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!!!!!!!
