How Mortgage Crisis in US Pushed The Whole World in to Depression.

Let me share you what I felt about this topic.

While we are getting ready to deal with ‘depression’ which has spread across the whole world now and saw some big names tumbling; the question comes up is, how in the first place a visibly simple mortgage crisis in US couple of years back turned to be a depression? Affecting the whole world?

The search leads to one word ‘derivatives’.

Derivatives are financial instruments that are used to reduce financial risk, just as a fire insurance policy is used to reduce the risk of a fire by compensating possible damage in the event of one. Why did, then, Warren Buffett, whose financial acumen is legendary, describe them recently as “weapons of mass destruction”?

Wikipedia definition of derivative is; these are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (eg commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (eg interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (eg weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit.

The main types of derivatives are: forwards (which if traded on an exchange are known as futures); options; and swaps.

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

It is not hard to see why such “derived” securities or “derivatives” have become so popular. A bank that makes a loan, for example, for a house, faces many different types of risk. The borrower, for instance, may not be able to return the loan on due date. Or, he may not be able to keep up with interest payments. Or, the market interest rate may rise far above the rate the bank has given the loan, leaving the bank stuck with a loan at a low interest rate. Or an earthquake might hit the area demolishing the borrower’s business. Or, high inflation may reduce the value of the loan by the time it gets repaid. Derivatives are a way to “hedge” against these risks. For example, a housing loan to a borrower in, say, Pune can be combined with a housing loan in Mumbai and another one in Bangalore under one common instrument and this combined “derivative” can be sold to an investor. This combination reduces the risk of disparate housing markets such as Pune, Mumbai and Bangalore all suffering downturns at the same time. The investor in this derivative rightly believes that the instrument he holds has a balanced risk.

If derivatives can diversify risk, as just described, what can go wrong? For one, the borrowers may have mis-represented their income. Or, the loan issuer may not have verified their incomes. Or, they may have borrowed 95 per cent of the value of their houses such that if property prices decline by, say, 20 per cent, the asset cover may become inadequate. In all of these cases, should interest rates rise sharply, from say, 6 per cent to 10 per cent, these borrowers may no longer be able to meet their monthly payments. When Greenspan, who was Chairman of the US Federal Reserve Board, was told about similar issues developing in the US mortgage securities market he believed that such problems in the housing sector would be restricted to a city and could never become a national, let alone an international problem.

This would normally have been true, but mortgaged-backed securities were sold not only nationally in the United States but also throughout Europe and Asia. When the US housing bubble burst and borrowers started defaulting on their mortgage payments, the value of the mortgage securities fell precipitously. The shock waves were transmitted throughout the world. What started as a crisis in some specific parts of the US now became a worldwide financial crisis.