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Wall street Fighters
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Domino effect
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Disclosure Issues
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Minimize Turmoil
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Suppose Lehman faces a redemption and has to repay another bank it has
borrowed from. If it sells the mortgage-backed bonds, whose prices have fallen,
it will not raise as much as was earlier expected. So, it sells some of the
other good assets or bonds which may have nothing to do with mortgages. But
since the bank starts dumping these assets, prices of these bonds also dip.
This is when the crisis spreads from sub prime to prime.
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by
Gandhi Rajan, Sr. Associate, ICICI Securities
| 1 year ago
The only point that I would like to add in here
is the strange accounting of bonds and derivatives like mortgage-backed
securities. All banks are required to mark-to-market (MTM) their investments. So,
if the price of an instrument falls, the difference between the price at which
it was bought and the current market price has to be provided — meaning, it has
to be deducted from the earnings. So, a drop in price leads to the MTM loss. So
this is the bigger problem which really has deepened the crisis.
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There are some disclosure issues: Lehman, in its last
conference call with investors, gave no clue that it was actually on the brink.
An investment bank uses its proprietary book (own money) to lend others and
invest. It started with the sub prime crisis. Banks like Lehman, buy mortgage
loans from other banks and then package them to sell bonds against the loan
pool. Often they add cash to make the loan pool more attractive, so that the
bonds can be sold at a higher price. Such disclosure issues is what I think
made the collapse inevitable.
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by
Gandhi Rajan, Sr. Associate, ICICI Securities
| 1 year ago
Suppose mortgage was earning 6%, these bonds are sold at 4%. The difference is the spread which the investment bank earns. By selling these structured bonds, it raises money and frees capital. But when homebuyers started defaulting, these bonds lost their value. It all began like this, and then the virus spreads across markets.
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No easy answer to that. Maybe, some of the accounting norms need to be changed, so that the definition of MTM gets narrowed down. Besides, to stop banks from going overboard, capital requirement may have to be raised for derivatives position. But all this may be easier said than done. |
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