Financial crisis in the U.S

It's well past midnight and I am suddenly woken up by the ringing of my mobile phone. Today is one of those rare days when I have forgotten to put my phone on 'silent' mode.

'Why is the wall street going bust?' the rather feminine voice on the other end asks.
It takes me a few seconds to realise who is on the line.

"Mam. It is 2.30 am. Can we discuss this at a more appropriate time?" I thought you know question."Well. I understand things much better after midnight, is what I meant. So I will be highly obliged if you could explain."

"Okay. This is a rather complicated question. Where do we start? You remember in the year 2000, the dotcom bubble went bust. In the aftermath of that the US Federal Reserve started to cut interest rates.'"Let me interrupt. What is the US Federal Reserve," She asks.

"The US Federal Reserve is similar to the Reserve Bank of India. It is the central bank of the country and one of its tasks is to set interest rates. Therefore, after the dotcom bubble went bust, the Federal Reserve started to cut interest rates to ensure that the economy did not go into recession. By cutting interest rates it wanted to ensure that people continue to borrow and consume and hence the economy continues to grow."

"Interesting. But don't you think you are deviating from the point. I want to know about Wall Street not the US Fed."

"Patience, my dear. The long-term interest rate was reduced to 1% by the middle of 2003. That is where it stayed for around the next twelve months. With the interest rates at such low levels, people started to borrow to buy homes. The idea behind this was very simple. The rate of increase in the value of the house would be more than the interest rate to be paid on the loans that had been taken. As more and more people started to believe in this, the home prices in the US started to rise at a very fast pace.""Where is this heading yaar. First you talk about the Fed, now you are talking about homes. I want to know about the Wall Street," she screams on the phone.

"Don't interrupt. Let me continue. Low interest rates, combined with the belief in the idea that house prices will continue to go up, fuelled another bubble Banks and other financial institutions that gave out home loans decided that it was a good opportunity to expand the market. So they decided to give home loans even to those individuals who were not creditworthy enough and would not get a loan in the normal scheme of things, " I explain.

"Hmmm. This is getting interesting, though we are still nowhere near Wall Street."

"In a way the home loan lenders themselves believed in the bubble and hence gave out home loans to individuals who were not creditworthy. Such borrowers are referred to as the sub prime borrowers. In order to attract these borrowers, banks offered home loans with teaser rates. The interest rates would be lower in the first couple of years. This would mean a lower equated monthly installment (EMI) to pay off the loan. In the later years, a higher interest rate would kick in and that would mean a higher EMI. The borrower was completely sold out to the idea of housing prices continuing to go up and he planned to sell the house to make a profit before the higher EMI kicked in."

"But by following this strategy, weren't banks taking in a huge amount of risk?"

"Yes and no. One the face of it, yes it was a risky strategy. But banks and other financial institutions giving out home loans were smart enough to get out of these loans very quickly by securitising them,' I reply/

"Wait a minute. What is this securitising thing you are talking about," she asks.

What they essentially did in case of securitisation was bundle similar kinds of home loans together and make financial securities out of it. These financial securities were then sold to savvy financial investors, most of whom were based out of Wall Street in New York. By selling the financial securities, the bank or the financial institution giving out the home loan did not continue to carry any risk. At the same time, it freed up the money and the bank could lend again. A major part of the EMI paid by the borrower was passed on to the financial institution that bought these securities. " "But why did Wall Street financial institutions buy these securities," she questions.

"They bought it because these securities offered higher returns than other modes of investment available. But they were just investors. They failed to realise the true risk of these securities. The bank or the financial institution giving the loan was best placed to assess how risky a particular loan was. But since it was in a position to securitise the loan, it was only interested in giving out more and more loans, and not assessing the risk involved. Other than this, documents of a lot of sub-prime borrowers were fudged to give them loans that were well beyond their capacity to repay. Initially, with low interest rates, these borrowers continued to repay, but once the teaser rates were over and higher interest rates set in, they simply could not repay and started to default. Once the borrowers realised that they wouldn't be able to continue to repay, they started to sell the property. But, with a lot of selling hitting the market at the same time, there were not enough buyers and this ensured that housing prices started to fall, " came my long wielding explanation.

"Ah. Now I seem to get it. With higher interest rates setting in, sub-prime borrowers started to default. Once this happened, all the Wall Street financial institutions that had invested in these securities stopped getting their money back. And once more and more borrowers started to default these hallowed institutions went bust. Wow, in hindsight, everything seems so explainable, " she exults over the phone.

"Yes Mam. Now that you have understood, why don't you think about it and I'II go back to sleep.'