Friday, October 17, 2008

A Dummy's Guide To US Sub-Prime Crisis

To begin with, let us answer a basic question: What is Sub-Prime?

Sub-Prime means "which is Below Prime" or "Less Than Credit-Worthy", in the context of a loan or borrowing.

In US, many banks have disbursed loans to borrowers who are not credit worthy or disbursed loans of value worth several times the value of the security against which the loan was given. Many intermediaries, like Investment Banks or Private Equity Funds, have purchased these loans in what is known as Derivatives, by paying still higher value to the banks, on the assumption that the underlying securities i.e. the house or land, will appreciate & they can sell them & book profits. That is how the Loan Bubble was formed in the US about two or three years back. But, when finally the time came for repayment and most buyers of these properties, who have been granted these loans by the banks in the first place, could not repay the loan and the banks tried to sell-off the underlying assets to adjust the loan amount, they found, to their horror, that the asset has not appreciated to the level they anticipated and THE BUBBLE BURST WITHIN NO TIME.

Let us try and see how chronologically the above would have happened, step by step, with some fictional examples.

FOUNDATION

Let us say there is a guy called Karunai Illa Nidhi (KIN, for short), who holds vast tracts of land. But, unfortunately most of his land is situated in remote areas (like, say, Ramnad district - Pottal Kaadu) and hence there are no takers. KIN gets into contact with a greedy bank called CICIC Bank. The bank somehow wants to become the top bank & hence is willing to give loans left, right & centre, without any due diligence. Their only aim is to get business - by hook or by crook.

Thus, CICIC Bank gets hooked to the crook called KIN and they jointly prepare a survey report on KIN's land. Obviously, the survey report predicts the market value of KIN's land to go up substantially within a couple of years. Armed with the survey report, they hunt for a borrower & a guy called Podhu Janam comes into their radar. KIN convinces Podhu Janam to buy his land by showing the survey report & promising him that if he buys the land, within a couple of years he will become a billionaire. Podhu Janam expresses his inability to buy due to his poor financial conditions. KIN then assures him not to worry & brings CICIC Bank on to the scene.

CICIC Bank assures Podhu Janam that if he buys the land of KIN for Rs. 10 crore, within a couple of years, it will be worth Rs. 20 crore due to rapid appreciation happening in land prices. It also assures Podhu Janam that CICIC Bnak will give him the entire money as loan and he need not repay even a single rupee for the first three years and his repayment will start only after 3 years. By that time, since the land value also would have multiplied several times, Podhu Janam can even sell the land for at least double its current value and pay back the loan to the bank & keep the balance cash with himself (All this for a land, which is worth only Rs. 1 crore now).

Podhu Janam finds it too tempting to reject the offer and he signs on the dotted line to get the loan for buying the land. CICIC Bank pays Rs. 10 crore to KIN, on behalf of Podhu Janam and KIN transfers the title of the land to Podhu Janam, but the same is kept in mortgage with CICIC Bank as the underlying security for the loan.

Podhu Janam is happy that he has become the owner of huge tract of land though he doesn't even know where it is located or whether it is worth so much. KIN is very happy that he has made a cool profit of Rs. 9 crore on a land in a remote area which did not even have a taker till the other day. CICIC Bank is happy that it concluded a huge business (loan) worth Rs. 10 crore, which it can leverage (re-sell) in the market. All are happy.

BUILDING BLOCKS

On such a flimsy and fradulent foundation, a basic mortgage loan has been concluded. Now, CICIC Bank does similar types of deals with the help of so many other KINs of this world and there are enough Podhu Janams to fall a prey to these kind of enticements. Like this, CICIC Bank builds a huge portfolio of loan assets.

For banks, lending is the main business and money lent becomes their asset. Even though Podhu Janam need not repay the loan or pay any interest for the first three years, as per accounting norms, banks have to recognise interest due to them from Day 1 in their books as Income. Thus, even though not a single paisa has been paid or received, CICIC Bank accrues interest on the loan amount of Rs. 10 crore paid to Podhu Janam as also on all other similar loans disbursed to its borrowers. Based on such a huge income, the CICIC Bank shows a hefty profit in its books and rewards its officials through hefty bonuses. Its shareholders also take huge dividends.

GLASS FACADES

Simultaneously, CICIC Bank also approaches some reputed Credit Rating Agencies (like S & P or Moody's) and appoints one such reputed credit rating agency called Mody Mastans to rate their assets. Mody Mastans rates the Loan Assets of CICIC Bank based on the papers of various borrowers like Podhu Janam given by CICIC Bank by assigning them appropriate ratings like AAA+ (For Very Highly Credit Worthy), AAA, AA+, AA, A+, A, B+, B, A-, B- (Low Credit Worthy).

Armed with its Loan Assets rated by a Reputed Credit Agency, CICIC Bank also approaches an Insurance Company to insure against any depreciation in any of its asset class. An Insurance company, which is a behemoth in the industry, called A. Iyaiyo. G. Insurance, finds that CICIC Bank has got huge Loan Assets & they have all been rated well by a reputed credit rating firm of Mody Mastans. So, it also wants to enjoy a piece of the cake by agreeing to insure those assets that, if, any of the underlying securities of these Loan Assets depreciate in their value & goes down below the loan disbursed, A. Iyaiyo. G. Insurance will reimburse the difference between the loan amount & underlying security's market value.

THE BUBBLE a.k.a MARKET DERIVATIVES

Now, CICIC Bank has got a mammoth business and is ranked among the Top 10 banks of the country. Similarly, Mody Mastans & A. Iyaiyo. G. Insurance are also figuring in the Top 10 or Top 5 Lists of their respective industries. All these have become the envy of every other competitor. Every other company worth its salt also want to reach such heights and they also start doing the Sub-Prime Mortgage business in the same unscrupulous ways.

Now, CICIC Bank, which has set the trend by doing the Sub-Prime Mortgage Business on an unprecedented scale, and buoyed by its success, wants to go one step further by altogether selling its Loan Assets as a Derivative Product to other Investment Banks or Private Equity Funds, who are called as Intermediaries.

For this purpose, CICIC Bank divides its Loan Assets into different classses, based on their assigned Credit Ratings, and bundling together each class as the underlying asset, it sells them to buyers as Derivative Bonds. A reputed Investment Banker called Layman Cousins, negotiates with CICIC Bank and agrees to subscribe to its Derivative Bonds as per agreed rates. CICIC Bank thus makes a cool profit by selling the loan asset of Rs. 10 crore (given to Podhu Janam) to Layman Cousins at Rs. 15 Crore. Layman Cousins is willing to pay that amount because it is satisfied that Mody Mastans have rated it and A. Iyaiyo. G. Insurance has under-written it. Moreover, it is convinced that the land's market value is likely to soar in a couple of years & hence there are no worries. Thus, Layman Cousins and others of its ilk, ends up with huge amounts of Derivatives running into several hundred billions of dollars by purchasing from the market several such derivative products issued by all such loan/mortgage institutions.

All has been hunky-dory so far.

KIN has sold-off his land for a hefty profit.

CICIC Bank has sold-off its huge Loan Assets as a Derivative Product and made a fat profit.

Layman Cousins has purchased huge Derivative Assets, whose market value is growing & is likely to soar to phenomenal heights. It is already booking profits in its books due to the appreciating value of these assets in the Bond Market as there are huge demands to buy these assets. Hefty bonuses are received by its Managers, who are all Ivy League Business Graduates and who are looked at with envy by the whole nation for their innovative business acumen.

PAY-BACK TIME a.k.a BURSTING OF THE BUBBLE

Everything was going fine for the first three years i.e. till the time when the repayment of the original loan was due. When that time came, Podhu Janam, obviously, could not repay the loan amount due, because he simply doesn't have the money to repay.

So, the underlying asset i.e. KIN's land parcel at the remote place had to be put on the block. But, alas, the land parcel, which was originally bought for Rs. 1 crore, is now worth only Rs. 2 crore (and not Rs. 10 or Rs. 15 crore, which was promised). The moment it is known that the underlying mortgage asset's value has come down drastically from its perceived value, all hell breaks lose.

FINANCIAL TSUNAMI

Layman Cousins' asset (Bond Investments) base erodes drastically from Rs. 15 crore to Rs. 2 crore - less than 14% of its book value. Due to the huge value erosion in its assets, it makes a huge loss, which has the effect of eroding its entire net worth accumulated over several years, in a single stroke of imprudence. Layman Cousins tries frantically to salvage the situation by looking for capital infusion to stem the tide. It tries from various possible suitors but none of then are willing to pay the price it wants. Finally, it even approaches the Government to take a stake in its apital but the Govt. refuses to bail out Layman. Ultimately, Layman Cousins has to file for bankruptcy proceedings as it has no way of surviving the financial tsunami which has befallen it.

Similarly, A. Iyaiyo. G. Insurance is also comes under enormous financial pressure due to erosion in the value of its insured assets. Because of its huge exposure to such kinds of inflated value assets, A.Iyaiyo. G. Insurance faces the prospect of bankruptcy. But, the Government, fortunately, comes to its rescue by agreeing to take it over by bringing in 80% of equity.

All such intermediaries like Layman Cousins, A. Iyaiyo. G. Insurance, etc., as also mortgage lenders like CICIC Bank, who too are tied up with other unsold Loan Assets, are, thus, finding themselves in deep hot water, which is of their own making. Now, all of them are crying for help from the Government.

TSUNAMI EFFECT ACROSS CONTINENTS

The effect of this financial imprudence and mis-adventure has been felt across continents. In Europe, it is predicted that, similar deals are likely to come out very soon, once the repayment time comes up.

In order to salvage whatever little cash they could, these Financial Institutions, who also invest in many markets across the world, have started liquidating their investments & repatriates that money to US. This has created a huge ripple effect in all those countries. For eg. whatever investment Layman Cousins might have done in Indian stock market, they would have sold-off overnight & repatriated to US. This act would result in huge selling pressure in the stock market resulting in Nifty/Sensex tumbling several hundred points in a single trading session. Also, because of its repatriation of the proceeds from its sold-off invesments, there would have been huge demand for & resultant shortage of. US Dollar in India. This will depreciate the value of Indian Rupee against the US Dollar.

Similar fate awaited all other major currencies too, like Japanese Yen, Aus/Sing Dollar, British Pound Sterling, Euro, etc. US Dollar gained strength against all these currencies. This crisis has not yet seen its end; and many more such skeletons are expected to roll out of the US & other cup-boards in the days to come.

CONCLUSION

All this indicate only this: greed and fraud. These are the underlying traits which, in the first place, made KIN & CICIC Bank to entice a reluctant Podhu Janam into signing on the dotted line for a loan to purchase a land which is NOT AT ALL worth that price. They both did it knowingly and defrauded the entire system based on that basic transaction. This is possible in western societies like the US where morality is given the go-by in their day-to-day lifestyle.

If people try to learn some lessons out of the crisis and sets their respective countries' financial systems in order, we can say with relief that, like in the movie Dasavataram, here too, the Financial Tsunami has befallen the humanoids, to prevent a much greater damage in future.

29 comments:

pradeep said...

Dear Arunji,
What a superb post. I am a novice when it comes to understanding economics, but you have explained in such a way that even i can understand. I have forwarded it to my school group. Your have a great sense of humor(KIN,CICIC, Aiyaiyo ins- We can understand whom you are referring to sir)

Kameswara Rao said...

Dear Arun

Beautiful Post ... I am just copying it and sending it to my friends ---- a coloumn written by my friend Arun ... as to what will happen and how things are going around the world what will be the effect if it continues and what is that we need to learn...

Simply Good...

Keep it Up and your views on SS Stand very good... but alas we have to feel for our friends Rajasekar and all who can't even digest this stance of Talaivar.

Kamesh
Botswana

Saikrishna said...

hahaha....i just cant control laughing...really funny and at the same time made me understand the financial mess....i couldn't make head or tail of what was happening over the past few days...apt title u noe...

i guess this is again butterfly effect like dasavatharam....just because of ppl like karunai illada nidhi and banks like CICIC .....Layman Brothers and A.Iyaiyo.G went bankrupt and many other industries are getting affected by this...and ya...money is the root of all evil...fantastic post...'m sure tht any 11th grader like me can easily understand

jynterpek said...

Uncle,
Very nice post about how Podu Janam got amBushed! No wonder he's goin' "Oh Bummer....!"

I enjoyed reading it!

gopi said...

Arunji

As i already told u, this write-up is adding one more feather to your cap. What a fantastic write-up it is.

Hats off arunji.

Expecting more such write-ups from you...

Vasumathy said...

Excellent post. Keep up the good work.

rdharma said...

Arun, I don't think any one can explain the malaise affecting the world and all of us in some form, better than this.It is like a re make of a famous hollywood flick in local Tamil for us.

EE. RAA @ Rams said...

Dear Arun,,

U are reaching next levels of writing....

May u get more time to write more like this....

ERams

Ananthoo said...

hey Arun!
That was hilarious and educative all at once!
fyki- i have linked that in my blogs. thx to pradeep!

M said...

It is definitely not a dummy's guide, it is indeed an expert's guide to US sub-prime crisis.
viji

Kalyan said...

This is ur best post till day.. Hats off to u..congrats.. and keep doing this..

With your permission(for granted) i forward to my friends..

Thanks

M Arunachalam said...

Thanks to you all for your encouraging feedback.

Pl feel free to send it to your friends/contacts, as you wish.

Arun

rdharma said...

it is a well researched write up made in the most lucid form for laymen to understand the lehman's

maran4u said...

Mr.Arun,

Though I closely follow economics around the world, I am a big 0 when it comes to understanding its tecnicalities. I have no words to praise the way you have articulated it in humourous and in layman terms. Keep up your good work.

If you can pls write about what this GDP, GPP and related stuff in the same language. I have already forwarded this to 30 to 40 of my friends.

Regards

Maran.R

Srikumar said...

Dear Arunachalam(Narayan), Excellent. What a way to explain a complex subject. You are fit to take training sessions on financial matters in premier institutes.
Let me add some comments based on my study of the book 'Support Economy'. Greed and fraud have become part of managerial capitalism. It is going to spell the deathknell for that popular brand of capitalism. Like communism, managerial capitalism will become a relic of the past. In its place, end-individual support economy will spring up driven by psychological self-determination, which will seek sanctuary, voice and interconnectivity. Knowledge society will provide the deep support to such a economy. For more on the subject, look into website www.thesupporteconomy.com. Thanks. Srikumar

pradeep said...

Dear Pradeep,
I am aware that you are medical pro...
It it good to know that you are also a financial wizard.
Good article about current financial turmoil...
Now it is time for your shopping to buy other acres of land that are left behind...
Regards,
Prem
Dear Arun sir,
This is the mail i got when i forwarded your mail. See, for what you have done i am getting credit. Ofcourse i have sent a reply denying it
As Dharma said this the best from you on Nonrajini posting.
Hats off to you
pradeep

Raja said...

Hi Arun,
Simple & very good Explanations to the current situation with Know names

Raja

Sudershan said...

Excellent writing.. Hats off to you man...

Ramya said...

Very beautiful post, I have come across. Keep writing and create awareness.

Sampathkumar said...

Arunji,

Awesome write up. this is not Dummy's guide, This is the guide for the Dummys.Im in the banking industry and knows what is happening now in the world market. But I cudnt explain it to my friends. Shame on me. Im now gonna steal ur write up now and share with my friends. Proud to have a thalaivar fan like u..

maithri said...

Moral of the story???...Overcome Greed!! Excellent! what a beautiful way of elucidating the entire theme with local examples!! Ultimately its a story WITH A SOUL. Thalaivare....you should be writing movie scripts!! hail hail!

Kishan said...

I’d like to raise a glass to another Rajnikanth fan who deserves a tribute :
fantastic analysis of sub prime crisis and very well explicated.
As thalaivar has always said : Adhikama aasai padra ambaley(KIN) nallavaazhyuva saritra mey kadeyadu .
It’s nice to see you making the subprime mortgage crisis funny…
Adaptable Mortgages + Unwitting Grabby capitalists = downside for all.

padma said...

Excellent.

padma said...

Excellent.

Divya.B said...

Quite insightful, yet humorous.
Divya

ashwath said...

wow!!!!!!!!!!!
All the famous story and screenplay writer should atleast seek some advice about how to pen a story and how to make it compact with its racy narration like this article...
If every critical situation like this is explaied in this simplified manner i am sure that every layman can better understand about lehmann
This story is for all those podhu janam(i must console this character 'rombo paavam ella situation la yum ivan azhudukitte iruppan') who are unaware about the fraud being weaved over them...as the famous Quote goes in tamil 'yematharvana vida yemarravan than kutravaali' so it is the podhu janam's responsibility to know the fact and act accordingly..
thanks mama for taking superb,extraordinary and self explanatory post like this for podhu janam like us to understand better about person like kin and banks like cicic..

i must say that this article is one of the best article compared to all other articles written by you..
SSSSSUUUUUPPPPPEEEEERRRRRBBBB!!!

Zhinkaas said...

Great post indeed. It is real dummy's guide. This should be part fo some textbook on subprime crisis.

Naveen said...

wonderful post. thnks for making it easy to understand. but i dont think the bubble burst was entirely a product of wrong judgement like u suggest. Though it certainly is a cause, many feel the money and banking system has fundamental flaws in it and such events are bound to happen. the below article gives an overveiw, plz let me know wht u think:
www.realitysandwich.com/money_and_crisis_civilization

விஜய் said...

Hello Mr. Arunachalam,
It is really a very informative and thought provoking post. Actually I had read your post on Sonia some time back :-)

Would have been better if you had given some tips to people like Podhu Janam on how to evaluate a property before buying it. If the rating agencies do fraud, then whom do we believe in?