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I wish this article can help many people understand how the mortgage loan related to financial crisis this time.

The article is very easy to understand, I believe that even the housewives and normal office workers can grasp it. I wish through this article, people can get to know what is depreciating in this crisis, why the stock and funds in your hand devalue so much this time.

1 Gearing or Leverage

Currently, in order to made excess profits, many investment banks adopt 20-30 times gearing operation. We assume that the own capital of bank A is 3 billions, 30 times gearing is 90 billion. In other words, bank A used 3 billion capital as mortgage to borrow 90 billion as investment capital. If the profit of their investment were 5%, then A would gain 4.5 billion as profit. To A, this is excess profit which is 150% of his own capital. However, on the contrary, if the loss of the investment were 5%, then A would lose all his capital and carry 1.5 billion debts as well.

2 CDS Contract

Because the risk of gearing operation is high, according to the normal regulation, bank should not adopt this kind of high risk operation. However, someone find a way to use this gearing investment to buy “insurance”. This kind of insurance is called CDS. We assume that in order to avoid the risk of gearing, bank A found organization B, organization B could be another bank, or an insurance company, etc.

A said to B: “How about you help me to buy the default insurance using my mortgage? I will pay you 50 millions insurance fees every year, for 10 years. In total it is 500 millions. If my investment doesn’t default, you can take the insurance fee for free, but if I default, you should give me compensation.” A thought that if I do not default, I can earn 4.5 billion. But if I default, the insurance company will pay the loss for me. Therefore to A, either way is a net gain.

B is very smart as well, he didn’t accept the invitation of A immediately. Instead, he went back and does a statistical analysis; he found that the risk of default is less than 1%. If he found 100 clients, he would gain 50 billion insurance fees, even among them there were one default, the compensation would be less than 5 billions, if there were two default, B still could earn 40billions.

Both A and B felt this business is beneficial for them, so they made agreement happily.

3 CDS Market

After B made this business, C felt envy. C came to B and said:” How about you sell these 100 CDSs to me? I will pay you 200 millions for each contract, in total it is 20 billions.” B thought: that I have to wait for 10 years to get these 40 billions, now if I sell it I can have 20 billion immediately without risks, what a bargain!

Therefore, B and C made the deal at once.

In the end, CDS can be sold and bought in the financial market just like stocks. Actually after C got these CDSs, he didn’t mean to gain 20 billion after 10 years. Instead, he price them 22billion and sell them out.

D saw the products and thought that 40billion minus 22billion equals 18 billions, there’s still 18 billion profits can earn. This is not too expensive for initial offerings, so he bought quickly.

Therefore C earned 200 millions.

After that, these CDSs were sold in the market many times and now the market value of these CDSs is 62 trillion US dollars.

4 Subprime Mortgages

A,B,C,D all earned big money, but where dose these money come from? Originally, all these money from the profits of A and the other investors like A. And most of their profits are from subprime mortgage in US. Many people say that this crisis caused by the fact that all the mortgages were given to the poor, but I don’t agree with it.

In my point of view, most of the subprime mortgages were given to the normal US real estate investors. The capital they had was just enough for them to buy their own houses. But when they saw that the house price increased dramatically, they started to think about investing in real estate. Therefore they mortgaged their own house and use the loan to invest the real estate.

The interests of this kind of loan are more than 8%-9%. It is very difficult for them to afford by their own income. However they can keep mortgaging the house to the banks, paying the interest with the loan.

At that time, A felt happy, because his investment was helping him earning money.

B also felt happy, because the default rate is very low, his insurance business can still go on,and C, D E, F who followed them are also earning money.

5 Subprime Mortgage Crises

When the housing price reach certain level it cannot go up anymore, there are no successors follow up. Then the real estate investors felt anxious, because although he can’t sell out the house, he still had to pay the high interests. Finally, he cannot help but leaving the houses to the bank, default happened.

A felt sorry, but he thought even he cannot earn big money, but he still won’t loss too much, he still held the insurance from B. B didn’t feel worry as well, because he had sold it to C. Then where is this CDS? It was in the hand of G.

G just bought 100 CDSs from F by 30 billion, before he sold them out, out of sudden, he received this news that these CDSs have been degraded, and there were 20 contracts default. This is far higher than 1% or 2% default rate estimated at very beginning. For each default contracts, G had to pay 5 billion for compensation, in total it would be 100 billion. Plus 30 billion CDS acquisition cost, the total loss for G is 130 billion. Although G is top 10 organizations in US. He still cannot afford such great loss, and now G was facing bankrupt.

6 Financial Crisis

If G bankrupt, then 50 millions insurance A bought was waste. The worse thing is because A was using gearing operation, according to the result we mentioned before; A would lose all the money and carry great debts. Therefore, A also faced bankrupt.

Besides A, A2 A3… A20 all nearly bankrupted. So G, A, A2…A20 all came to finance minister of US and cried to him: ” G cannot bankrupt, if he bankrupt, we will all die.” Finance minister saw the situation and he nationalized G. So the compensation for A, A 20, total 100 billion was pay by US tax payers.

7 USD Crises

Before, we mentioned that the market price of 100 CDSs was 30 billion. But the total market value of CDSs was 62 trillion. We assume that if there is 10% default, then there will be 6 trillion default CDSs. This is 200 times of 30 billion. After US government purchased 30 million CDSs he would loss 20 trillions. If US government doesn’t want to lose, then he will see A 20. A 1, A 22, etc, bankrupt one by one. Neither way, he cannot avoid USD depreciating greatly.

The figures used in the assumptions may be different from the real situation, but we cannot underestimate the severity of the consequence of US financial crisis.

Edited By Vicky Yin