Importance of the feel good factor

I hope this explains why we might have a bumpy road to recovery ahead!!

Credit crisis in the making!!

Credit crisis in the making.. short and simple !

1. To understand the crisis lets first under stand the whole –process.

- Commercial banks sell loans get mortgages

- Investment banks buy mortgages from commercial banks, collaterised them and issues CDOs (trenches: superior/safe, mezzanine, equity/ unrated)

- Investors (Pension funds, hedge funds, individual investors) buy these trenches/ securities and keep with them / rebundle.

2. Scenario in 2002-2005
- Treasuries rate remain very low @ 1% even after a recovery in 2003 (loose monetary policy)
- Mortgages become really cheap and there was a lending boom
- Investors were not getting much returns on treasuries and started looking for other safe alternatives
- CDOs (superior trenches having AAA ratings) give better returns to the investor vis-à-vis treasuries.
- Demand for CDOs/ CLOs/ ABCPs increased.

SUB Prime:
- Commercial banks started lending to the sub prime lender to accommodate the demand.
- They introduced various schemes to rope in sub prime segments:
- No down payments, step up interest rate, no securities etc. All this under the premise that housing prices will keep increasing and the sub prime home owner can dispose of the property after few years.

3 Scenario in 2006-2009
- Home prices stagnated and even started decreasing. Interest rate also started to increase. This resulted in an increase in Sub prime default rate.
- This had a cascading effect:
...... Investors become weary of CDOs and other financial instruments (this was the result of bundling and rebundling of other financial securities with CDOs and subprime)

...... Lack of market for CDOs broughtdown the market prices
...... This further put pressure on already stressed LTV (loan to value) ratio.
...... Investors having these CDOs as financial assets had to report losses due to MtM (marked to market)pricing concept
...... Consequently they had to unwind their portfolio and sell securities (CDOs in the market) putting further pressure on prices and a vicious cycle took place.

4 Spreading of the crisis:
- Banks started taking less and less risk and started hoarding cash. They almost stopped lending to banks (call money rate went up), individuals (mortgage market further declined) and companies. Causing a financial meltdown.
- Institution and economies that worked on principle borrow short and lend long started failing as they found it increasing difficult to refinance the loans. Causing further pressure on the market. (Classical example is the case of Dubai).
- Businesses found it difficult to get loans. Banks were hoarding cash and bond markets were practically dead. Businesses stopped new and existing projects.
- Businesses started downsizing. Consumer confidence fell to the rock bottom. Consumerism went down and another vicious cycle took place!