Recession/0.5 Depression 2008-09: Explained in my words

In software engineering, we have “trail and error” to fix an issue, we don’t know the solution for a problem but merely provide a code change and hoping that would fix the issue. If not, then try again. We are in same mode for current recession also. Mr. Obama’s stimulus package definitely going to help economy to flourish but how long. It was very unfortunate that world leaders not coming together to fix the fundamental financial architecture break down.

We have to first understand what caused this issue.

  1. Joe planning to buy a house in San Jose, CA.
  2. He walks into a bank for a loan at value of $800,000/.
  3. Bank determines that Joe has some issue with credit history hence he will not eligible for prime rate.
  4. Even though Bank gives mortgage loan to Joe at sub prime rate @ 3.5 Adjustable Rate Mortgage.
  5. Bank then sells this mortgage to big investment firms like Lehman Bros, Bear Sterns etc.
  6. This investment firms bundle up all this loans and sells all over world. This is called Mortgage backed securities (MBS). 
  7. Among investors, MBS are safe heaven bet, since it backed by a real asset and historically house price never went down other than great depression period.
  8. So technically Joe bought his home with John’s investment from Russia, and Gupta bought a home at Delhi with George’s investment from Chicago.
  9. When one buy a MBS he/she thinks that he is investing to a real estate, low risk, high return on investment etc. No body never ever thought that we are moving towards 1930 great depression days.
  10. At same time investment firms bought insurance for this high risk mortgages.

Now who is accountable for mortgage that Joe got it from Bank, the mortgage was sold and it is not under Bank’s radar and investment firm’s radar, some one across the border holding it. The actors are loosely coupled here and Joe is single point of failure. The well proven business flow was just reused for sub prime market without any research and analysis.

These MBS was backed by credit default swaps (CDS) which is insurance like contracts to cover bonds in case of defaults. Usually CDS covers only very low risk bonds such as municipal bonds, government bonds etc, but again due to the confidence about real estate, CDS started covering MBS also. Unfortunately CDS is not regulated, hence it can be traded in secondary market, it is like today XYZ hedge fund holding contract and tomorrow it can be ABC hedge fund. The price for CDS determine based on investor’s confidence about outcomes. 

So now the stage set for Banks and investment firms, what all bank need to do is give mortgage loan to Joes, Johns and sell it to investment firms and investment firms buy a insurance from AIG and convert mortgage into MBS and sell it to open world market. MBS was now held by some one in earth, AIG now convert these insurance into CDS and was held by some hedge fund, nothing was regulated because CDS mainly traded at various places like London, Berlin and New York, we don’t have a global policy to control it.

This is how we do real estate business for 15-20 years it was greatly worked and smoothly integrated. What went wrong now is mainly, easy money flow and uncontrollable global economy. What we need is greater global co-ordination and greater technology to forecast risk and mitigate it.

Source:

http://www.slate.com/id/2186801/

http://www.fool.com/investing/general/2008/09/17/aigs-failure-is-so-much-bigger-than-enron.aspx

http://www.time.com/time/business/article/0,8599,1723152,00.html

http://www.investopedia.com/terms/l/lcdx.asp

http://www2.standardandpoors.com/spf/pdf/index/SP_CreditDefaultSwap_FAQ.pdf

Comments

Anonymous said…
Mortgage is the root of our economic crisis.So it is really important to be updated... Government should really prioritize this issue.
1:30 AM
Subba Muthurangan said…
Thanks Joe, for your visit and comment.

Subba
7:15 AM
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