Ref: 10-003 of 19-Jan-2010

by Kalidas

ead or watch any media report in Uncle Sam’s America – newspaper,magazine, Business channels on TV or any interview of seniorexecutives of large corporate. They talk about only Top Line andBottom Line. Top-bottom, top-bottom, top-bottom……… they go onlecturing for hours using above words in different contexts. In theprocess, the body, the substance, is lost

.What happens when a person with blood group A+ is on operating table and is in need of blood.Will any other group of blood be acceptable? Of course, not. He will die if he is injected withdifferent blood group.Same thing applies in the field of finance and economy. Those of you who has read my book “SubPrime Resolved” and the primer series “How to Invest into anything…” would have known that “Long term assets should be financed by long term liability which could be in the form of capitalsuch as Equity or Preference shares and long term borrowings from banks, financial institutions,public issues in the form of Term Loans, Bonds, Debentures or perpetual instrument.Thus, if you grant a loan on 10 year basis, it should be financed by either equity or 10 year longterm borrowings. The borrowings have to necessarily match the maturity profiles of the financedassets. If a bank or Mortgage financing institution is granting a fixed rate mortgage on 30 yearsbasis, he should have capital or borrowing on matching terms and maturity, those who finance thelong term assets with short term liabilities are bound to fail sooner or later.This is what is going to happen in America. The banks and mortgage institutions, with a view toboosting stock prices of their company, lent mortgages at incredibly low rates, often not exceeding3 or 4%, and financed them from short term borrowings from Fed under Federal funds rate

Yet another Banking Crisis – Maturity Mismatch by Kalidas Page 2 of 4

program or in discount windows at near zero rates. In reality, they were arbitraging betweenshort term borrowings and long term lending rates. THIS WAS SUICIDALLet us take a concrete example:Suppose Banker A grants $ 250,000 Fixed Rate Mortgage loan @4% 3,750 repayable in 30 years.The rates are fixed, without recourse (unique in America) and without escalation clause. See thestupidity of the American banker. How could they take the view of Interest rate for 30 years? Howcould they lend on such incredibly low rates for 30 years?LENDER IN HEAVENHe does not have enough capital. He borrows short term (monthly rollover or Libor based) eitherfrom Fed or interbank market. He pays at the most 0.25% and lends at 4% netting interest differential of 3.75% or $ 3,750 per borrower per year. It is his net profit with least maintenancecost. The stock price goes up, his stock options become more valuable asset and he also earns fat bonus at year end running into millions of dollars. That is his performance. He is considered by hiscolleagues and neighbors as “Smart Ass”LENDER IN HELLNow, what happens when the interest rates rise? Well, until the rates rise by 2% to 3%, his profit margin merely narrows down. Instead of earning arbitrage interest differential of 3.75%, hewould earn 1.5 to 2% or $ 1500 to $ 2000 per borrower per year.However, when the interest rates rise to 3.5%, and above, he will have to visit Wash Room often.He is losing in every case. Being a fixed rate mortgage, he can not pass on extra cost to hisborrower. If he tries to under other Alt-mortgages, the borrower will come to him, hand over thekey and say, sir, enjoy your property. He becomes “lender in possession” with no recourse to theborrower. In short, the banker is now in duress.If interest goes to say 8%, he will have shell out 4% from his own pocket or $ 4000 per $ 100Kmortgage per borrower per year. If he has granted $ 300 billions of such loans, he would lose 4%or about $ 12 billions from his bottom line. NOW, his bottom line becomes bottom less pit.There are about $5.5 trillions of mortgage loans in United States. In the event of massive rise ininterest rates, the banks would be losing $ 220 billions for rise in interest cost by 4%. In otherwords, the lenders would lose @ 55 billions for every rise in interest rate by 1%. If the rates riseto say 24% as it happened in early 80s, the bankers and mortgage lenders will lose over $ 2trillions ($ 2000 billions) per year. We are not counting derivatives which run nearly 6 to 20times the above amount.There will be catastrophe. The borrowers will not be affected because they have fixed ratemortgage. But when his lender gets bankrupt and gets sold to some third party, what happens if the said third party annuls the agreement on the ground of equity (it is possible legally) and fairplay?At the moment, thanks to Four musketeers – Hank Paulson, former Treasury Secretary fromGoldman Sachs, Timothy Geithner, incumbent Treasury Secretary, Ben Bernanke, incumbent Fed

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Chief and Alan Greenspan, former Fed chief for over 18 years. They are the “Destroyers of America”The rates are about to rise. China has already expressed intention not to buy any more T-Billswhich has infuriated the United States. A vicious propaganda is launched to the effect that Chinabubble is about to burst. They are trying to squeeze Chinese nose so that their mouth and purseopens up. But then, they do not know the Chinese.When the rates begin to rise, all the banks and mortgage lenders will come under severe squeeze.The double “dhol” (an Indian musical drum) with Bernanke on one side and Geithner on the other,will make such noise that the markets would be rattled to the extreme.There could be several defaults in the interbank market. The bond securities often labeledinvestment grades A+ to AAA will be reduced to “D” or default status causing the US crisis a trulyglobal one. Every bank lends to another bank without insisting on any security. Such degradationof rating will mean wholesale selling of the bank debts.Several banks will fail, in thousands. Several trillions will be lost again. The Fed will find difficult toprint more and more $ notes. FDIC will be busy taking over banks day in day out with no funds inthe kitty.President Obama with no cash in the kitty, printing press closed, no majority in Senate to passmischievous Health Care bills, will be pushed to the wall. His popularity will go down below 30from 46 at the moment.Hell will break lose again in the financial market. Will it happen and so early. It all depends at what speed the rates rises. It is not the question of “whether” but “when”Ride the rally in the stocks and bonds for the time being. A financial earthquake, much severe thanHaiti, is in the waiting. I could hear the simmering sound, I could smell the faint smokes, what I donot know the precise time when this volcano and earthquake will burst and with what intensity.Kalidas (Anil Selarka)Hong Kong, 19

Janury, 2010 Ref: 10-002Personal Blog:http://anilselarka.com Book Web :http://www.subprimeresolved.com