Demystifying the financial crisis in USA

Recently people across all sects, ages, and both sexes of society are buzzing words like Lehman Bros, Merrill Lynch, WaMu( Washington Mutual Fund), Bank of America, hitherto restricted only to people who knew finance subject or worked in finance related projects. Media is constantly beaming words like financial Tsunami, financial crisis, depression, etc words making common man scarier.

Though people are not sure what exactly happened to these stalwarts of finance industry, but they have understood that US economy is going through one of its bad phases of its history. Various media channels have tried their best to put across the situation before the common mass in as much fair manner as possible.

In the next few sections I would like to share my understanding and the historical backdrop of the current turmoil. Needless to say, I derive these inputs from a varied source of information to get to the crux of the issue.

The market started feeling the heat, roughly one month back, Fannie Mae and Freddie Mac started negative quarterly results. This followed up with news from the AIG (the biggest insurer of USA) facing huge claim honors from mortgage companies and added to that US treasury secretary declining to extend any financial help to save AIG. Then followed news of Lehman Brothers being pitched for a possible acquisition by a Korean bank; and finally the whole world is a witness to what it encountered, Lehman filing for Chapter 11 under SEC rules, on 15^th September. This has repercussion not only in the USA but extended as far as Asia and Australia.

The whole issues boils down to just three aspects (a) Bad loans underwriting by Fannie Mae and Freddie Mac, (b) Insurance of those bad loans by AIG and (c) Securitizing (by way of CDO, MBS instruments) of these bad loans for refinancing by investment banks like Lehman Bros and other investment banks (d) Inappropriate rating by Standard & Poor’s and Moody’s Corp.

If we clearly look at the chain of events and the players involved in this, one thing that clearly emerges as the sole cause, is prolific expansion of mortgage loan sector in the USA. In other words to be precise the much discussed and most haunted word the last 3-4 years i.e., Sub-Prime issue. Let’s understand how a Sub-prime loan could have such rippling effects on the world economy.

Rise of Sub prime loans

It all started after the technical bust in 2000 bust in USA, where the interest rates prevailing in USA were at 1%. Interest rates at this level are unheard of and unimaginable for most parts of the globe. At that juncture, US Federal ramped up and promoted housing for every US citizens. This caused giving boost to the mortgage sector and treated mortgage loans as one of the priority lending. Gradually this activity gained momentum and in this process there was a particular section of society, aka Sub prime borrowers, who could not manage to get mortgage loans on fairer terms. As sub prime borrowers didn’t have good credit history or sound credit worthiness, or didn’t possess a steady stream of income, Mortgage banks were reluctant to grant any loans to these borrowers.

But the investment banks in US, came forward and were ready to take risk of lending to these sub prime borrowers at a higher rate of interest and were worried less about consequent default rates. This activity continued in the US economy quite for sometime. As result of which a lot of increased activity was witnessed in the mortgage sector of US, resulting in overall boom for the real estate sector. At the same time the interest rates has reached levels beyond 6%. The higher interest rates resulted in higher EMIs for the sub prime owners and they started defaulting on their mortgage loans. Higher interest rates also created tight liquidity in the market.

AIG

AIG has played a significant role in the American insurance sector close to hundred years. What caused this to fail in the recent times? Off all the instruments products that AIG dealt in, one product stands clear as one of the culprits for the fall out of AIG. That is the Credit Default Swaps. This is an insurance product which insures loans given by retail mortgage banks, in case the final borrower makes default in repayment of loan.

AIG has to meet large amount of money to honor CDS obligations and thus was facing liquidity crunch severely. AIG has recorded losses amounting to $13 bn in two consecutive quarters. And it has exposure of $57.8 bn to sub prime loans.

To tide over the credit crunch and to avoid any systematic risk the Fed Govt came up with $80 bn rescue package for AIG.

Lehman Bros

All the turbulence at the Lehman Bros can be attributed to one specific area of their activity that is refinancing or securitization. Securitization means converting all mortgage loans into a special purpose vehicle (a pool of similar type mortgage loans) and issue fixed income or floating rate instruments known as MBS or Mortgage Backed Securities. The MBS has all the mortgage loans as the underlying assets.

Let’s see how these instruments work in reality, say there is a bank, ABC Mortgage bank which gave out fixed interest bearing loans(4% loans worth 100 mln dollars) to various customers. The borrowers will pay EMI to the bank every month, but the bank’s liquidity is reduced due to these mortgage loans. So in order to increase the liquidity, the bank approaches an investment banker such as Lehman Bros to buy all the mortgage loans from it. Lehman has ample of idle cash resources, which it thinks that it can park in some fixed income earning and highly liquid assets. So what it does is, it will buy all the mortgage loans from the ABC Retail bank and pool similar type loans into a common vehicle and break into market tradable lots of MBS, and issues in the money market.

There are two institutions in the US market, Fannie Mae and Freddie Mac, who invest and guarantee such type of MBS issues, mortgage loans and assure the investors that in case of any failure on the part of the borrowers, these institutions will make good the loss on these securities. The MBS can be traded on the exchange and are most preferred by big financial institutions as a high income earning money market instruments.

The limitation of MBS is its income and principal recovery is dependent on the recoverability of the EMI from the end borrowers. If they fail to pay up their EMI, then the interest and principal payments on the MBS is also affected.

Because of the Sub prime issue as the economy witnessed borrowers defaulting EMI payments, the financial institutions who have invested in MBS started loosing money or erosion in value of these MBS instruments.

In the whole process, Lehman has exposure to such investments, and the defaults owning to sub prime started wiping off the refinance done to mortgage banks. And rest is what we have witnessed just two weeks ago.

Freddie Mac and Fannie Mae

These two are premier institution of the US economy who guarantees all mortgage instruments issued in the US market. They underwrite such instruments and also lend out money for mortgage needs.

The loans to sub prime sector went sour and these institutions too booked heavy losses and witnessed severe capital erosions.

Ratings by Moody’s and S&P

The inflated or to be precise mistaken rating by these institutions of the MBS scrips, led the investment banks believe that these instruments are very liquid and safe. But the rating agencies have definitely failed to evaluate the riskiness of these investments and the investors were equally blindfolded to overlook it, in order to make more profits.

Conclusion

Hope I have tried to drive the point home to help you understand the reasons and implication of current turmoil that US is going through. We Indians have a need to know about our major global economic partners; just to be worried if not as much an American does, as we are influenced by the actions and inactions of the USA economy in more than one ways. Most the heightened economic activity that we saw in India is partly fueled by the US led capitalism. Today in India the boom that we have witnessed in sectors like retail, IT and ITES, real estate and overall consumerism can be assigned to the bilateral trade relations that India has with US economy.

As I pen down the concluding section of this article, news in the making is Wachovia bank of US and Fortis of UK could be the next targets. It seems the worst isn’t yet over.

Courtesy:

www.bloomberg.com

www.busineesweek.com

www.marketwatch.com

http://www.insurancedaily.co.uk/