A Guide To Understanding The Financial Crisis

As the financial markets suffer major losses, many are asking themselves, why? What has changed over the past two weeks that has caused trillions of dollars of value to be shaved off equity prices? Why do sub-prime mortgages affect the price of technology stocks? When is this going to end? The answers to these questions will enable you to understand exactly what is going on.

What has changed over the past two weeks that has caused trillions of dollars of value to be shaved off equity prices?

The price of risk is being readjusted. Period.

Any financial instrument has an inherent amount of risk. The investment one makes can go down in value or in a worst case scenario become totally worthless. How risky an investment might be determines the amount of reward, or return on that investment. The more one risks, the more one anticipates in return.

A US Government bond has always been deemed a safe investment simply because the US Government always pays its debt on time. The assumption is that the US Government will be here for at least another few years and will maintain its ability to repay its debts. As a result, US Government bonds have a lower yield, or pay less interest than other more risky investments.

A corporate bond is more risky than Governments. Corporations go bankrupt. Corporations run into financial troubles. Sometimes they cannot repay their debt. The buyer of a corporate bond assumes more risk than the buyer of a Government bond. As a result, the buyer expects a higher rate of return.

An ever riskier type of bond is a mortgage backed bond. (I am not going to discuss government agency or government backed mortgage bonds). A mortgage backed bond is a bond that packages together many mortgages and pays interest to the buyer from the cash generated from mortgage repayments. For example; Bank A has written 1 billion dollars in mortgages at 6%. Bank A does not want to be exposed for the next 30 years to the possibility that the homeowners will not meet their payments. The bank will then sell the mortgage obligations to an investor who is willing to take on that risk. As long as the homeowners make their monthly payments, the buyer of the mortgage backed bonds receives his interest payment.

With the advent of the sub-prime mortgage market, these high risk mortgages were also packaged and sold to investors. With US bonds at historically low yield, investors looked for riskier investments which offered higher returns.

The demand for these high risk bonds became so great that their prices rose and therefore their yields dropped. The change in a bond's yield is the direct inverse of the bonds price. The more you pay, the less you earn.

As a result of the huge demand for these high risk bonds, their yields dropped so dramatically that they became ever so cheap in relation to the safest bond of all, the US Government. That is what is known as a "spread"; the net difference between the yields of two different bonds. When the spread is "narrow", the yields are, relatively speaking, close in number. When the spread is "wide", the difference in yield is relatively great.

As the "spread" between the sub-prime mortgage backed bonds and the US bonds narrowed, many other similar types of higher risk bond saw their yields drop and close in on US bond yields. In a sense, the return on bonds was not truly reflecting the inherent risk.

Once homeowners started defaulting on their mortgages, it became apparent that the mortgage backed bonds were much riskier than implied by their steadily dropping yield. The prices for these bonds started to drop in a hurry. Suddenly, no one wants to own them anymore.

The market has come to terms with the fact that sub-prime mortgage bonds in particular and other risky bonds in general have been overvalued; they are actually worth much less than what they thought. This turned out to be a major error.

The market is currently adjusting the pricing of all types of riskier financial instruments. In this case, it means the prices are going down as the yield goes up. Again, the higher yield reflects the higher risk which translates into a lower price.

Why do sub-prime mortgages affect the price of technology stocks?

Bad sub-prime mortgage debt has nothing to do with technology or most other industries for that matter. However, many companies, pension funds and other institutions own different types of high risk bonds which are currently being marked down in price. As a result, heavy losses are being recognized as many of these investments have lost a substantial share of their value. As a result, even technology companies might be losing substantial amounts of money if they hold these securities.

Furthermore, as the market adjusts the value or cost of risk, interest rates on these bonds are rising. In the future, any company that would look to sell a new issue of bonds will have to pay a higher interest rate in order to attract investors. That costs money. That cuts into profits. As a result, stock prices, which reflect the health and potential profits of a particular company, will go down.

When is this going to end?

Not until the price adjustments have been completed and the market can weigh the damage. Once the market can determine the exact value of these bonds and determine exactly who holds them and how much was lost, then things will settle down. A large part of the current panic is due to a major case of uncertainty. That is why it seems that every day another bank or hedge fund announces they have trouble. They have come up with some sort of valuation and it usually not pretty. Once, so to speak, the garbage is taken out, then the market will be able to fairly evaluate stock prices. How can one come to a rational conclusion that a particular company's shares are worth buying if you don't know what kind of exposure the company has to this bad debt?

It will take some time to clean up this mess, but that time will come soon enough. It always does.