Professor Elam

This is as good a summary of the sub prime crisis as I have read.  I have previously posted articles about MER and CITI.

Okay let me attemtp to shorten all that. First one has to grasp the concept of a margin call. When one buys securities with borrowed money and the securities fall in value, one can be asked to put mp additional collateral. This is a margin call, the owenr of the securities is literally called up one to put up more margin, and RIGHT NOW!  This of course is the problem.  Here is an example.

Let’s supose we boughty 1,000 shares of CFC Countrwide Financial at $40 earlier this year.  We put up half the purchase price  in cash and borrowed the other $20,000. Why did we do this? this is employing debt which is the concept of leverage.  We have leveraged our ownership to more than our own cash resources would allow.  We of course are certain that CFC is going up as it is the number one lender in the never ending housing boom. Now as we know CFC proceeded to fall in value.  As it gets to say $35 we are now $5,000 underwater with our lender.  The stock is only worth $35,000 but remember we borrowed $40,000, while the stock is falling the original debt is not.   So the lender will ask us to put up collateral for the value the stock has lost.  Suppose the lender wants half the drop in value, in fact there are specific rules about how much and when but this is hypothetical to give you a flavor of what this all means.  Okay if we did not have the extra cash to do this in the first place where are we going to get it?  We either have to borrow it somewere else or we have to sell some CFC, and we have to do so at the reduced price of $35.  Here we would need to sell 71.42 shares to raise $2500. But wait a minute, this is like the dog chasing its tail, if we sell some of the CFC now we only have 930 shares left, so from that standpoint we have less collateral than we started with, ie fewer shares. THe better idea is that if one has received a margin call the entire thing ought to be sold as it is going down not up and things are not liable to get better soon.  Well in fact CFC dropped to $14.35 as of the close this past Friday Nov 2. YIkes, once it dropped below $20 we had lost our entire $20,000 wse borrowed. Needless to say the lender would have been pounding on our door all the way down as the stock dropped in price.  If we had not been smart enough to sell all back up there at $35 we could conceivably have wiped out our entire investment making margin calls in which case we would have lost all our $20,000 we put up. 

Now unless this is perfectly clear there is no point in proceeding because this is at the heart of the problem. When asset values fall, as the wiki article points out, SIVs CDOs whoever is required to meet the margin calll. What to sell, that is the question as Hamlet might put it.  Ford had to sell Aston, CITI will have to liquidate something that it CAN liquidate, and that is not liable to be the subprime stuff it has in the SIV or CDO.

Send me some posts with questions before I go on so i know where you are on this!