Monday, March 24, 2008

The Credit Crunch de-mystified in 2 minutes

Every other day, we are seeing reports on the US Subprime problem. The reports frequently occupy the whole page in the Straits Times or Business Times. Lazy readers like you and me are put off by these reports. Are you guys still confused what is happening???

I try to summaries for busy people like you using my 10 points approach.

1) The Junk Bond idea
* The sub-prime concept arise from the junk bond concept.
* Junk Bonds are Bonds issued by companies with poor credit ratings. They have to issue bonds with a higher coupons than other companies to attract investors.
* The sub-prime follows this concept. Sub-prime are loans taken by people with lower credit capabilities. They have to pay a higher interest than others in order to be accepted for the loan.

2) The low interest Rate Environment
* From 2001 to 2004, the discount rate ramain low to help US economy get off from the 911 and bubble. Many people started taking loan due to the low interest. Its cheap money anyway.

3) Housing Price will always rise
* The Americans thought that the economy will always be bright and housing price will keep going up. So, they borrow more cheap money to buy more properties. They stopped savings altogether.

4) Lenders start to share Risk into the Financial market
* Financial Institutions took in more loans and start packaging these Sub-prime mortgages together with other mortgages into innovative investible securities like Asset backed Securities and Collatoral Debts Obligations, etc. to reduce their risk.

5) How these securities became popular?
* These lenders get Bonds insurers to insure these securities and make them as desirable as AAA ratings. Other Banks, Insurance Companies and Financial Institutions round the world buy into these securities since it looks so safe.
* They even use these securites as collatoral against other loans with each other.

6) The American dream dashed
* Federal Discount rate start going up followed by Mortgage interest.
* The economy slow down followed by housing prices that came down.
* Prices of house plunged to prices below the loan that they took.

7) Subprime borrowers stop paying
* Subprime borrowers either cannot pay their loan or refuse to pay their loan.
* Due to falling housing prices, their loan became higher than the price of their house. It does not make sense for them to continue paying the loan.

8) The problem spread
* Subprime borrowers don't pay. The Lenders get into problem. The problem are passed to those who purchased the securities which they packaged. The problem are further passed to those who accepted these securities as collatorals.
* The bonds insurers further worsen the problem as they lose their credibility. Other bonds they insured got into problem due to their reduced credit ratings.

9) Financial System crumpled.
* The whole system became wary of the problem and refuse to lend each other money. The money became tight in the economy and affected normal businesses.

10) The problem passed down to the people
* Businesses and household are affected by fear of recession.
* People are worried of the economy. They reduce spendings. Coupled with other problems like Inflation and falling US Dollar and rising oil prices, the US economy is indeed in big problem.


Khiat Han Hwee Adrian said...

Modified comment:

In US mortgage loans are sold by brokers like insurance agents here. They earn a commission. During good time, housing boom, to increase sale they lent to people with low credit rating, even the jobless. The brokers would sell to anyone regardless of their ability to service the loan. They would sell" the sure win or sure make" idea and convinced the buyers that property prices would go up and they could make a tidy sum.
In the short term then need not worry about the loan. They charged these people high interest , like Ah Long here.
Unfortunately, the property market crashed.Defaults and foreclosures became the order of the day..
In the meantime, financial whiz kids, cooked up some ideas to repackage these good and bad loans and get the credit rating company like S&P to give high rating for thier MBS, later became CDOs and the likes.
These new products were sold and repackaged a few times like MLM and marketed to banks to improve their returns.

Well the rest is history.
Like them, today insurance companies are imitating them. Many new useless products are repackaged products, supposedly with enhanced value but dubious, are hitting the market.
Buyers must examine with the help of good advisers and competent enough to see through fake and dubious products.Don't fall for them just becuase your trusted agent introduces to you. Some agents, just like the loan brokers , who are interested in nothing but the commission. These agents are not interested whether you are homeless or have adequate coverage. They just want your money.


Khiat Han Hwee Adrian said...

One of my reader emailed me saying that I did not mention about the problem escalated due to margin losses where hedge funds & private equity had to cash out, also unwinding of yen position.. all these lead to stock mkt crashes & companies going bankrupt.

Thanks for the email and I shall talk about these in future postings.