Tuesday, September 16, 2008

Why banks fail in the US?

Foreword:
If you dont understand the following, here is the pictorial representation of the mess..
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Everyone knows that the economy is down and US is not doing great. Scrap the surface and we dont really know what really the issue is. Some initiated may say "its the sub-prime crisis".
After much difficulty I think i understand it now..
Wading through the complex jargon and inherently complicated financial system, what I see is profoundly dumb decisions masked as "investment models" based on one fndamentally stupid premise
"Lend money to someone who cannot repay. Thats the way to make money for everyone"
A lends money to X and charges X a hefty interest (to cover the risk of default by X). B decides that there is a risk-reward premise. Assuming (Ass u me) the default is going to be less, they securitize these mortgages ( "If X pays, banks make money. More such X's pay bank pays more money. So lets issue a bond to an investor by name C, who will make money if X pays A. If X keeps aying, A's mortgage loans are performing well. More people would want to own securities whose underlying mortgages do well)
So mortgage based securities were sold and sought like hot cakes by C's. C's then issue what is known as "CDO (collateralized Debt obligations" - which means "someone took a loan. some one bet a gamble on it. I am gambling on the outcome of that gamble).
So these CDO's were sold to investors like you and me - who thought
X will pay A; A will make money; When A make money, B's bonds will make money because B's bonds perform well if A performs well; If B's do well, C's will do well, if C does well, I will make money.
Contrived? No. Complicated? Yes, because you making money depends on 3 other parties meeting their obligations of which the primary party (A) is a known defaulter (and hence called sub prime).
So what's the big deal if C loses money? C is not you and me as I earlier said. C is multi billion dollar investment banks which hire in IIM campuses.
So are the C's dumb? Yes and No. Yes because they are greedy beyond the limits for non-existent money and No because they insured their CDO's with AIG and other insurers who willfully agreed to insure against defaults of the instruments.
Will it affect India? Yes, because even our insurers, reinsure these insurances!
Will it affect a pensioner in India? Yes, if one of the insurance companies in India go belly up (depends on the exposure levels).
But India being an under insured nation, that front of damage is less. But hey, in many ways our lending institutions have bought US securities. What about them?
Watch sensex. You will know the answer!

3 of my fans were here!:

Jan said...

scratch! scratch! onnume puriyala!

>>Jass<< on 12:50 AM said...

You ought to read a forward that i got about three months back! If you would be so kind to give me your email address I can forward it to you. [no i do not see viagra pills for 1.99$ and i am not a bot :P]
Or maybe you already read it! :) A pretty hilarious way to explain the same CDO/CMO shit on the surface atleast :)

>>Jass<< on 8:51 AM said...

oh here are a couple links :D :D

http://in.youtube.com/watch?v=q8hjUei-Nwo

http://in.youtube.com/watch?v=nTDZU56jLoM

Hope you like em ;)

 

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