In layman language; CDOs, CDS, ARM, house equity-loans, and all other US major loans

Art, 15 Mar 2008

With a $100K deposit collected, Bank A then lends $1million to person X to buy a $1million house. He then uses his one million house deed as collateral to borrow $800K from Bank B where he may splurge on holidays, car and even a down payment for a second or even a third house. Bank A buys a loan default insurance on the house, then packages it as an asset-security of AAA rating (Collateralised Debt Obligation, CDO), and sells it to hedge fund investors or other banks. These investors then buy ‘insurance’ (known as Credit Default Swap, CDS) against possible defaults against these CDOs from the financial market while Bank A gets his $1million cash into the bank. Bank A can now lend out $10 million to new house buyers and this can go on and on. If we assume a multiplier effect to the power of 3, from $100K deposit, the banks will be able to loan up to $100millions. Banking rules allow only about 20 times leverage (or 5% reserves against total loans), whereas, US banks, through the above off-balance sheet bookings, can easily operate at 100 times leverage.

In the meantime, Bank B will report profits from interests charged on the house equity-loans while X believes that the property market is rising and, as such, took up further loans with little or no down payment for his second and/or third houses since the 1st year interest charged is only 1% p.a. and the interest charge will increase significantly in subsequent years (Adjustable Rate Mortgage loan, ARM). Everything is fine as long as the house prices continue to rise and X remains in employment to pay for his mortgages loans and he is able to sell his houses and take profits before the new high interest charges kick in. At the same time, there is no inflation which can reduce X’s ability to pay for his mortgages in the meantime.

Currently, we are witnessing the reversal.

US housing loans
1. USD1 trillion of loans have been made to people without any proof of income or assets (Sub-prime loans)
2. Alternate-A mortgage loans are made to those with proof of income but without known assets ‘seize-able’ if the loan defaults.
3. Prime housing loans are made to those with proof of income and own assets that can be seized as collateral. Alternate-A and Prime housing loans total about USD5+ trillions.
4. Total equity-loans against the house value stands as USD635 billions.
5. CDS exposure now at USD40 trillions
6. Commercial properties exposure is significant, guesstimated to be at USD4 trillion. It has dropped by 2% followed by 5% in 4th Qtr 2007.

Other personal loans:
Credit Card loans of about USD800 billions
Cars mortgage loans of about USD800 billions

Corporate loans stands at USD40 trillions

Projected write-off from the above items: (assumed failure rate)
Sub-prime = USD300 billions (30% failure rate)
Alt-A & Prime = USD250 billions (5% failure rate)
Home-equity = USD127 billions (20% failure rate)
Commercial pty = USD600 billions (15% failure rate)
CDS = USD 17 billion (netting effect)
Car-loans = USD 80 billions (10% failure rate)
Creditcard = USD 80 billions (10% failure rate)
Corporateloan = USD500 billions (1.5% failure rate)
Total: USD1.954 trillions

To-date, sub-prime USD150 billions have been written-off whilst the rest are still hardly written down. US is about 15% from the total projected write-off. When bank write off loans (assets), recapitalisation is needed or new cash injection would be needed to meet the banking reserve requirement.

In short, it is far from over.