Tuesday, September 23, 2008

Wall Street Turmoil and US Congress response

I planned to take a minute to recap on some of the recent happenings on the current Financial crisis hitting Wallstreet that is ubiquitous on internet, radio, TV and street talks.

To provide some background on why we are where we are :

The creative financial instruments invented by the Wall Street heads in terms of derivatives like MBS, ABS, CDO, CDS etc have started to expose their real face as the interest bearing debts collateralized by these assets don't meet the investment expectations. In simple words, as people holding mortgages can't make their payments on time or get into foreclosures, these derivatives which expect their returns through their payments take a direct hit. This leads to banks not able to pass through their payments to the investors who had bought those derivatives from the bank. In addition, those investors who have insured these risks through insurance companies have passed on these effects to those Insurance companies as well. The creative financial instruments masked the mortgages with low ratings through packaging in different facets thereby giving them an artificial uplift.

Where are we now:
As investors sense a risk to their expected returns due to missing mortgage payments, the confidence level in the underlying assets ( All the securitized derivatives mentioned above) goes down, thereby shorting them. With no cushion build up to resist this fall, this gets into a spiral downward movement. Aaha, the credit ratings , who is supposed to be leading the curve, now wake up and short their ratings on these companies as well paving way for the perfect storm. The companies who didnot see this coming but are burdened with these poor assets are at the brink of filing bankruptcy or closing their business. The trillions of dollars and the big institutions involved in this has the potential to crack the US Financial system which is the rockbed for the jaggernaut capitalistic system. Hence the government intervention to ponder a $700 billion bailout.

Root cause of these issues from my point of view:
1) The rate of these instruments/derivatives coming up were too fast for the credit rating agencies to keep up that ended up endorsing these.
2) The SEC and Govt regulations were not keeping up with these as well.
3) The institutions impacted by this turmoil were too busy finding new customers than take a second look at their risk management models. In addition, their models relied on the credit agencies' ratings.
4) People were either greedy or scared of the skyrocketing home appreciation that everyone wanted to be part of the crowd than taking time to calculate if they can meet their financial obligations.

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