Subprime crisis and capital markets meltdown...

Past few weeks have been severe on global financial markets and as we all know root cause of this mayhem is sub-prime loan. But before we could go into details its worthwhile spending some time on understanding what is sub-prime loan and how it is originated.

In US if a consumer wants any kind of loan eg. car loan, house loan etc , he first need to go through credit check. Credit check is nothing but a numeric value which indicates how much credible you are in terms of paying the loan back. So for example two consumers A & B approach Bank for loan of USD 5000 and A's credit score is 400 and B's 450 (just imaginary number taken) . Since B's credit score is higher than A's , that means B is more credible and there are less chances that he will default on the loan repayment. So in this case B might get the loan at lesser interest rate and A will have to pay higher interest rate as he is less credible (as per his credit score) . So credit score plays a vital role in any kind of loan transaction.

After dot com burst and 9/11 attack US economy was lymping, as people were less willing to spend. US being a consumer centric economy , its growth is closely tied to people spending their money. So in order to give boost to US economy, FED cut the interest rate to 1-1.5% . Since interest rates were very low, credit was very easily available to every one. So much liquidity available with banks, people started taking loans for every small thing.

It all begins with an American wanting to live the famed American dream. Since credit is cheaply available so he can fulfill his dream of having a nice house. But not everyone will have good credit score, which means even though the credit is available consumer with bad credit score will not be able to avail this loan. From here the drama starts, it has three main characters

A - Consumer with bad credit score who wants to take the housing loan
B - a Financial institution with good credit score and willing to take some risk.
C - Bank the lender which originates the housing loan.
D - Institutional investors, investment banks.

A can not get housing loan from C because of his poor credit score. B has good credit score and can easily get loan from C. B sees this as opportunity to make quick money. So he takes huge amount of loan from C at lets say X% interest rate. B then divides this loan into smaller loans and gives them out as home loans to people like A at (X+Y)% interest rate. This new interest rate is called sub-prime rate and this market is called sub-prime home loan market.

Now lets try to understand B's strategy here. As B is big financial institution and willing to take risk. On every sub-prime loan given he make Y% as the profit. Since these loans are risky as some people might default. But even if 5-10% people like A default on their EMI, B will still be seating on huge profit. But story takes a U turn from here. B does not stop here, he does not wait for people like A to pay the principal plus interest so that he can pay back C (the Bank). B goes ahead and securitises these loans . Securitisation means converting these home loans into financial securities, which promise to pay a certain rate of interest. These securities are then sold to D (FII or Investment banks) and principal, interest paid by A is passed on to D. So this way D also make good profit from these securities backed by mortgage loans. B passes the money received by selling securities to C (the Bank) , thereby repaying the loan. Now B can take more loan from C securitise them and sell to D. There by creating continuous flow of money. These sub-prime loans were given at floating rate, which means if interest rate increases in future then monthly EMI paid by people like A will also increase which might lead to defaulting the loan.

By late 2006 interest rates started to rise. People like A who had taken sub-prime loan had to pay more now for monthly installment. Since there had unstable income so lot of people started defaulting, leading to losses for Institutional investors like D.Housing bubble was about to burst and B had major contribution to this burst. To make quick money they relaxed lending terms & conditions and gave loans to people with poor credit history. As more number of consumers started defaulting on home loans, this meant huge amount of losses for these Investment banks,FII's . These institutions failed to manage their risk properly and wiping out their net worth.

FII's & IB's generally spread their investments all over the globe to diversify their investments. FII's maintain some fixed portion of their investments in markets globally like China,India etc. So when their investments turned bad in US, to maintain the asset allocation they pulled out their investments from emerging markets like India where they were sitting on huge profits. Thats the reason why in Dec 2007 Sensex crossed 21k and now struggling to maintain 13k and USD strengthened from USD/INR=38 to USD/INR=47. Will explain this in next blog................

Credit crunch in capital markets....

I am pretty sure everyone would have come across this jargon while browsing on internet. I knew what does it mean, but never actually thought what leads to this and how does it impact capital markets. Now as capital markets are melting globally there was a need to delve into details.

Credit crunch occurs when there is lack of funds available in credit market, making it difficult for borrowers to borrow money. Credit crunch can severely impact economic growth of a country.Many companies need to borrow money from lending institutions to finance and/or expand operations; without this ability, expansion is not possible and in some cases, companies will need to cease operations.

All said and done next big question is what leads to credit crunch....

• Increase in capital requirement for Banks - Many banks and lenders are required to maintain minimum capital liquidity based on their assets. This capital requirement is regulated by regulatory bodies in the respective countries (in US FED). So if FED increases the capital requirement then lenders need to increase the capital reserves, left with less cash to lend to borrowers hence leading to credit crunch.

• Increase in lending/interest rates - To curb inflation regulatory bodies tend to increase the lending rate, so that it will cost more for the same credit. So people will take lesser number of loans. This again leads to credit crunch and may hamper the growth of economy.

• Greater risk in market - If bank sees there is risk involved in lending because of adverse market conditions or poor credit history of the borrower. Bank can increase the lending rate to offset the risk its taking. This increases cost of borrowing and makes borrowing more difficult.

Now we know what is credit crunch and what leads to it, next i would like to discuss about Credit default swaps which played a key role in AIG,Freddie Mac downfall........

Who was better off?

We all know who is Sabeer Bhatia and why he is so famous, but its worth having a look at this...

Sabeer came up with an idea of web base email system which was named as HotMail. After setting up HotMail.com he invited 7 of his closed friends to join and create a HotMail account. In less than 6 months HotMail had attracted more than 1 million users. As HotMail was originator in web based email and it had huge user base, Microsoft eventually bought HotMail for 400 million dollar in 1997.

Now here is the most interesting part, why did Mircosoft buy HotMail?

Was it because of new concept email? I dont think so, being a pioneer in technology microsoft could have very easily developed better email system than HotMail. Then what is it which attracted Microsoft towards HotMail. Lot of people thought that its not a good idea to pay such a huge amount for just a email website.

But Mr. Bill Gates had some other plans and he was looking one step ahead of normal people. He realized the potential of growing web community, and what he can achieve with that web community. So Mr. Gates bought HotMail.com and setup an e-commerce web site and linked it to HotMail.com . So now he had 1 million users visiting his e-commerce web site msn.com. Even if 5% of the users shop on msn.com with in no time Microsoft would earn more than what it investsed.

Now here is the striking difference in approach and thinking of Mr. Bill Gates and Mr. Sabeer Bhatia. Sabeer did all the hard work to setup HotMail.com and his efforts did pay huge returns, he got 400 million $ from Microsoft but what after that?? To earn more Sabeer had to do more work right??.

Now here is Mr. Gates point of view. He paid 400 Million $ for the web site and the web community. This web community will always visit HotMail.com for free email and also visit msn.com which is linked to it and some of them will shop also. Once msn.com is setup and linked to HotMail.com Mr. Gates had his job done. Now he had huge traffic diverted to msn.com and generate returns which is ongoing and residual. He does not need to any thing extra to earn more money,because he had the web traffic diverted to his site on daily basis.

So what do you feel who was better off? Mr. Gates or Mr. Bhatia.

Let me give one more example.

There is a piece of land available at cheap price and you know that there is a highway going to be built through that land. So what you will do now? As you know price of land will surely increasee once the highway is built, most of us will buy the land at cheap price and sell it at higher price to book the profit.

But here is another approach. You say i dont wanna sell this land but i can let the Highway cross through my land, but i will put a toll booth on the highway and for every passing car you need to pay me 30cents.

So what do you feel which approach is better off?? First one(Mr. Bhatia) or Second one(Mr. Gates)

Financial freedom in our career??

I have heard this phrase lot of times "Financial freedom" but never tried to understand what it means to me,you or any common people.So before asking myself whether i am financially free or not i thought its worthwhile to understand what it means to be financially free.

We all work for money so that we can fulfill our dreams and have comfortable life. So as long as we are working, we will be earning money. But how much can we earn is limited by how much we can work. If we work for x hours then we get paid for x hours. So i have to increase my income to 3x then i need to work for 3x hours. But we have only 24 hrs in day, so there is limitation on how much we can earn.

What if on one fine day you go to office and your boss tells you that you are laid off due to some bussiness issues (as a matter of fact getting laid off in US is pretty common). Suddenly your income becomes zero. So what do you do now? Are you financially free? No i am not and i am sure most of you would agree me on the same.

So i thought there is always a limitation on how you can earn and that can vanish any time. So is there a way to have residual income. I mean an income which keeps on coming even if you dont work?? My mind said are you kidding.Its not possible to have income without going to work.

My mind started to wander here and there to find the answer. Today only i was browsing through some articles when i came across this article "On Dhiru Bhai Ambani" and tells how he created this empire Reliance Industries. Even though he is dead long back but still empire is running and growing and there is a source of income for ever. This is what is called as residual income.

Similarly i read about Ray Kroc founder of McDonanld who started McDonald. I was amazed to know that every monrning he woke up with 30 Million Dollars without even going to work.Because he has opened 30000 McDonalds around the world and created a source of residual income. Even though Ray Kroc died long back but still McDonald Corp earns around 30 Million Dollars daily. Wow thats amazing and this is what i mean by residual income source.

But again the same question how do i fit in all these? I really dont know but its worth giving a second thought............................................................

Change is the only permanent thing in life..

I dont remember much about my childhood it was only when only when i joined coaching for CPET exams i came into senses. One day i was just sitting in class room in coaching institue and thinking what is my goal in life and why i am sitting here.

Then my consensus told me that your goal is to get through CPET exams so that you can get your degree in good college and secure your future. I tried and gave my best and finally got through CPET and got CSE in REC Hamirpur.

That day dad was very happy and told that now your future is very much secured and now you dont need to do any thing. Just go to college and after 4 years you will be an successful engineer and you dont have to put any efforts. I was pretty excited to hear that and thought life is bed of roses now.

So here i am REC Hamirpur, place of my dreams and jubiliant about my future ahead.Slowly things started moving prettty fast and went through serious ragging period. Finished first semester with 76% marks which was much above my expectations. I was very glad and thought what ever dad told me was correct. I dont need to put any further efforts.

But there is a saying "Life comes back very hard at you even if u slack a bit" and thats exactly what happened in next semester and got meagerly 69%. Now thngs were taking u turn. Bed of roses now turned to bed of thorns.

"Tough times dont last but tough peopole do" i wanted to prove the same. And here i am in 3rd semester scoring 75% marks again. So for me life has always been full of ups and down. So i learnt one lesson that day "Life is not bed of roses and it will never be" so you need to move on.

From that point i consistenly got good marks in each semester hoping that i will get good degree and finally be placed in good company... and i started dreaming..

But bang and my dreams shattered ......Our college was closed undefinitely due to uncontrolled events and suddenly TPO calls our batch and says that since college was closed for 3 months so it will have severe impact on placements... and here i am graduated from college still dont have jop in hand. I used to think even if i get 10k per month job i will be very happy.

Had lot of dreams so came to bangalore in search of a job and thank god within a month i got a job and moved to chennai.Worked there for 3 months but was not happy with work and felt some thing was missing..

One more change..................................
So once again i was busy doing thought processing at Marina beach. I told myself "hemant you have good job,good salary,good friends... everything is fine so what is missing now" . After introspection my heart replied that i am not happy with the work i am doing.
If i do some quality work then i will happy.

So my heart told me hemant you need to change your job. Hearing my hearts advice i came to bangalore working in Tavant tech for 2 years. Worked at Tavant tech. and met some of the most amazing people and they helped me in ups and downs. And thats how my career started moving.
Things were going smoothly and again i went into comfort zone and again "Life is bed of roses"

On one week end i was sitting at home and thinking what shall i do next? I have good job,good technical skills,good salary,good bike what else i want? nothing right???

But suddenly my heart woke up again and said "how much are you earning and is that enough for you and your family?" and you know what was the answer.. yes it was i am earning peanuts. Is there stability in your profession.You remember there was IT slow down in 2002-2003 and thousands of skilled employees were laid off.....

I literally started shivering and i told that "Yes you are right.What if i am laid of at some point.This is one of the hard hitting facts about corporate world.. as long as you are billable you are good else u are worthless. So no need to get emotional about the comany"

One more change.................................. i need to earn more money.
So i shifted to Techspan in Bangalore which paid higher than market. Life again started moving smoothly and had lot of money to spend or save.

Things were going fine suddenly i realized that almost 90% of my friends are in US or UK and earning handsome money. it will take me years to save the same amount of money which they save in few 2-3 months.

One more change..................................
So once again i was busy doing thought processing sitting in my office at 11 PM in night and here is what my heart asked me "hey hemant tell me some thing are you less qualified? are you less skilled? are you inferior to some one? if no then why are you sitting here and all your friends sitting at some other corner of the world"

I said no not at all.... and i moved to US. Earning decent salary as compared to what i was earning in India. Its only three months since i have moved here and slowly but surely some thing has started pinching me again... i dont know what it is and i need to figure it out.

Dont know where i am heading but i can expect some thing coming my way... lets see what it is.
But one thing i have realized that "For it to be its up to me........ and i need to make it happen"