Leveraging
Since the interest rate was low, and housing prices were going up, all participants extended themselves. Households borrowed more than they needed, banks lent more than they could, investment banks held and traded too much of the structured products, and investors bought more and more in the hope of profit. This extension created sub-prime loans, where households could borrow even if they had no in come, no papers, no credit rating, or payment record. They only needed to use the money to buy a house, whose price went up.

Bubble
As everyone's books blew out of proportion, the bubble burst. When housing prices crashed, the domino effect came into play Across the balance sheets that the loans were spread into, all values dropped.

And panicky investment banks tried to sell off what they held, and found that the market had become illiquid.

When they want ed to borrow to keep the assets, the rates had moved up, and money was not available. They began to sell in panic what they had, and prices only dropped even further.

Bust
Investment banks now faced a situation where the assets they held were worth less than the amount they had borrowed. So, they went around asking for capital. At the peak of the boom, many of them had $40 of borrowings for every dollar of capital. Now, when the value of the assets fell off to say $20 or less, there was no money to repay the borrowings, unless they got equity capital. Equity capital was not forthcoming because the value of the assets was dropping by the day. The result: they simply went belly up.

Bail out
So what did regulators do? They reduced interest rates so that money would be available to borrow and hold up the assets. But markets only tightened from further fears of default.

Money was handed out, through a special window opened for investment banks by the US Fed. When that would not do, there was bailout by taking on the bad assets. Now Central banks across countries have come together to create a $247 billion fund to provide credit where it is needed, to stop further failures. (Illustration: more money pumped into toxic assets)

Fear Factor
Since fear of failures grip the markets, credit has dried out. As value of assets held by large players has shrunk, the market itself has shrunk. Money is difficult to get. Loan is the new bad word and no one wants to lend money to fund risky assets. Safe havens like money market funds have begun to lose value, and investors are holding back cash, worsening the liquidity crunch.

What Now?
The US already runs a $3 trillion deficit. Adding billions of dollars of bailout money to this is a sure fire way to trigger a full blown recession. The US recession is also likely to draw others along with it. The weakening of the US dollar may then be inevitable in such a situation. Investors face the double whammy of default and depreciating dollar. The crisis in the credit markets shows all signs of extending into the currency markets.

Plan of Action
Everyone seems to blame regulation now. Since commercial banks are more closely regulated and have strict capital adequacy norms, the clamour is to close down or merge investment banks into commercial banks. That may shrink the size of the financial markets as we now know, significantly The .

entire edifice of risk-taking and thus expanding capital markets would crumble and we will return to loan officers from market-driven risk takers.

Before we heave a sigh of relief about how we may not be affected so much, we need to worry about global headwinds that will affect markets across the world.

We may still keep our jobs, continue our SIPs and pay our EMIs. But the lessons in this crisis are for macro managers of the economy If we have to be plan for a .