Domino Effect: How Did the US Financial Crisis Become a Global Epidemic ?

By now, much has been written about the fall of three of the biggest global financial institutions in the US - Bear Stearns, Lehman Brothers and Merrill Lynch in addition to other recent casualties within the Banking sector. The fact that these were reputed institutions in existence for more than an average human lifetime suggested that they would withstand the test of time and weather all odds. Yet, in one fell swoop, these companies vanished without a trace ! Worse still, their disappearance caused a trail of casualties across the globe. Why did the crisis in the US become a global epidemic of such a large proportion ?

The concept of securitisation leading to the creation of a market of Mortgage backed securities (MBS) was initiated in the United States many decades ago with the intent to attract new market participants who were interested in buying a share of the Loan cash-flows that existed on the books of various banks across the country. Loans, although assets on the books of the banks as they ensured interest payments from borrowers, brought with them risks - most important among them being the risk of default. The creation of an MBS market gave the banks an opportunity to offload the default risk to investors who were interested in buying a percentage of the cashflow of their loan portfolio, thereby, clearing their books of any contingency capital (which is a percentage of risk rating of their portfolio).

This ecosystem was laid on the foundation of transferring default-risks from institutional lenders to various investor categories like retail, institutional, banking, fund houses, pension funds etc... This process of allowing retail banking portfolio to enter the capital markets as trade-able paper (security) caused the capital markets to be exposed to the retail banking system. This, in hindsight would be the biggest reason for loan defaults to cause a big dent in the capital market system of a trillion-dollar economy.

So, why should a loan default on a mortgaged home in Iowa cause a ripple in China ?

Once the stage was set for securitisation of asset-backed securities, mortgage loans were not to be left far behind from being securitised. Large investment banks like Merrill Lynch, Lehman Brothers and Bear Stearns got aggressive in building a portfolio of MBS securities which were subsequently re-packaged and sold to global investors as credit derivative instruments as insurance protection against default-risk. If a home loan in the US was defaulted, the firm in China which bought the insurance for such a default would be compensated for, by the American firm which sold that protection.

Home loan defaults are directly proportional to the prevailing interest-rate regime. When the interest-rates are looking north, the defaults on Home Loan are bound to rise. All along the good times, home loan defaults were under control since the interest-rates werer stable. When the rates began to rise leading to a rise in defaults, the snowball had become too big to handle. Billions of dollars of credit derivatives bought by global investors as insurance against default were now at the doors of the American banks to claim their compensation. Such an interlinked a tightly coupled liquidity chain had to get stuck in a deadlock very soon as the insurers (in this case the American investment banks) themselves had no cash to honour all the compensation claims.

Filing for bankruptcy was the only choice for some institutions like Lehman Brothers, while others had to settle for an acquisition at a significant discount to shareholder value!

The American government had to step in to stem the rot and protect the interests of the retail investors. Central banks of other countries had to come to the rescue of their local institutions / banks who had exposure into the US sub-prime mortgage market.