News/Entertainment-cmk

cmkondotty's blogs

2010-02-20T01:28:00.000-08:00

Investment Opportunities-Techno park, Kerala

2010-02-16T08:28:00.000-08:00

Investment Opportunities-Techno park, Kerala

http://www.keralait.org/

Bangladesh beauty

2010-02-15T06:26:00.001-08:00

Revenge Animals

2008-10-12T09:24:00.000-07:00

Revenge Animals

2008-10-12T09:22:00.000-07:00

A game of Riba leads to the financial crisis in US !!

2008-10-07T08:34:00.001-07:00

A well explained article about the ongoing financial crisis in US

A lot has been happening at the Wall Street in the past few days. Bloodbath! Nightmare at Wall Street!! And Fall Street!!, are some of the phrases being used to describe the situation in the US financial system.

Lot many of us just try and say "credit crunch", "bank failures" etc without understanding what's really happening. And nobody really knows where did all the money go after this? Let's try and understand what has happened.

The danger of these banks failures is not really consumers loosing their deposits and savings. The Fed government would be less worried if it were so. The real issue lies in the cascading failures of banks. And how did that happen?

Consider this simple scenario. All banksters (bankers and brokers together are called banksters) are sitting across a really huge round table where each bankster is seated next to another and has a pile of receivables from the adjacent bank on his right, and a pile of payables to the bank on his left. All these receivables (and payables) are actually a set of inter-bank obligation instruments, including what is called derivatives, bonds etc. In a normal situation, all banks receive their 'receivables' from the adjacent bank and pay their 'payables' to the next bank, on time and with interest.

It's just one bank who would renounce its turn to pay and there goes the entire pack. Simple, isn't it? No, there are slight complications here. Read on.

There is something called as 'Settlement Risk' (http://en.wikipedia.org/wiki/Settlement_risk) in the financial world. What is it? It's like paying your credit card dues at a specified date. When Bank A fails to make a payment against the instruments (debts, bonds, mortgages etc) to Bank B at an agreed time, Bank B is unable to pay to Bank C and this leads to a cascading effect. But then where is the money gone? Why is Bank A not able to pay up in the first place?

Enter mortgages. Mortgage is nothing but a housing loan (or any other loan) that needs to be paid by individuals/customers on a regular basis. Back in the 70's and 80's the value of the home could not exceed 2.5 times the individual's annual income. After 2000, the ratio of housing prices to income jumped to 4.5 times of the annual income. Facts prove that generally people are able to service their mortgages at a ratio of about 2.5x. But people were not able to pay up until recently this high amount of loans (EMI). Factor in a rising interest regime and the 4.5x factor balloons exponentially compared to 2.5x.

But why did banks approve loans of people at 4.5 times of their annual earning? Simple! Greed to have more business and customers. They did not even verify that the individual may be able to pay the outstanding amount in the future.

It's simple. If an individual had a household income of $100,000 in 2000 and bought a home for $400,000, the real estate crunch would not yet be over till the actual price of the house reaches about $250,000, and this may take another year or two. When the price of that house falls to about $250,000 (give or take 5%) then the 2.5x factor sets in once again and individuals are at a comfortable level to service their debts.

But why did anyone not figure this out earlier? That the housing bottom is still way ahead and there is a larger credit crisis that looms? What happened to those really smart accountants and investment bankers from Ivy League schools, which could crunch numbers in their heads and amazed you at their financial acumen?

The problem lies in the way accounting rules are set. Once the mortgages are through there is no way to do (or rely on) a 'bottoms up' accounting of the financial firms to find out where the defaulters lie. CITI alone has more than 7000 off balance sheet entities (http://www.bloomberg.com/apps/news?pid=20601109&sid=a1liVM3tG3aI&refer=home) and this applies generally to all banksters in the financial world. Because it's extremely difficult to validate through a 'bottoms up' analysis of the firms, only a TOP-DOWN approach is done to get an idea of the problem. After this try and narrow down through some back of the envelope calculations, where do those defaulters lie and the extent of those losses. It's too late by then. The losses exponentially increase without any inkling to the banksters. And one fine day, everything collapses like a pack of cards.

What happens next?

The US government tries to bail out the firms by billions of dollars being doled out to the rescue. But what is it exactly doing? It's taking the firms risks & liabilities on to itself. And the net result is that in a year or two the US government is also loaded up with massive losses. In the international context, foreign buyers of US debt and other instruments would look at them with suspicion (The federal government needs about $ 2-3 bn of foreign money EVERYDAY to keep the system in place). As a result of all this by mid/late 2009 or early 2010 the viability of US government would be in question. Who would then bail them out?