came across this article on The Hindu magazine, this article clearly
tells why Lehman Brothers collapsed? ...and the reason for the eventual
economic crisis, a video is also added under resources/videos tab 'The
Crisis of Credit Visualized'.
The bursting of the speculative bubble in the U.S.
housing market has destroyed billions of dollars in investor wealth
across the world, crippled the banking system, expunged close to a
million jobs…and India
has not been spared either. With banks failing by the day, definitely,
these are uncertain times for the financial services industry. While
many people who have lost their jobs are faced with permanent shrinkage
of their lifestyle, others in the industry are going through the trauma
of not knowing if and when their turn would come. Who is to blame?
Flashback to year 2003:
(name changed to protect identity), a good friend of mine and someone
who was officially considered to be a genius with an IQ of 150+,
graduated from one of the leading IIMs. Rohit
managed to make it into the New York Headquarters of the most sought
after firm that had arrived on campus for the first time — Lehman
Brothers — a top U.S. Investment Bank (then). On joining, he was
assigned to Lehman’s mortgage securities desk that dealt with Collateralised Debt obligations (or CDOs).
Following is an extracted transcript of a chat session I had with Rohit back in 2004:
Me: So man, you must feel like you are on top of the world.
Yes dude, the job here is amazing, I get to interact with people around
the world, investment managers who want to invest millions of dollars
Me: Great…so tell me something interesting. What’s your job all about?
Rohit: You know there is a great demand for American home loans, which we buy from the U.S. banks. We then convert these into what is called as CDOs (Collateralised
Debt Obligations). In plain English, this refers to buying home loans
that banks had already issued to customers, cutting them into smaller
pieces, packaging the pieces based on return (interest rate), value,
tenure (duration of the loans) and selling them to investors across the
world after giving it a fancy name, such as “High Grade Structured
Credit Enhanced Leverage Fund”.
Me: Wow! I would’ve never guessed that boring home loans could transform into something that sounds so cool!
Rohit: Hahaha…actually we create multiple funds categorised
based on the nature of the CDO packages they contain and investors can
buy shares in any of these funds (almost like mutual funds…but called
Structured Investment Vehicles or SIVs)
Me: Dude, you make your job sound like a meat shop…chopping and packaging. So, in effect when an investor purchases the CDOs (or the fund containing the CDOs), he is expected to receive a share of the monthly EMI paid by the actual guys who have taken the underlying home loans?
Rohit: Exactly, the banks from whom we purchased these home loans send us a monthly cheque, which we in turn distribute to the investors in our funds
Me: Why do the banks sell these home loans to you guys?
Because we allow them to keep a significant portion of the interest
rate charged on the home loans and we pay them upfront cash, which they
can use to issue more home loans. Otherwise home loans go on for 20-30
years and it would take a long time for the bank to recover its money.
Me: And, why does Lehman buy these loans?
Rohit: Because we get a fat commission when we convert the loans into CDOs and sell it to investors.
Me: Who are these investors?
Rohit: They include everyone from pension funds in Japan to Life Insurance companies in Finland.
Me: But tell me, why are these funds so interested in purchasing American home loans?
Well, these guys are typically interested in U.S. Govt. bonds
(considered to be the safest in the world). But unfortunately, Mr. Alan
Greenspan (head of Federal Reserve Bank, similar to RBI in India)
has reduced the interest rate to nearly 1 per cent to perk up the
economy after the dotcom crash 9/11attacks. This has left many funds
looking for alternative investments that can give them higher returns.
Home loans are ideal because they offer 4-6 per cent interest rate.
Me: Wait, aren’t home loans more risky than U.S Bonds?
Rohit: We have made home loans less risky now. In fact they have become as safe as U.S Govt. bonds.
What are you saying, man? What if the people who have taken these
underlying home loans default? Then the investors would stop getting
the EMIs, and their returns would take a hit. Wouldn’t it?
Boss, may be some will default, but not definitely more than 2-3 per
cent. Moreover, we have convinced AIG (a leading insurance company) to
insure our CDOs. This means that even if there were big defaults,the insurance company would compensate the investors.
Me: that’s amazing. What are these insurances called?
Rohit: Credit Default Swaps.
Me: Definitely you guys are the most creative when it comes to naming.
Me: And why has this AIG guy insured millions of home loans?
See man, the logic is simple. Home prices in the U.S always go up. In
fact over the last three years alone they have doubled. So even if
someone defaults paying the EMI, the home can be seized and sold for a
much higher price. So there is no risk. Insurance companies are
actually competing to insure this, because they can earn risk-free
Me: No wonder investment managers from all over the world want to put money in your CDOs.
global financial cobweb started getting built around the American dream
of purchasing a home and it rested on the assumption that “home prices
will keep rising”. As demand for the CDOs
started growing across the global investment community, the investment
bankers (like Lehman) who were meant to sell these instruments also
started investing a significant portion of their own capital in these.
I guess after selling the story to the whole world, they themselves got
sold on the seemingly foolproof concept. Gradually the markets for CDOs
and Credit Default Swaps started expanding with traders and investors
buying and selling these as if they were shares of a company, happily
forgetting the underlying people behind these products who took the
home loans in the first place and on whose capacity to repay the loans,
the safety of these products depended.
As Wall Street firms like Lehman were churning more and more home loans into CDOs
and selling them or investing their own money, there was a pressure on
the banks to issue more loans so that they can be sold to the Wall
Street firms in return for a commission. Slowly banks started lowering
the credit quality (qualification criteria) for availing a home loan
and aggressively used agents to source new loans. This slippery slope
went to such an extent that in 2005, almost anyone in the U.S could buy
a home worth $100,000 (45 lakhs INR) or
more without income proof, without other assets, without credit
history, sometimes even without a proper job. These loans were called
NINA — “no income no assets”.
housing market went into a classic speculative bubble. Home loans were
easy to get, so more and more people were buying houses. The increased
demand for houses caused the price to increase. The rising prices
created even more demand, as people started to look at homes as
investments — investments that never went down in value.
When I touched base with my friend Rohit in late 2005, he was on cloud nine. During the previous one year, he managed to buy a home in Long Island (a posh area near New York City)
worth almost a million dollars, and got himself a Mercedes. All this
was interesting to hear, but what shocked me was that although he was
earning close to $20,000 a month (that is what CEOs in India make) he was not able to save anything because his lifestyle expenses where growing faster than his salary.
late 2006, Mortgage lenders noticed something that they’d almost never
seen before. People would choose a house, sign all the mortgage papers,
and then default on their very first payment. Although no one could
really hear it, that was probably the moment when one of the biggest
speculative bubbles in American history popped. Another factor that lead
to the burst of the housing bubble was the rise in interest rates from
2004-2006. Many people had taken variable rate home loans that started
getting reset to higher rates, which in turn meant higher EMIs that borrowers had not planned for.
problem was that once property values starting going down, it set off a
reverse chain reaction, the opposite of what had been happening in the
bubble. As more people defaulted, more houses came on the market. With
no buyers, prices went even further down.
early 2007, as prices began their plunge, alarm bells started going off
across mortgage-backed securities desks all over Wall Street. The
people on Wall Street, like Rohit, started
getting calls from investors about not getting their interest payments
that were due. Wall Street firms stopped buying home loans from the
local banks. This had a devastating effect on particularly the small
banks and finance companies, which had borrowed money from larger banks
to issue more home loans thinking they could sell these loans to Wall
Street firms like Lehman and make money.
got into a mad scramble to seize and sell the homes in order to get
back at least some of the money. But there were just not enough buyers.
The guys who had insured these loans thinking they had near zero risk
(e.g. AIG) could not fulfil the
unexpectedly huge number of claims. The best part was that since these
insurance policies (credit default swaps) could themselves be traded,
multiple people had bought and sold them, and it became so tough to
even trace who was supposed to compensate for the loss.
global financial cobweb built around mortgages is on the brink of
collapse. Firms, large and small, some young some as old as a 100 years
have crumbled as a result of suing each other over the dwindling asset
values. Lehman’s India operations, that employed over a thousand staff, is
up for sale and many of the employees have been asked to leave. The
Indian stock market has crashed almost 50 per cent from its high (and
so have markets around the world) as the Wall Street giants sold their
investments in the country in an effort to salvage whatever is good in
order to make up for the mortgage related loss. Hedge funds, pension
funds, insurance companies all over the world have lost billions in
investor’s money. Many Indian B-School graduates with PPOs (pre-placement offers) in the financial sector (India
and abroad) have either received an annulment or indefinite
postponement of joining dates. IT firms that built and maintained
software for the U.S.
mortgage industry or the related Investment Banks, have shut down their
business units, laid-off people or transferred them to other verticals.
all the hoopla over the sharp and sophisticated people on Wall Street,
the current financial crisis has exposed the fragility of the system.
Wall Street is blaming the entire episode on people who could not repay
their home loans. But the reality seems to point towards the stupidity
of people who lent all this money, financial institutions that built
fancy derivative packages and in effect facilitated billions in trading
and investments in these fragile low quality loans.
The U.S. Govt
is planning to grant 700 billion dollars to the Wall Street firms to
compensate the financial speculators for the money that they have lost.
Isn’t this like rewarding greed and stupidity? The head of a leading
Investment Bank has stated, “This is necessary to sustain financial
ingenuity. We don’t want to spend this money on ourselves. We just want
this money to go into the market so that we can carry on trading
complex securities, borrowing and lending money.” (Yeah…right, so that
one can act as if nothing had happened without analysing too much into it). The real question is: Who is going to compensate the common investors across the world who have lost their wealth in the resultant market meltdown? (either directly or through pension funds).
After being unreachable for a month now, finally I heard back from my pal, Rohit, saying he is back in India
to take a break from the roller coaster ride that he had lived through.
After Lehman’s collapse he has lost his job and probably the house that
he had bought by taking a hefty loan. I really don’t know whether to
feel happy for him, for getting an opportunity to learn a lesson or two
from the experience or to feel sad for him for losing his job. May be
I’ll get a better sense of things once I meet him next week.