Financial Crisis Understanding From the Ground Up (part 4)

Financial crisis understanding from the ground up (Part 4) By George C (www.finance-database.com)

The current financial crisis

The public have a common understanding that the subprime mortgage crisis has leaded to a far more serious consequence, so called “the financial crisis” recently. To be exact, It has been going on for seven months. But how will that be happened? This is the question. The subprime load crisis is relatively simple to understand. People bought homes they couldn’t afford, and now they are falling behind on their home loans. This has caused the loss of related financial institutions. However, the amount of loss is not the major cause of the financial crisis. US government has already announced to take over Fannie Mae, Freddie Mac and AIG, and have injected the capital over that amount into the market. Besides, the majority of homeowners are still doing just fine. The conventional mortgage market is still healthy. So, how is it that a mess concentrated in one part of the mortgage business: the subprime loans, has frozen up the whole credit markets in United States? How would that crisis caused such a big impact to the stock market, causing the collapse of Bear Sterns, lehman brothers, etc, and left the economy on the brink of the worst recession in a generation and forced the Federal Reserve to take its boldest action since the Depression in 1923?

In order to have a big picture of this incident, I think this could be explained in this way. First of all, behind the whole financial crisis, there are actually 3 major components: the subprime mortgage, Leverage (or gearing), and the Credit Default Swap(CDS). We have mentioned about subprime mortgage before. So, what is leverage? In the finance industry, leverage is a common way to use in such a way to magnify the outcome of the investments. This can be done by various financial instruments such as options, futures, margin or borrowed capital, to increase the potential return of an investment.

At present, many investment banks use leverage to operate more then 20 times of their capital. For example, if bank A have an asset of 5 billion, then 30 times of leverage means that bank A can operate 150 billions of money, in which most are borrowed. It is obvious, if there is 5% of profit in the investment, then bank A has a profit of 7.5 billion. However, on the other hand, if there is 5% loss in the investment, then bank A loss all it’s 5 billion of asset, and still owe the lender 2.5 billion.

The third component is CDS. What is CDS? As explained above, the operation of leverage is very risky. So some bankers think of a way to take insurance on these leverage. This insurance is called CDS. It is a specific kind of agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments. For example, Peter borrows $100 from John. John wants to get insurance on this $100 debt in case Peter was unable to return the money. The John goes to Jane and asked for Jane to insurance that debt. Jane agrees to do so if John is willing to pay her an insurance fee of $5 per year. That is exactly the most simplified scenario of CDS.

Now, apply that in the world of banks. Recall the example of “bank A”. Bank A operates a leverage of 30 times. To reduce the risk, it goes to bank B and asked for bank B to do CDS insurance. After analysis the market data, bank B knows that the breach of contract case is less than 1%. Therefore, bank B is willing to take that insurance to earn the insurance fee. However, this is not the end of the story. Although bank B agree to accept the insurance, it can not have the insurance fee immediately. At the same time, some other banks such as bank C, bank D, etc. are interested to these CDS contracts. So bank B is willing to re-sell them to other banks to have the cash immediately. This is the scenario. The CDS contracts being sell and re-sell continuously among different financial sectors. In the mean time, the market value of the CDS has reached 62 trillion.

However, you may see that, all the banks A, B, C, etc are making money. So, where is the money comes from? The money comes from the revenue generated by the subprime mortgage business. So why the honey moon period can continue in the previous few years? It is because the real estate prices keep rising in the previous few years. In that period, home owners and buy and re-sell the real estates easily, who can earn good money at the same time. It just likes snowball or bubble. The market keeps rocking until 2006. When the downturns came, the prices of the real estates dropped. People who are lack of financial ability was unable to pay the high interests of those subprime loans. In that case, the subprime mortgage market started collapsing, which in turn affecting the CDS market. Banks and financial institutions who are involved in those products is unavoidably being affected. In fact, nearly all I-banks and most of the commercial banks are involved in this storm, or more appropriates, the tsunami.

George C
http://www.articlesbase.com/personal-finance-articles/financial-crisis-understanding-from-the-ground-up-part-4-608120.html

Determine Financial Matters Prior to Marriage

For most engaged couples, but especially for women, talking about a pre-nuptial financial arrangement is something that might sound totally out of context. In addition, certainly it is not a romantic affair but a practical issue between two persons who have decided to share their life and often their assets.

However, sometimes women are who see the practical side on financial matters and at times both partners are aware of how important setting up their financial context really is, also understand it has nothing to do with the love they feel for each other.

Whether they decide to keep separate properties that they own, or share their assets, having a pre-marital agreement allows them to determine what will occur with assets and properties that they share, including their home.

Pre-nuptial or pre-marital arrangements are made between prospective spouses, which mean that they will not be effective before they marry. In addition, such agreement will allow them to learn more about differences that rule on marital property through the different states of America, because in case of divorce, laws apply differently in each state.

In the past, only wealthy or famous couples entered into pre-nuptial agreements. Today, these agreements are more common among mid-class people, but especially between engaged couples that have faced a previous divorce and want to preserve their property for their children of the previous marriage, or to avoid unwanted surprises.

Sometimes one of the spouses has to pay off the debt or taxes of the other partner just because there was no pre-nuptial agreement in place and he or she may find they are responsible for credits, loans and other debt obligations signed during marriage.

Pre-nuptial agreements determine financial matters that the spouses will share, covering their rights and obligations, and determining who will manage their common finances, or if they both will take the shared challenge.

Even though, in such agreement they can setup certain clauses preventing the sale, use, or lease of determined properties, avoiding exchange of properties, goods, or assets, assign financial roles and limits to all the aspects of their money matters.

Prior to marriage, both partners can take some time to learn from each other the others financial habits and discuss how to cut costs or modify insecure financial practices before marriage.

In fact, discussing with your partner your financial matters could be enjoyable. Consider that in the same way the wedding day is being planned, your financial goals and dreams can be discussed to find the way to make them come true during the time when your lives will go together also in financial affairs.

Anita
http://www.articlesbase.com/finance-articles/determine-financial-matters-prior-to-marriage-103374.html

Financial Spread Trading: an Introduction

In the past, trading on the movement and price direction of financial markets was largely the preserve of major banks, high net worth individuals and sophisticated investment houses. However, the advent of online applications like the Internet has now made it possible for retail investors with limited capital to trade worldwide financial markets in exactly the same way these sophisticated investors did in the past. This form of online trading is widely known as Financial Spread Trading/Betting.

What is Financial Spread Trading?

Financial Spread Trading is a highly leveraged form of trading that has become a mainstream investment tool for retail investors around the world. Effectively, it is a mechanism for ordinary individuals with limited capital to gain access to worldwide financial markets. You can actually trade shares, options, indices, currencies, commodities and just about any other financial instrument through an online financial dealer.

Unlike the traditional way of investing the stock market, Financial Spread trading is based on a simple concept. Individuals get the opportunity to back a trading judgment that they may have, that a particular market is going to rise in value or is going to fall in value. For instance, if you believe that the shares of Microsoft are going to rise in value, you would “buy” Microsoft shares. Conversely, if you believe that Microsoft shares are going to fall in value, you would “sell” Microsoft shares. You don’t actually own the underlying asset. You are simply trading on the price direction of the financial instrument. If your prediction is correct, you make a profit. If you are incorrect, you suffer a loss.

There is also provision of posting a “stop loss order” on every trade you initiate. A stop loss order is a way of reducing your risk exposure to the markets, which means that you can effectively limit your loss in the event of the price moving against your perception.

Spread trading is most easily explained through an example – the concept is the same whatever the market. Let’s assume that it’s October, and due to an imminent breakthrough in the cure for bird flu, the shares of XYZ Corp have been rising steadily over the past few weeks. You’ve been following the market closely, and decide you want to get in on the action. The shares of XYZ are currently selling at $42.14 per share. In order to buy shares in any listed company, you need to buy a minimum of 100 shares. This means that you need a minimum of $4214 just to buy 100 shares. However, you only have $150 risk capital. What can you do?

Well, given your limited capital, you can simply place a spread trade with a financial dealer on XYZ Corp shares to rise. Financial spread trading enables you to be highly leveraged because you actually trade on margin. Leveraged trading, or trading on margin means that you are not required to deposit the full value of your trade in order to open a position, so buying XYZ Corp shares at $1 a point is actually the equivalent of purchasing 100 shares of the same company. Thus if you are looking to buy 1000 shares of XYZ shares, instead of paying $42,140 for the shares, you can place a spread trade on XYZ shares to rise at $10 a point.

Let’s assume that you contact a dealer for a price on December contract futures in XYZ Corp and get a quote of 4214/4219. You always buy at the higher price, so you buy $4 per point at 4219. This means that each penny movement in the price of the shares is worth $4 to you. To limit your risk exposure to the market, you also place a stop loss order of 30 points, which means that should the market go against you, the maximum you could lose is $120. Over the next few weeks, the stock of XYZ Corporation continues to rise. Six weeks later, you contact your dealer, and the quote for December XYZ Corporation is now 4293/4298.

Because you’re trading futures, it means that the contract expires in December. However, this doesn’t mean that you have to wait until December before you close out the trade. You can close out the trade the same day or at any point before the contract expires.

You decide to take your profits and sell to close at 4293. Because the market went in your favor, you get your full deposit of $120 back. In addition, your profit on this trade is calculated as follows:

Closing level 4293

Opening level 4219

Difference 84 points

Your profit: 78 x $4 = $336

Financial Spread Trading is a derivative product. This means that you are trading on a price that is actually derived from the underlying product. Therefore, if you are trading Microsoft shares, a financial dealer would give you a “derived” price of Microsoft shares. As the prices of those shares go up and down, so would the dealer’s derived price of Microsoft shares go up and down.

Jide Hospedale
http://www.articlesbase.com/investing-articles/financial-spread-trading-an-introduction-87652.html