Some articles pointed out that the root of the financial crisis is the “lever transaction” used by the financial institutions. Some other experts pointed out that what’s behind this financial crisis is the $62 trillion Credit Default Swap (CDS). So, how is the relationship between the subprime, the “lever transaction” and the CDS? What is the interaction between them that causes today's financial crisis?
In order to make it easy enough to understand, we will use several imaginary examples to explain.
1. The lever. Currently, many Investment banks use 20-30 time of leverage to earn colossal profits. Suppose that Bank A has a net asset value of $3 billion, 30 time of lever is $90 billion. That means, Bank A uses $3 billion asset as mortgage to borrow $90 billion funds in investment. If the investment gains 5%, then A obtains $4.5 billion profits. This increasing $1.5 billion relative to A is the colossal profits. Whereas, if the investment loses 5%, then besides losing all the assets, bank A will also create debt of $1.5 billion.
2. The CDS contract. Since the high risk of lever operation, banks would not take the risk of the operation. Therefore, some one find a way: use the lever investment to make “the insurance”. This kind of insurance is the CDS. For instance, Bank A finds Organization B to avoid the lever risk. Organization B could possibly be another bank or an insurance company. A said to B: If you help me do the CDS, I will pay you $50 million as an insurance premium every year, remain10 years, so totally will be $500 million. If nothing serious happened, you will get the insurance premium. But if something happened, you must compensate for me. A thought that if every goes right, it may gain $4.5 billion; take out the $500 million to make the CDS, it can also gain $4 billion. If accident happens, B will help to compensate. So it is a profit business anyway. B is a smart person, so B does not give the answer immediately. But after doing a statistical analysis, B discovers that the chance rate of compensation is less than 1%. If doing 100 business case like A, the total revenue will be$50 billion. Even if one breaks the contract, the compensation is no more than $5 billion, and if two break the contract, B will still earns $40 billion. Finally, both A and B think it is an advantageous business; therefore, they sign the contract happily.
3. CDS market. After B has done this safe business, C is jealous about that. C comes to B: How about selling these 100 CDS I to me, and for each contract I will give you $200 million, altogether $20 billion? B thinks that I need 10 years to gain the $40 billion, as soon as I sell them to C, I can get $20 billion immediately without any risk, why not? B agrees. As thus, the CDS enter the financial market like the stock, can be trade. As a matter of fact, C also does not want to wait for 10 years to gain the $ 20 billion, so C pricing them at $22 billion. D sees this product, and after calculating, D still can get $18 billion ($40 billion - $22 billion). So D pays C $22 billion. From then on, these CDS are sold in the market again and again. Now, the market value of these CDS is $62 trillion.
4. Subprime. Above A, B, C, D……is making money, but where this money comes from? Some people say that the cause of this subprime mortgage crisis is lending money to the poor. However, others believe that the subprime has been given to the ordinary American real estate investors. These people can only afford to buy one house, but after seeing the rapid increase of house price, they started to invest in the real estate. They mortgage their own houses and loan to do investment. This kind of loans has an interest rate usually above 8%-9%. A is happy, his investment is making money for him; B is also happy, the market violation rate is very low. Following C, D and so on are waiting for making money.
5. The subprime mortgage crisis. The house price will stop increasing in a certain point. The investors could not sell the house, at the same time; they got high interest to pay. Finally, one day, they give up the houses to the banks. This time Bank A felt disappointed for could not gain the colossal profits. But with the contract with B, A will not lose money. B did not worry, because it had already sold to C. Then, where is the CDS? F just bought the CDS from E, and heard the bad new. Even though F is the top 10 organization in the United States, the huge lose can cause it to go bankrupt.
6. The financial crisis. If G goes out of business, then the amount of money A spent on the insurance will be gone with the wind; what is worse? Because of the using of lever principle, A will lose everything and has to pay a huge debt. Therefore A will bankrupt immediately. Besides A, B, C, D…… will also face the bankruptcy situation. As a result, G, A, B, C, D…… altogether go to the US minister of finance, and persuade minister to save G. What will happen next? The ministry of finance nationalized G, and the huge amount of insurance premium will be paid by the American taxpayers.
The hypothetic data may be discrepancy, but the severity of American financial crisis should not be underestimated