What exactly happened in US Finance Market

There cannot be a simpler explanation to the problems being faced by the global economy today. The illustration in the below piece is simple, the underlying cause for the crisis explained through a chat transcript the author had with his investment banker friend from Lehmann Brothers sometime back in 2003. The naivety of the big investment banks and their managers comes across beautifully in this chat transcript. Also shows how Lehmann's collapse engulfed AIG and other banks across the world. For everyone wondering what all this fuss about, here is is a great article to understand the crisis.
http://www.hindu.com/mag/2008/10/05/stories/2008100550010100.htm

When the bubble burst
SHYAM P.

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. Apart from the revised $700 billion bailout plan, can the U.S. government do enough to restore confidence and assuage the trauma?

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?
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?
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 IIMs. 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 $20,000 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 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).
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. May be I'll get a better sense of things once I meet him next week.