What is sub prime mortgage?
Individuals or corporates who have a good credit rating are eligible for cheaper loans. Business with them comes under prime brokerage/ prime mortgage. Others need to pay a premium to get loans due to the risk of default. These loans are classified as sub prime loans. Mortgages extended to them are called sub prime mortgages.
What is a Collateral Debt Obligation(CDO)?
Imagine John wanting to borrow some money for his house. John being a louse, is low on his credit ratings. So he is denied loan at prime lending rate. He then goes to some one who would shoulder the risk of default and offer John some money at a higher rate. He borrows money using the house as collateral. He borrows it from a bank say ABC bank. Since ABC bank doesn't want to carry the risk entirely by itself, it collects a lot of such loans and sells most of them to an investment bank say I-Bank. These loans obviously share a low rating, some thing like C--. I-Bank then carefully packages some of these C-- debts, some A++ rated instruments like a T-Bill and brings out a security that stands a rating of say B. Apart from mortgages, I-bank might want to include credit card loans, bonds and other instruments into the package and turn them into securities. This process is know as securitisation. The resulting security is stripped and sold in parts to different clients such as pensioners, retail investors and some times to hedge funds. In the above example if the I-Bank invested $11 Mil and it wants to sell it for $15Mil as 1Mil discrete units, each unit would cost $15 and could be traded just like any other mutual fund unit or the more stable T-Bill them self. This is an example of CDO. In the actual market place, the pricing of the security and the product mix is much more complex than that we discussed.
Why did they fail?
Lets carry the above story further. John true to his nature wants to default. But, since there are a lot of options, he approaches some one else to repackage his loan. Just like what we do to our credit card loans; go to some other bank and buy time. The other bank offers him some cooling period for an extra spread for the time provided. Johns debt is now involved in the CDO and through refinance in an another CDO created by another bank. Since during 2000-2005 the realty sector took off like anything, dumb John expected the same trend to continue and agreed to the conditions, thinking he could sell out for a better rate some time later. But the reverse happened. There was a slump in the housing sector. He now has to repay @ a higher rate than the original rate borrowed from ABC bank. He now defaults.
How does that affect the I-bank?
Now more about the role of I-Bank. Lets say, the I-Bank buys 10 $1 Million debts from ABC bank using a process called leveraged buying. Meaning, they put in $2.5 Million(assuming 25% margin), borrow $7.5 Mil and buy the entire $10 Mil. They now add $1 Mil of their own assets with good rating and sell the $11 mill asset for say $15 Mil. Once they receive payment from the clients, they keep plowing back more into the ABC banks margin account and buy more. When John defaults, the $1 Mil amounts to nothing. Similarly when 9 people default, the $10 mil asset amounts to $1 Mil. Now the I-bank needs to put in the extra $6.5 Mil to cover the $7.5 Mil borrowed. If they don't, they may as well kiss their $2.5 Mil and the accompanying assets good-bye. So its imperative they meet their margin requirements to save their assets from going bust. This is one of the potential downsides in trading on margin accounts. If you don't meet the margin, the debtor can do whatever with your asset to get back his money.
Finally how did bear fall?
One of Bear Stearn's more profitable businesses is prime brokerage which provides lending and brokerage services to Hedge funds. These hedge funds hold their assets with Bear. Bear having a good rating in the market raised a lot of loans based on these assets. When Bear scrapped two funds, a lot of these hedge funds wanted to pull out their assets from Bear accounts. But Bear already has secured loans using these assets. So the immediate demand for release of assets was impossible to meet. On the other hand the value of the assets Bear invested in, fell dramatically and was supposed to meet the margin requirements. On 13-14th of march, they were pushed to the wall for want of liquidity. Unable to raise the required capital, Bear was caught in a quagmire of sorts. The showdown ultimately happened on that weekend when JPMC bought Bear and its liabilities with Fed's help and stood guarantee to bear's commitment's.
Individuals or corporates who have a good credit rating are eligible for cheaper loans. Business with them comes under prime brokerage/ prime mortgage. Others need to pay a premium to get loans due to the risk of default. These loans are classified as sub prime loans. Mortgages extended to them are called sub prime mortgages.
What is a Collateral Debt Obligation(CDO)?
Imagine John wanting to borrow some money for his house. John being a louse, is low on his credit ratings. So he is denied loan at prime lending rate. He then goes to some one who would shoulder the risk of default and offer John some money at a higher rate. He borrows money using the house as collateral. He borrows it from a bank say ABC bank. Since ABC bank doesn't want to carry the risk entirely by itself, it collects a lot of such loans and sells most of them to an investment bank say I-Bank. These loans obviously share a low rating, some thing like C--. I-Bank then carefully packages some of these C-- debts, some A++ rated instruments like a T-Bill and brings out a security that stands a rating of say B. Apart from mortgages, I-bank might want to include credit card loans, bonds and other instruments into the package and turn them into securities. This process is know as securitisation. The resulting security is stripped and sold in parts to different clients such as pensioners, retail investors and some times to hedge funds. In the above example if the I-Bank invested $11 Mil and it wants to sell it for $15Mil as 1Mil discrete units, each unit would cost $15 and could be traded just like any other mutual fund unit or the more stable T-Bill them self. This is an example of CDO. In the actual market place, the pricing of the security and the product mix is much more complex than that we discussed.
Why did they fail?
Lets carry the above story further. John true to his nature wants to default. But, since there are a lot of options, he approaches some one else to repackage his loan. Just like what we do to our credit card loans; go to some other bank and buy time. The other bank offers him some cooling period for an extra spread for the time provided. Johns debt is now involved in the CDO and through refinance in an another CDO created by another bank. Since during 2000-2005 the realty sector took off like anything, dumb John expected the same trend to continue and agreed to the conditions, thinking he could sell out for a better rate some time later. But the reverse happened. There was a slump in the housing sector. He now has to repay @ a higher rate than the original rate borrowed from ABC bank. He now defaults.
How does that affect the I-bank?
Now more about the role of I-Bank. Lets say, the I-Bank buys 10 $1 Million debts from ABC bank using a process called leveraged buying. Meaning, they put in $2.5 Million(assuming 25% margin), borrow $7.5 Mil and buy the entire $10 Mil. They now add $1 Mil of their own assets with good rating and sell the $11 mill asset for say $15 Mil. Once they receive payment from the clients, they keep plowing back more into the ABC banks margin account and buy more. When John defaults, the $1 Mil amounts to nothing. Similarly when 9 people default, the $10 mil asset amounts to $1 Mil. Now the I-bank needs to put in the extra $6.5 Mil to cover the $7.5 Mil borrowed. If they don't, they may as well kiss their $2.5 Mil and the accompanying assets good-bye. So its imperative they meet their margin requirements to save their assets from going bust. This is one of the potential downsides in trading on margin accounts. If you don't meet the margin, the debtor can do whatever with your asset to get back his money.
Finally how did bear fall?
One of Bear Stearn's more profitable businesses is prime brokerage which provides lending and brokerage services to Hedge funds. These hedge funds hold their assets with Bear. Bear having a good rating in the market raised a lot of loans based on these assets. When Bear scrapped two funds, a lot of these hedge funds wanted to pull out their assets from Bear accounts. But Bear already has secured loans using these assets. So the immediate demand for release of assets was impossible to meet. On the other hand the value of the assets Bear invested in, fell dramatically and was supposed to meet the margin requirements. On 13-14th of march, they were pushed to the wall for want of liquidity. Unable to raise the required capital, Bear was caught in a quagmire of sorts. The showdown ultimately happened on that weekend when JPMC bought Bear and its liabilities with Fed's help and stood guarantee to bear's commitment's.
Why did Fed have to rescue Bear Stearn's ?
One factor could be the CDS (Credit Default Swaps). These instruments are similar to insurance plans, the difference being; they are insurance against default of contracts. How it works is I-BankA enters into a contract(any financial contract) with I-BankB. Now I-BankB carries a risk, in case I-BankA defaults. To mitigate this risk, I-BankB enters into a CDS agreement (by paying a small premium) with say I-BankC who covers it against I-BankA's default. Remember, in a CDS, I-BankC doesn't need not show the funds required for providing the cover. It simply promises to pay-up. CDS became so popular that according to one estimate, its a $43 trillion market (notional). Banks freely traded CDS against each other sometimes in a circular tangle assuming counter party default was a rarity.
Bear being a leading player had many contracts attached to its survival. With the inevitable bankruptcy looming, it sent jitters down the market about the magnitude of claims that would have to be settled. Clearly it had to be stopped. It was then Fed stepped in to its rescue and brokered a merger with JPMC.
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