Learn the debt crisis in an analogous way !

For anyone who cannot understand the present financial crisis of the UK, the EU and indeed the whole western world economies. 
Mary is the proprietor of a bar in Dublin. She realises that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronise her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

"Word gets around about Mary's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Mary's bar. Soon she has the largest sales volume for any bar in Dublin .

"By providing her customers' freedom from immediate payment demands, Mary gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages.

"Consequently, Mary's gross sales volume increases massively. A young and dynamic vice-president at the local bank recognises that these customer debts constitute valuable future assets and increases Mary's borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

"At the bank's corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into Drinkbonds and Alkibonds. These securities are then bundled and traded on international security markets. Naïve investors don't really understand that the securities being sold to them as 'AAA' secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

"One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Mary's bar. He so informs Mary. Mary then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Mary cannot fulfil her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

"Overnight, Drinkbonds and Alkibonds drop in price by 90%. The collapsed bond asset value destroys the bank's liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Mary's bar had granted her generous payment extensions and had invested their firms' pension funds in the various Bond securities. They find they are now faced with having to write-off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

"Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion euro no-strings-attached cash infusion from their cronies in government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Mary's bar.

"Now, do you understand economics in 2011?"

US sub-prime

   

The US sub-prime mortgage lending crisis or simply sub-prime crisis has been the catchphrase in various countries. It will affect the Indian economy or rather the global economy as a whole.

Sub-prime borrower
In US almost everything, right from getting a credit card to receiving various banking services, is dependent on the credit history of a person. A good credit history can be directly attributed to making payments on time, less revolving credit on credit cards, fewer payment defaults and check bounces etc. and is denoted by the FICO score or credit score of a person set by few credit rating agencies. It is easy for a person with a good credit history to get loans and other services while it’s exceedingly difficult for a person with a not so good credit history or low FICO score to avail banks’ services, let alone loans. Such poor credit history borrowers are called sub-prime borrowers. Since there is a risk of default on loans to sub-prime borrowers, US banks usually charge a higher rate of interest to them for the risk they are taking. From the bank’s side, a higher interest means a higher return, well with a risk. As a result, some banks had seen lending money to sub-prime borrowers as an opportunity.

Sub-prime boom
For a crisis to happen, first there has to be a boom. There were a few things that led to the sub-prime boom. I better quote Christian Stracke of Financial Times who had explained the situation quite nicely. “It all originated with a global imbalance between the supply of credit and the demand for credit. Global Central Bank let monetary policy move to a nearly unprecedented accommodative stance, pumping money into the system. At the same time, corporate, the traditional mainstays in terms of borrowing funds to invest moved to a defensive stance, having grown much more conservative in the wake of the Enron and WorldCom fiascos. Finally, the major developed countries began to gain a measure of fiscal discipline, with budget deficits shrinking, which further reduced the demand for credit on a global basis. That imbalance between investors flush with cash and the traditional borrowers not really needing or wanting that cash meant that investors had to look for new markets to invest in. As the Asset Backed Securities (ABS) market had been taking off and coming into the mainstream, a natural target was the sub-prime borrower - borrowers who in the past had wanted to borrow but who had been locked out of credit markets. Eager lenders met eager borrowers, with the mortgage originators, ABS underwriters, and credit ratings agencies playing the role of matchmaker, and the sub-prime boom was born.” Now, let's see what the banks or mortgage originators did to target the sub-prime borrowers’ market.

Role of Banks and Hedge Funds
So there was an opportunity among sub-prime borrowers and there has to be someone who could take the money from investors and give it to the borrowers. Who could do this better than the banks? Banks gave money to sub-prime borrowers and then they bundle the loans to a package and sold securities whose value was linked to the performance of the package of mortgage loans. Investors bought these securities and thus indirectly provided the money required for sub-prime lending. These derivative instruments are called Collateralized Debt Obligations (CDOs), which is one form of Asset Backed Securities. Thus, banks did away with the role of playing a financial intermediary. The total volume of CDOs in the US market is around $900 billion and only 17% of the CDOs were created out of sub-prime mortgages. Hedge Funds hold majority of these sub-prime related securities due to the inherent nature of their business making them extremely vulnerable to sub-prime related issues. So everything was set and now let’s find out what triggered the crisis.

Sub-prime crisis
Quite obviously the sub-prime crisis occurred when the sub-prime borrowers defaulted in their mortgage loans, which affected the returns of CDOs. The main reason was the inability of sub-prime borrowers to pay back the money. Another catalyst was the rising segment of credits like Home Equity Loans through which the borrowers could take a second credit on the same mortgage. These added to their inability to payback the money. As a result, some defaulted. Some started force selling their houses due to which property prices came down, which made it more difficult for other sub-prime borrowers to refinance their mortgages into loans with lower rates. The result, more and more defaults!

Now at the securities side, the highly leveraged hedge funds, found themselves in distress due to the rising defaults by sub-prime borrowers. Investors who had put their money in these funds wanted their money back which forced these funds to liquidate their assets. And thus started a vicious spiral of forced selling of sub-prime securities! This reduced the price of these securities in the market and thus the crisis grew new bounds. Since hedge funds are highly leveraged, a small decrease in their asset values is enough to make them bankrupt. As a result several funds filed for bankruptcy. Thus the sub-prime crisis showed its red face!

Effect on global and Indian economies
Few companies in the US filed for bankruptcy which led to the loss of thousands of jobs. People who invested through hedge funds lost their money. UK and Japanese economies were affected a lot as there were a lot of money from investors belonging to these geographies that had been put into sub-prime securities through the hedge funds.

In other economies, hedge funds faced selling pressure to meet margin calls which led to the fall of various non-US stock indices, Sensex, Nifty being few of them!

Though not severe, Indian economy got affected by this in the following ways. A reduction in the investments in Indian securities/major selling of Indian stocks by foreign investors (foreign funds having CDOs created out of sub-prime loans and had selling pressure) and a subsequent melt down of Indian stock markets, IT companies losing few of their clients belonging to US mortgage industry & Hedge Funds due to cost cutting or bankruptcy are some of these.

Analysts say that the US sub-prime crisis is not over yet. Let’s see what more this disaster has in its store in the days to come.