When the tech bubble burst, the Fed lowered interest rates and sowed the seeds of the present crisis. Will this bailout spawn the next crisis?
Enough has been written in the press about the global financial crisis and the Paulson-Bernanke package for a $700 billion bail-out. To the ordinary observer with no formal training in finance or economics, the basic question is about what went wrong and why. The simplest way to look at the crisis is to understand the basic linkage between capital and risky assets. This fundamental relationship is universally applicable to all financial structures.
Why the trouble
If one buys assets, one needs money to fund such a purchase. One can use equity (or capital as we know it) or borrowings (leverage as we know it) to fund the assets. If the assets move up in value, it is possible to sell them off, pay off the borrowings, and make a high return on capital. Let’s say we put in Rs 10 as capital, borrow Rs 90 at 10 per cent and invest in an asset worth Rs 100. If we can sell it off at Rs 200 later, we repay Rs 110 to the lender, and on the Rs 10 of capital, we make a profit of Rs 90. This is the simple leverage benefit.
Now if this is too good to be true, here’s the downside risk. If an asset can move up from Rs 100 to Rs 200, it can also fall off from Rs 100 to 0. If that were to happen, there will be no money to repay the lender. Therefore, for a structure to be stable, its capital has to be at least large enough to bear the loss in the value of the assets.
In the case of the failed institutions in the US, the values of assets have all dropped after the steep fall in housing prices. This means, they have Rs 10 of capital and Rs 90 of loan, but the asset value is now Rs 20. To salvage the situation, they are only three choices. One, hold on and hope that the assets will go back to Rs 100. This is unrealistic and lenders may not wait for eternity to be repaid. Two, ask the lenders for a write-off. This they will do to some extent, but a large default will require the borrower to