Friday, October 24, 2008

Lehmann down, y?

I solely feel the reason behind the sad demise of Lehman Brothers is over-smartness of the policy makers, not only in Lehman but also other such banks.

Let me first of all brief you about the kind of work investment banks do. They basically invest the money deposited by the customers-big (companies) or small (individuals). In return they pay them some interest to them. This is a sound business. Since, you get a lot of money to play with. And with highly intellectual strategists (no sarcasm!!), they devise newer plans everyday.

And everything worked out well for them (read Lehman and alike companies). But we all know something hit them real hard. And this something was- Sub prime crisis. Now, what is sub-prime crisis?

Every bank has a set of customers to whom it is going to give loan or provide a particular set of services. Technically, these customers are called Prime customers. So, the banks were giving away loans to them and everything was going their way. But these banks had a lot of money and fewer and fewer prime customers. So, they started looking for Sub-Prime customers. These were the customers to whom the bank was unwilling to pay loans earlier. But now, they were also considered 4 loans.

Even now the ball was rolling well. These customers were paying their installments and the cycle was good. But now comes the twist. The customers (majorly sub-prime) loaned money for buying properties and making profit. The property rates as a consequence were reaching sky. And people found it an easy way to make money. Let's take a scenario to understand the whole stuff.

A customer (name him Sam) took a loan of 10,000 USD to buy a property (with sole purpose of making profit by later on selling it at higher rates.)
He was paying the installments faithfully and things were good. But, the real estate prices have a limit. The real estate prices started plummeting due to certain factors pertaining to global reasons.

So, what happened to customers like Sam? They did not know what to do because their real estate costed less than the amount they had invested. Suppose, Sam's property now costs 6000USD, so what would smart Sam do? He would leave the papers with the bank and would stop paying INSTALLMENTS. Smart Sam as i said!!

Now, bank finds out that Sam is unwilling to pay his installments-So, the bank goes into the market to sell the property and guess what, it finds out that the property against which it had availed a loan of 10,000USD now costs 4500USD. Leave the interest, its principal amount can't be recovered even. So, the bank gets screwed up. And there was not one Sam. There were Sam’s all around. Becoming defaulters and making banks poorer and poorer.

So, why on the first hand banks did this? They could have kept the extra money with themselves instead of risking it with the Sub-primers. But banks never do so. They are always willing to loan it for INTEREST. And if one bank does that, others unwillingly also have to follow the trend in order to stay in the market. And hence, the complete cycle of the downfall of not only Lehman but all the other biggies.