The crisis are started by leveraging the money 30 to 50 times and investing in the risky assets. This is same analogy when people sold their gold and buy stocks, back in 2000. But this time Bank and Brokerage are caught up.
Let's do some mathematics here. Usually, banks (FDIC insured) on average has about 8% of capital for their assets, and loans are 60% of assets. It means they have leverage the money approximately 12 times (60 divide by 8) . What does this leverage means? For example, if you have 100k in your bank in CD (i.e your Capital), then you (if not you than bank) can borrow and lend 1.2M (100k X 12). You have done 12 time leverage of your capital. So if you paying 2% (Current Fed Rate) for your money you borrow and charge 6% to other for the loan. The loan could be for Car, Mortgage, Home Remodel or may be to take vacations. So you can make profit of 4% (6%-2%) on 1.2M i.e 48k. You just made profit of 42k on 100k. This is 42% gross profit on your invested capital. Amazing, isn't it? This is why you see small banks are started.
Now, let's take a look at risk factor. Out of 1.2 M you lend, let says 10% if it (i.e. 120k) is bad loan. The person you lend forclose the home, or they have no money to pay for whatever the reason. So all of your profit i.e 42k gone and on top of that it dipped on your capital. So 1.2M + 42k (Profit) - 120k (loss) = 1.122 M. So you need to raise 78k. (1.2M - 1.122M) or you have to reduce your loan porfolio and have a write down the loss.
This is why you see the news about raising the capital and write down the loss. In this example above, I have just used 12 time leverage and 10% bad loan, the brokerage firm like Bear Stern made 44 times leverage. Fannie and Freddie made 50 times of leverage. Fannie and Freddie combined has a loan of 6 Trillion, half of the whole mortgage market which is 12 Trillion. Considering house price went down 20% so far; and delinquency rate is still high more than 4.5%. If you apply this number with above formula it is no brainier Fed has to bail out Fannie and Freddie. Not only that, one more top tier bank has to go out of business.
Merill Lynch are selling the asset to raise the capital and so what Fannie do, but there is not enough demand in the market to buy this assets. Couple of weeks back, Merill sold all of the mortgage portfolio for 22c for the $1 value (They sold 30.6B asset for 6.7B.), on top of that they give buyer (Loan Star) a financing of 75% of it. So basically that means they may get 5 cents for the face value of one dollar. Additionally, they will sell 8.5B in stock, so it will dilute the value of share by 38%. This is how the bad it can go, and this is the reason why Goldman rates Merill stock to Sell.
And not only US bank is on this mess, country like Singapore, Kuwait, UAE all has invested on this brokerages and banks (Merill, Morgan Stanley, Citigroup, Barclays, UBS ) as a part of raising the capital in 2007 and 2008. They are all down more than 40%. So far Banks and Brokerage Firms across the world has write down 500B, more to come.
I am not saying it is the end of the world; the market will find the solution. But there is some more short-term pain for many investors like me, and we need to be aware of the problems and see if we can avoid them for ourselves.
Update as of 9/7/2008: US Govt has undertake Fannie and Freddie under Conservatorship for indefinite time, they will get a credit line of upto 20B/month from treasury, to save 2B they are going to cut 100% dividend on Stock and Preferred Stock, but they will pay the debt, common stock will be last on the line, so it won't wipe 100%. Most of the detail can be found below:
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