But bank B has no new mortgage as there are no more home buyers.

Now, as we know that prices of house are ever increasing so bank B thinks, if the home owner defaults then his house can be sold as collateral. Thus, bank B starts adding risk to the mortgage like, no down payments, no income checks etc... This is called 'Sub-Prime Mortgage'.

This is where the time bomb actually starts!

The above process, from 2 to 4 repeats. unsurprisingly, few the home owners start defaulting. Which stops EMI from the home owners. So what! Bank IB sells of their houses as house prices are high and covers up the default. But slowly and gradually as more and more home owners start defaulting, a situation arises where there is more supply then demand. Obviously, the housing prices will not increase in fact they plum.

Now the family A which is still paying the EMI thinks, "why we are paying so high value of EMI for house which is not worth that much?", and even they put up the house for sell and don't want to pay EMI. 

This increases the default rates and further diminishes the value. So now the question is, IB had taken a lot of credit from other countries to make the CDO boxes which is now worthless and IB cannot afford to pay back the money it borrowed. This situation is not only with IB but also, the family A, bank B and group Z. This is known as 'Frozen Credit Market' and eventually they go bankrupt. 

...BOOOOOOOOOM!!!!!!!