Bankruptcy Explained through a story

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.

1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.

The net asset of the country now = 3 dollars.

3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.

*A has a loan to C of 1 dollar, so his net asset is 1 dollar.
* B sold his land and got 2 dollars, so his net asset is 2 dollars.
* C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.

Thus, the net asset of the country = 4 dollars.

4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result,
*A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.
* B loaned 2 dollars to A. So his net asset is 2 dollars.
* C now has the 2 coins. His net asset is also 2 dollars.

The net asset of the country = 5 dollars.

A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.

* As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars.
* B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
* C loaned 2 dollars to B, so his net asset is 2 dollars.

The net asset of the country = 6 dollars; even though, the country has
only one piece of land and 2 Dollars in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil wind blew, and an evil thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more."

(8) A also thought the same way.

(9) Nobody wanted to buy land anymore.

* So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
* B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
* C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating.

The net asset of the country = 3 dollars again.

(10) So, who has stolen the 3 dollars from the country? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B's net asset is still 2 dollars, his heart is palpitating.

(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.

* A owns the 2 coins; his net asset is 2 dollars.
* B is bankrupt; his net asset is 0 dollar. (He lost everything)
* C got no choice but end up with a land worth only 1 dollar

The net asset of the country = 3 dollars.

End of the story; BUT

There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting -

(1) when a bubble is building up, the debt of individuals to one another in a country is also building up.
(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land goes up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game. But you must know when you should change everything back to cash.
(8) As in the case of land, the above phenomenon applies to stocks as well.
(9) The actual worth of land or stocks depends largely on psychology (or speculation).

*P.S: Got this story as a forward.
**P.P.S: I'm not that creative ;)

Understanding Sub-Prime Mortgage

Sub-Prime Mortgage is no more a unknown word. People have started discussing it over coffee and it has suddenly become a buzz word. In the past 2 weeks I have notices at least 5 headline articles having this keyword in newspapers. So, its natural that everyone is eager to know more about the crisis which brought about the downfall of a 150 year old company. Here, I try to explain this crisis in simple "human-readable" terms.

Before dwelling into this hot issue, let me describe the current state of affairs (majorly in U.S market). We have seen that Lehman Brothers have filed for bankruptcy under Chapter 11. AIG has been taken over in a multi-billion dollar deal, to keep it afloat for god knows how long. Merryl Lynch was taken over (the deal was more like a give away price). Goldman Sachs and Morgan Stanley are no more just investment banks. Freddi Mac was brought by the US govt. And looks like many more are going under the hammer. So why is this chaos in the market. Well, to explain this I will have to start with the happenings as back as in 2001.

The US real estate industry witnessed a boom between 2001 and 2005, with property prices soaring to historic highs due to low property loans, interest rates and other factors. Some of the weaker borrowers, who were either on the verge of defaulting on their financial commitments or had already done so, owned house properties whose values had risen dramatically on paper. So lenders looking at increasing their margins were quick to spot an opportunity and lent money to such borrowers on the basis of this increase in the paper value of their homes and these loans were either used to repay the old loans or for other expenses. All was fine till the housing party crashed.

The US property bubble collapsed, and interest rates began to rise. The rising rates led to a spate of defaults by borrowers, as a result of which several US sub-prime mortgage companies had to declare bankruptcy.

The result was that the shares of lenders dealing in sub-prime mortgages took a tumble. That's not all. The effect spread to the entire financial markets because these lenders had raised monies on the basis of such loans and were now not able to pay them back. And the ripple turned into a wave, affecting a wide section of the markets, and then spread overseas.

Exact definition of sub-prime mortgage:
A sub-prime mortgage is a loan offered by a lender to a borrower with a poor credit history (meaning he has defaulted on his financial commitments in the past) against the security of his house property. Such borrowers are called sub-prime borrowers. Since the risk of default is high, these loans are offered at relatively higher interest rates compared to loans offered to people with an impeccable repayment track record. However these sub-prime mortgage loans are relatively much cheaper than completely unsecured loans to the same profile of borrowers.

How does this affect Indian market and does this slow down the Indian Growth Wagon?
The US sub-prime crisis has had a short-term impact on the Indian stock market and on credit instruments with overseas investments. Collateral damage in India was extremely limited, as Indian entities do not own structured finance instruments. In effect, all it has managed to achieve is to create panic among investors. But soon those who were too quick to shed off their shares will repent their hasty decision. Our market is strong (or as strong as before the Wall Street crash), and it is highly unlikely that a sub-prime mortgage crisis will ever happen in India, since most of the Indian population which has bad credit rates are Non-prime users. Borrowers falling in this category may have never defaulted, but have low incomes or may not have proof of such incomes. These people may have borrowed earlier, but from local moneylenders and not banks or formal institutions. This is the case even with the ridiculously high interest rates the local money lenders charge. There is a reason for this. Since lower income group people do not find the need for large capital investments, they only need to borrow to sustain their daily needs. So they would prefer small amount, short duration, no surety loans, which no banks offer. Because of this, I think there is extremely less chance that the Indian markets will fall as it did in the US for this reason. But I do think that it is time the property bubble collapsed in India too.