Global Credit Crisis 2008

The Genesis:

An investment bank uses its own money to lend others and invest. It started with the sub-prime crisis. Banks like Lehman, buy mortgage loans from other banks and then package them to sell bonds against the loan pool. Often they add cash to make the loan pool more attractive, so that the bonds can be sold at a higher price.

Example: Suppose mortgage was earning 6%, these bonds are sold at 4%. The difference is the spread which the investment bank earns. By selling these structured bonds, it raises money and frees capital. However, when homebuyers started defaulting, these bonds lost their value. It all began like this, and then the virus spreads across markets.

The Acceleration:

Owing to the financial chaos of this magnitude, banks refrain from lending each other, fearing that the money would get stuck. Thus the liquidity dries up and further leads to something called as “Domino Effect”. For Example:  Suppose Lehman faces redemption and has to repay another bank it has borrowed from. If it sells the mortgage-backed bonds, whose prices have fallen, it will not raise as much as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since the bank starts dumping these assets, prices of these bonds also dip.

This is when the crisis spreads from being sub-prime to prime.

Underlying Technicalities:

Many of these instruments are over-the-counter (OTC) instruments unlike exchange traded (like stocks). Here two consensual parties come together and get into a buying/ selling agreement as per their own set rules.

However, this arrangement has a marked-to-model architecture unlike the market-to-market (for exchange traded instrument), which is based on the rules of demand and supply (bid-ask). 

What the bank does is construct a model, feeds the available market price of these variables in the computer, to arrive at what the market price of the OTC instrument could or should be. This is an artificial model-generated price.

The trouble is when the bank actually goes out to sell them, it discovers that there are no takers. And, even if there are buyers, they are willing to pay just a fraction. In other words, there is a sea of difference between the price that is being offered in the market and the high artificially-generated price thrown up by the model. So, when the bank ends up selling the instrument, the loss suffered is far in excess of the mark-to-market loss.

As an Investor:

If you are an investor, sit on cash. Or a better way, invest in Liquid Funds . Or if you are little adventurous, search for other asset classes. Or if you want as much excitement as Bungee Jumping.. Try equity markets..