The following is a very good explanation of all that is happening around us in the financial

markets. Good Read.

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.

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 B
schools. 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 $200,000 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 call 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 analyzing 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. Maybe I'll get a
better sense of things once I meet him. Now I know why Warren Buffet calls derivatives, the
financial instruments of mass destruction!