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.