Financial Weapons of Mass Destruction

This financial tsunami that has engulfed the US is no less dramatic than the one that struck in 1929. The blurred geographical differences due to high economic integration have ensured that the world suffers due to financial over-innovation by I-Bankers from Wall Street.

The US government announced a bailout package of $ 700 billion and all the European countries have also introduced a slew of reforms that includes the € 1,000 billion bail out package for the financial institutions. All these packages bailout that are aimed at rescuing the financial majors, the real problem of bailing out the common investors across the world will still persist.

Bursting of the speculative bubble

There used to be a great demand for American home loans, which used to be sold by US banks to investors through investment banks, before the crisis began. These were converted and packed into what is called as CDOs (Collateralized Debt Obligations). This refers to a practice where the boring home loans, that banks have already lent to customers are cut into smaller pieces and packed as smaller 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 names, such as “High Grade Structured Credit Enhanced Leverage Fund”.

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There loans are created multiple funds categorized 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). To an ordinary man, this job might sound like meat shop which involves chopping and packaging.

The banks from whom the loans are purchased send interest payments regularly, which in turn are used to pay the investor. The banks are motivated to sell the home loans due to two reasons, one being selling-off probable bad assets and to get back money which would have taken more then 20-30 years in a matter of months.
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The investment banks get huge commission to convert these loans into CDOs and sell it back to investors. Investors also include big financial institutions such as insurance companies. These firms invest in these home loans as they offer attractive interest rates of 4-6 percent, more than that of US govt bonds.

There is always a risk of defaulting in these home loans default. In that case, the investors would stop getting EMIs. In order to mitigate the risk, the investment banks have convinced insurance companies to insure the CDOs. In this case the insurance companies would compensate the investor. These insurances are called credit default swaps. As the prices of houses in US have doubled in last three years, the insurance companies believed that value of underlying asset will be more than the default, so there was very less risk.

The entire meltdown started with the dream of every American of buying a home and it rested on the assumption that housing prices will never come down. As the demand for CDOs started to increase because of its low risk nature, even investment banks started to invest heavily in these bonds. These CDOs where started to get traded like a stock. These investors forgot the people who had taken housing loan were behind these products and the safety of these products was highly depended on their capacity to repay the loan.

As the demand for these CDOs increased, the banks were under a constant pressure to sell more housing loans. The banks had to resort to lower the qualification to lend. The credit worthiness of those availing loans was going down. In some time even people without jobs or assets could avail themselves of a housing loan.
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This was followed by a gigantic speculative bubble. The home loans were easily available which enabled everyone to get a home loan. This increased off take of housing loans lead increased demand for houses, which lead to increase in prices of houses. The rising prices created even more demand, as people started to look at homes as investments — investments that never went down in value.

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Unheeded signals
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In late 2006, Mortgage lenders noticed something that they had never seen before. People would buy houses on loan and default on their very first payment. This was leading what was probably the biggest speculative bubble in American history. The housing bubble burst with an increase in interest rates. 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 started once property values starting going down, it set off a reverse chain reaction, the opposite of what had been happening in the built-up to bubble. As more people defaulted, more houses came on the market. With no buyers, prices went even further down. The investors were not getting their monthly interest payments. As a result of this the I-banks stopped buying loans, which lead to a devastating effect on the banks who had disbursed housing loans thinking they could sell these loans to the I-Banks.

There was a big scramble to sell those houses at reduced price. The insurance companies who had insured thinking that these were a near-zero risk loans, could not fulfill their contractual obligation. The number of claims began to swell as the prices of houses started to fall.

The complicated structures that were built around mortgages could not sustain for a long time. Lot of firms, some young and also ones as old as 150 years started to crumble. The stock markets world over have slipped in last few months, some are trading at close to half their values. Many banks have shut down and some have curtailed their operations which has lead to loss of jobs.

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Fragile system

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The Financial Engineers and I-Bankers had built sophisticated models to sell the bad loans to investors. The models were difficult to understand and these banks to not evaluate the risks they were bearing and finally some went bankrupt as well. Even though the US govt is trying to have a bailout package for them but these models have made it impossible for anyone to correctly value the quality of assets. The current crisis has brought the fragility of the system has come to the fore. It is all those people who lent there money to trusting these fancy derivative packages in order to satisfy their greed have been the most affected.

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. Some detractors do claim that this is necessary to sustain financial ingenuity. Who is going to compensate all those investor who lost their wealth in the market meltdown is still a puzzle for many.