While some blame the greed of Wall Street investment bankers and the
dangers of a totally unregulated system for the current financial
crisis, what can't be denied is that lives, and lifestyles, have been
suddenly changed across the social spectrum and careers built up over
a lifetime have vanished in an instant.
Flashback to year 2003:
Rohit (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 B schools. 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.
Rohit: 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?
Rohit: 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?
Rohit: 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.
Me: 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?
Rohit: 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.
Rohit: Thanks.
Me: And why has this AIG guy insured millions of home loans?
Rohit: 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
premiums.
Me: No wonder investment managers from all over the world want to put
money in your CDOs.
*A 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".
The U.S. 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 $200,000
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.
Unheeded signals
In 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.
The 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.
In 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 call 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.
Everyone 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.
The 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.
Fragile system
For 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
analyzing 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. Maybe I'll get a better sense
of things once I meet him.
Now I know why /*_Warren Buffet calls derivatives, the financial
instruments of mass destruction! !!!!!!!!_ */
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