Sunday, October 05, 2008

The story behind the Lehman Brothers collapse

Having heard and read little here and here about the Lehman Brother's bankruptcy over the last few weeks, I really could not understand what went wrong.

I was too lazy to ask anyone to know in detail. All I knew was people failed to repay home loans and that led to bankruptcy. That made me wonder how it could only happen with Lehman, it should be a common case. However, there were too many things that my mind had to munch in the last couple of weeks that this took a back seat.

Today, I came across an article in the Hindu Magazine answering all my questions and much beyond. I appreciate the way the writer has put down the facts that makes it easy to comprehend.

In short, this is how it works

Banks offer home loans to people --> Investment banks like Lehman Bros buy those loans from the banks. This is good for the bank as they get back the loan money at one shot and now they can issue more loans. Lehman brothers now coverts these loans in to funds which investors buy.
Each month the bank sends the EMI paid against the loan to Lehman Bros who then splits it and sends it across to its investors. These investors now get a monthly returns for their investments.

Isn't that a very interesting way of looking at the concept of home loans? Now, where could the problem come? What if the EMI is not paid on time? Well, as this concept emerged the interest rates for home loans were very low and there was close to 1% of defaulters. So, this was not considered to be a major risk at all.

Now you should see the strategy of Lehman. They now convinced AIG (Insurance) to insure these home loans. There being almost a minimal risk in the home loan payment business, AIG promptly signed the deal. Everything was going smooth. With more and more investors getting into this business, Lehman was buying more and more home loans. This internally pushed the banks to offer more loans. Slowly, the qualifying criteria of loan approvals detoriated and it seemed like anyone could get a loan. Around the same time, the interest rates all increased. All this mounted to a large number of defaulters.

As the EMI's were not paid, the banks could not give Lehman the monthly share who then had nothing to give the investors. This was when Lehman Bros felt the heat of the situation. AIG now had to insure all these defaulters and ended up loosing so much money in an area which was considered the least risk.

And the rest is history today...


Prakash Venkat said...

In one way what they did is one of the nicest ideas to make more money on the money to be given ... I guess they went over board and its for us (Indians) to learn from it ... But as said if US sneeezes we catch cold ... the effect of FII's ...

Mihir jha said...

Nice Post!!!