[Reader-list] When the Bubble burst

[Jeebesh]

dear All,

Here is a nice and precise analysis of the present turbulence in the  
financial market all over the world. It's incredible how a extremely  
complex web of trading and speculation got built around the monthly  
EMIs of Home Loans. Now the bubble has burst and has sunk many million  
small players. The big players will try to keep themselves afloat  
through various crafts of petition making, threats and blackmails. The  
coming time is going to be interesting...

warmly
jeebesh

(extract from)
When the bubble burst
SHYAM P.

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?

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.

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, 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.

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 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).

Date:05/10/2008 URL: http://www.thehindu.com/thehindu/mag/2008/10/05/stories/2008100550010100.htm