From USA...........The bank story in layman terms

The Recent scenario of the Financial Market is quite dismal. Every day the paper surprises us with another surprise – Trust me this kind of surprise is not much appreciated. The downfall of Lehman Brothers, one of the oldest and certainly one of the pillars of the financial market is the latest surprise. We have understood that markets can be punishing and reversal of fortunes can be dramatic. The situation is far worse, if the organization is over leveraged — when loan and investment books are way more than its capital. What accumulates problems and leads to disaster are strange accounting practice and high-risk nature of the loans and investments. Moreover there are certain disclosure issues: Lehman, in its last conference call with investors, gave no clue that it was actually on the brink.

Lehman building Lehman building Generally an investment bank uses its proprietary book (own money) to lend others and invest.
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> The entire episode started with the sub prime crisis. Banks like Lehman, were used to buying mortgage loans from other banks, and then packaging them to sell bonds against the loan pool. Often they used to add cash to make the loan pool appear more attractive, so that the bonds can be sold at a higher price. For Eg: a mortgage was earning 6%, these bonds are sold at 4%. The difference is the credit spread which the investment bank earns. The idea is to sell these structured bonds, to raise money and free capital. But when home buyers started to default, these bonds lost their value. It all began like this, and then the virus started to spread across markets.
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> Moreover slowly over the years, their prop books have multiplied. Investment banks also organise big loans for their clients for funding acquisitions. There are times, when the investment banks take positions, only to palm off the securities to other clients and banks. In a crisis, they may not get the opportunity to down-sell such positions. That is when a liquidity window from the central bank thus comes handy.
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> For Eg: Lehman faces a redemption and has to repay another bank it has borrowed from. If it sells the mortgage-backed bonds, whose prices have fallen, it will not raise as much as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since the bank starts dumping these assets, prices of these bonds also dip. This is when the crisis spreads from subprime to prime.
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> Herein lies the strange accounting of bonds and derivatives like mortgage-backed securities. All banks are required to mark-to-market (MTM) their investments. So, if the price of an instrument falls, the difference between the price at which it was bought and the current market price has to be provided — meaning, it has to be deducted from the earnings. So, a drop in price leads to the MTM loss. But there’s a bigger problem which really has deepened the crisis. An MTM loss can be provided only if there’s a ‘market’. How do you provide when there is no market?
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> Remember, it’s very different from checking the price of a stock from a stock exchange website. Many of the instruments are over-the-counter derivatives, which are struck on a one-to-one basis between two parties. Suppose, a derivative is linked to variables like the yen-dollar rate, and may be prices of other actively-traded assets, say gold price and US Treasury bill. What the bank does is construct a model, feeds the available market price of these variables in the computer, to arrive at what the market price of the derivatives could or should be. This is an artificial model-generated price. This is called the mark-to-model against mark-to-market.

The trouble is when the bank actually goes out to sell the derivatives; it discovers that there are no takers. And, even if there are buyers, they are willing to pay just a fraction. In other words, there is a sea of difference between the price that is being offered in the market and the high artificially-generated price thrown up by the model. So, when the bank ends up selling the instrument or unwinding derivatives, the loss suffered is far in excess of the mark-to-model loss. Such extra losses on thousands of securities and multiple portfolios can wipe out the capital of the bank