Sub Prime Crisis Leads to Global Credit Crisis
November 6th, 2009 | by admin |Sandy Naidu asked:
The financial papers have been reporting the doom and gloom the global economy is facing due to the sub prime crisis…Suddenly sub prime crisis seems to be taking the blame for all the major problems (except maybe for the war in Iraq). This blame is not totally baseless…In this article I am going to try and decode and explain in plain English what this global crisis is all about.
It All Started Here
Five to Six years ago (or slightly before then), the real estate market in America was booming. The house prices were rising…The home owners were happy and the aspiring home owners wanted to buy a home as soon as they can…
At around this time there were huge amounts of money available in the ‘global money pool’..In early 2000s the size of the global money pool was almost twice its size in the previous couple of years. The booming global economy and the prosperity in countries like China, India (and others) were the primary reasons for this huge increase in the ‘global money pool’. When they say that there was an increase in the ‘global money pool’, what they mean is that the money held by hedge funds, investment banks, financial companies and other investors was all in the rise…So these guys had huge amounts of money ready to invest.
At around the same time the interest rates in America were at an all time low (around 1%) - Obviously not tempting enough for the global money pool to be invested in the treasury and Government backed bonds.
So you have the following:
? Huge sections of population looking to borrow money for their dream home
? A Big Fat global money pool ready to be invested somewhere
? A very low interest rate being offered by US Treasury bonds - So Global money pool was looking for an alternative investments.
A Match Was Made
The global pool of money found their perfect match (or at least thats what they thought until now)…To understand why this is a perfect match, lets work through the situation in reverse.
1. Lets assume Mary wants to buy a house
2. She gets a mortgage from a broker
3. The broker sells the mortgage to a bank
4. The bank sells the mortgage to a wall street firm
5. The Wall Street Firm is delighted with these mortgage investments - they are now getting monthly repayments for their investments (repayments made by home buyers) - the yield is much better than what they would get for treasury bonds.
The Wall Street brains did not stop at getting monthly repayments - they went ahead and created something called CDOs (Collateral Debt Obligations). CDOs are packages of securities backed by bonds, mortgages and other loans. The CDOs were given AAA rating by rating agencies - Seemed like a perfect investment. These CDOs were then sold into the global market. More than half of the CDOs sold were filled with sub prime mortgage debt.
The global money pool owners invested their money in these CDOs…. And apparently a lot of money market funds were also invested in CDOs..Mum and dad investors invest in money market funds (like cash management funds) because of their low risk…So how come these money market securities end up investing in CDOs…Probably because they have AAA rating (highest rating possible).
As a side note, if you are wondering how these CDOs got AAA rating, here is the answer - the rating agencies rated them based on the historical data…They had the historical figures for foreclosures, they doubled that and thought worse comes to worse this is how much the foreclosures will be…All loans were backed by bricks and mortar. It seemed safe…What they did not take into account was the sub prime loans…But the question remains to be asked, how could they miss the sub prime loans and the risk it poses…After all more than half of OCDs were loaded with sub prime loans…I am at a loss here and I don’t know the answer.
The Greed
The pressure was mounting on the brokers to sell more mortgages…And here is the reason why -
1. The demand for CDOs was on the rise. The wall street firms wanted to buy more and more mortgages from banks…
2. And banks in turn were putting pressure on brokers…
3. And so the brokers responded accordingly…They were desperate to sell mortgages…And they sold…Not one or two…But Thousands…And they sold it anyone and everyone who asked for one…There were no checks…There was no income test…They just asked you what your income was…You could say whatever you want, no verification was done…And what was lent had no connection to the borrower’s income…People were being offered much much more than what they could afford. The loans given to people who do not qualify for a proper (prime) loan is called a sub prime loan.
The problem started when the borrowers started defaulting…The blame does not lie on borrowers alone…The lenders should have expected this - They should have known that this would occur sooner or later. There were some borrowers who started defaulting right from the first repayment. So this further illustrates the fact that loans were made to people who did not deserve to borrow with their current financial credentials.
And then the house prices started falling…So even the foreclosures could not recover the losses (since the houses sold for much less than what they were financed at)…This is what the sub prime crisis is all about…People defaulting on loans and lenders forcing them out of their homes (foreclosures)…
Wall Street Firms Start Panicking
These firms were buying mortgages and bundling them up and selling them as CDOs…The CDOs were backed by mortgages which in turn was backed by the houses…So the houses were the real collaterals. Once the house prices started falling, the asset prices of the CDOs fell…The wall street firms were being hit two fold here - 1. loan defaults 2. asset values of CDOs falling. And as a result they became extremely cautious with their money and reduced all forms of lending. And now the global money pool which was previously investing in CDOs also became extremely cautious with their money - it realised CDOs were filled with sub prime debt (toxic debt). Plus the money it already invested in CDOs were returning less than the initial investment.
The Outcome
Every one has become cautious …Investors realised that even money market securities (supposedly safe investments) have invested in CDOs…So investors are not even ready to invest in money market securities…If there is no one to invest in then where will the money come from? Nowhere…
Credit squeeze can have a huge impact on the global economy..Every one needs credit - You and I need credit for our purchases (be it a home or a car or whatever)..Companies need credit so that they can finance various projects - Governments need credit…And so imagine if credit was squeezed and the pool available for all these was considerably less..And whatever credit is available, the costs for accessing that will be high (borrowing costs will rise). Less credit and hence less growth…. Sub prime crisis was the start and the outcome of which was the global credit crisis. The cycle will continue for atleast a couple of years or more.
But for general public wanting to borrow for a property its not all doom and gloom…The rules might have changed (for better)…The lenders are much more stringent now…But if you meet all the risk return criteria (meaning sufficient income to justify the loan plus a good deposit), you will qualify for the loan.
Alcoa Vinyl Siding
The financial papers have been reporting the doom and gloom the global economy is facing due to the sub prime crisis…Suddenly sub prime crisis seems to be taking the blame for all the major problems (except maybe for the war in Iraq). This blame is not totally baseless…In this article I am going to try and decode and explain in plain English what this global crisis is all about.
It All Started Here
Five to Six years ago (or slightly before then), the real estate market in America was booming. The house prices were rising…The home owners were happy and the aspiring home owners wanted to buy a home as soon as they can…
At around this time there were huge amounts of money available in the ‘global money pool’..In early 2000s the size of the global money pool was almost twice its size in the previous couple of years. The booming global economy and the prosperity in countries like China, India (and others) were the primary reasons for this huge increase in the ‘global money pool’. When they say that there was an increase in the ‘global money pool’, what they mean is that the money held by hedge funds, investment banks, financial companies and other investors was all in the rise…So these guys had huge amounts of money ready to invest.
At around the same time the interest rates in America were at an all time low (around 1%) - Obviously not tempting enough for the global money pool to be invested in the treasury and Government backed bonds.
So you have the following:
? Huge sections of population looking to borrow money for their dream home
? A Big Fat global money pool ready to be invested somewhere
? A very low interest rate being offered by US Treasury bonds - So Global money pool was looking for an alternative investments.
A Match Was Made
The global pool of money found their perfect match (or at least thats what they thought until now)…To understand why this is a perfect match, lets work through the situation in reverse.
1. Lets assume Mary wants to buy a house
2. She gets a mortgage from a broker
3. The broker sells the mortgage to a bank
4. The bank sells the mortgage to a wall street firm
5. The Wall Street Firm is delighted with these mortgage investments - they are now getting monthly repayments for their investments (repayments made by home buyers) - the yield is much better than what they would get for treasury bonds.
The Wall Street brains did not stop at getting monthly repayments - they went ahead and created something called CDOs (Collateral Debt Obligations). CDOs are packages of securities backed by bonds, mortgages and other loans. The CDOs were given AAA rating by rating agencies - Seemed like a perfect investment. These CDOs were then sold into the global market. More than half of the CDOs sold were filled with sub prime mortgage debt.
The global money pool owners invested their money in these CDOs…. And apparently a lot of money market funds were also invested in CDOs..Mum and dad investors invest in money market funds (like cash management funds) because of their low risk…So how come these money market securities end up investing in CDOs…Probably because they have AAA rating (highest rating possible).
As a side note, if you are wondering how these CDOs got AAA rating, here is the answer - the rating agencies rated them based on the historical data…They had the historical figures for foreclosures, they doubled that and thought worse comes to worse this is how much the foreclosures will be…All loans were backed by bricks and mortar. It seemed safe…What they did not take into account was the sub prime loans…But the question remains to be asked, how could they miss the sub prime loans and the risk it poses…After all more than half of OCDs were loaded with sub prime loans…I am at a loss here and I don’t know the answer.
The Greed
The pressure was mounting on the brokers to sell more mortgages…And here is the reason why -
1. The demand for CDOs was on the rise. The wall street firms wanted to buy more and more mortgages from banks…
2. And banks in turn were putting pressure on brokers…
3. And so the brokers responded accordingly…They were desperate to sell mortgages…And they sold…Not one or two…But Thousands…And they sold it anyone and everyone who asked for one…There were no checks…There was no income test…They just asked you what your income was…You could say whatever you want, no verification was done…And what was lent had no connection to the borrower’s income…People were being offered much much more than what they could afford. The loans given to people who do not qualify for a proper (prime) loan is called a sub prime loan.
The problem started when the borrowers started defaulting…The blame does not lie on borrowers alone…The lenders should have expected this - They should have known that this would occur sooner or later. There were some borrowers who started defaulting right from the first repayment. So this further illustrates the fact that loans were made to people who did not deserve to borrow with their current financial credentials.
And then the house prices started falling…So even the foreclosures could not recover the losses (since the houses sold for much less than what they were financed at)…This is what the sub prime crisis is all about…People defaulting on loans and lenders forcing them out of their homes (foreclosures)…
Wall Street Firms Start Panicking
These firms were buying mortgages and bundling them up and selling them as CDOs…The CDOs were backed by mortgages which in turn was backed by the houses…So the houses were the real collaterals. Once the house prices started falling, the asset prices of the CDOs fell…The wall street firms were being hit two fold here - 1. loan defaults 2. asset values of CDOs falling. And as a result they became extremely cautious with their money and reduced all forms of lending. And now the global money pool which was previously investing in CDOs also became extremely cautious with their money - it realised CDOs were filled with sub prime debt (toxic debt). Plus the money it already invested in CDOs were returning less than the initial investment.
The Outcome
Every one has become cautious …Investors realised that even money market securities (supposedly safe investments) have invested in CDOs…So investors are not even ready to invest in money market securities…If there is no one to invest in then where will the money come from? Nowhere…
Credit squeeze can have a huge impact on the global economy..Every one needs credit - You and I need credit for our purchases (be it a home or a car or whatever)..Companies need credit so that they can finance various projects - Governments need credit…And so imagine if credit was squeezed and the pool available for all these was considerably less..And whatever credit is available, the costs for accessing that will be high (borrowing costs will rise). Less credit and hence less growth…. Sub prime crisis was the start and the outcome of which was the global credit crisis. The cycle will continue for atleast a couple of years or more.
But for general public wanting to borrow for a property its not all doom and gloom…The rules might have changed (for better)…The lenders are much more stringent now…But if you meet all the risk return criteria (meaning sufficient income to justify the loan plus a good deposit), you will qualify for the loan.
Alcoa Vinyl Siding
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