The Chartered Accountant

GLOBAL PERSPECTIVE
freeze. Subprime lenders, who have very little over
sight compared with traditional banks, had strong financial
motivations to increase the volume of loan
originations, since they made money on each loan
they wrote. Because they sold the loans to investment
banks, which did not require the same level of underwriting
standards as did the GSEs, mortgage brokers
had very little motivation to assure the quality
of the loans they were making. In addition, the US
Congress and politicians from both dominant political
parties pressured Fannie Mae and Freddie Mac
to increase home ownership by encouraging lending
to poorer consumers by relaxing lending norms.
Corporate governance at many of the failed institutions
is also suspect for compensation plans that may
have encouraged excessive risk taking by executives.
In particular, some compensation plans discouraged
retail banks and subprime lenders from making timely
provisions for the bad loans they were writing. While
such provisions may have depressed the stock prices
of those firms and hurt the compensation of their executives,
this action would have sent appropriate and
opportune signals to the markets that subprime loans
were not performing well. Sooner discovery of this
problem may have isolated the companies that had
exposure to subprime loans and prevented the crisis
from spreading. Auditors and audit committees for
these financial institutions also bear some responsibility
for not forcing companies to make provisions for
bad loans and to write down impaired assets in a timely
manner. While the FAS 157 rule that mandated markto-market
accounting methods forced a reflection of
the sharp decrease in MBS values, it is unclear that
MBS and CDS markets are functioning well enough
to be good sources of information on security values.
Hence, the mark-to-market rule should be re-thought
for environments where the market does not function
effectively and lacks proper infrastructure.
Credit rating agencies also are accountable in part for
the MBS market debacle. SPEs paid the ratings agencies
for their securities to be rated. A system where
the firm being rated pays for its ratings is rife with
conflicts of interest. In particular, when firms play
one ratings agency against another (also known as
opinion shopping) to get the highest ratings that money
can buy, ratings become meaningless. We clearly
need more regulation of how ratings agencies do
business.
It also appears that credit ratings agencies and financial
institutions used flawed models to model risk.
They seem to have grossly underestimated the corre-
lation in default events. Large numbers of homeowners
tend to default at the same time as each other if
home prices decline and interest rates move up simultaneously.
This will then lead to financial institutions
with MBS on their books defaulting at the same time.
This correlation in default events seems to have been
underestimated by most players in the market. Thus
insurance companies were covering risk that they did
not fully comprehend. To make matters worse, investment
banks and insurance companies were highly levered.
The impact of their risk exposure to the real
estate market was amplified by their astronomical leverage
levels.
Lax oversight of mortgage brokers and mortgage loan
originators allowed consumers with very poor credit
histories to borrow large sums they possibly could not
afford. The list of exotic or predatory loans widely
available to home buyers reads like a litany of bad
ideas. Loans with teaser rates (low introductory rates
that step up rather rapidly), and “no documentation”
loans (also known as “liar loans”) where the potential
home buyer’s financial position was taken on faith,
and interest only loans (where borrower payments do
not pay down principle) should not have been allowed
in the first place.
Implications for India
India is prone to rapid increases in real estate prices,
and the use of credit to finance real estate purchases
has become very common. In fact, property prices
have appreciated much more rapidly during the last
ten years in urban India than they have in the United
States. This price increase has been fueled by NRI investments,
IT professionals buying flats in large numbers,
and commercial property buildup to support IT,
IT-Enabled Services, and export businesses. With the
world economy headed into a recession, the factors
that fueled the real estate boom in India may no longer
be able to support real estate prices in India. To
make matters worse, loans to asset values have been
steadily climbing in India as well. If salaries in the Indian
IT sector decline in concert with a decline in the
United States and European economies, many professionals
who are first-time homeowners may default on
their home mortgages in India. Private-sector banks
that have taken the lead in financing home purchases
may be hit the hardest. In India, however, problems in
the real estate and banking sector are likely to be contained
and are unlikely to impact insurance companies
and investment banks, because India lacks a strong
secondary mortgage market. Banks in India are also
unlikely to witness liabilities from off-balance sheet
SPEs.
THE CHARTERED ACCOUNTANT 1013 DECEMBER 2008