The Chartered Accountant

The real question is, given the recent meltdown in the
United States, should India avoid growing a secondary
market, or emulate the United States and actively
develop a market for MBS and CDS? We believe that
the answer is a resounding yes to secondary market
development. There are risks to this strategy, as the
current crisis so aptly illustrates, but the benefits of a
strong secondary market outweigh the risks. The benefits
of a broad and deep market for MBS are likely to
accrue to millions of current and future homeowners
in India and reduce the costs of financing their home
purchases. It would be an egregious mistake to draw
the inference from America’s recent experience that
India does not need a well-developed market for MBS
or CDS.
India has an opportunity to learn from America’s
mistakes. It should develop secondary markets carefully
and thoughtfully, with appropriate regulation,
infrastructure, and disclosure requirements. In the
primary market, lenders must monitor borrowers’
credit histories and track credit scores. If the mortgage
industry can develop a system that regularly and
accurately tracks and reports credit scores to lenders,
it can lower borrowing costs and make credit available
for millions of Indians. The secondary MBS market
in the United States worked amazingly well until there
was a push from politicians and investment banks to
lower credit standards and expand subprime lending,
respectively.
Unfortunately, India has already experienced some
of America’s problems. As in the United States, political
pressure on banks to make loans to consumers
and businesses with poor credit histories and an
obvious inability to service the loans, have resulted
in government bailouts paid for by India’s tax payers.
While India has not seen such bailouts in the home
loan industry yet, it is perhaps because the borrowers
in the home loan industry have been from the middle
class rather than the vote-heavy poor class or the
politically-connected wealthy industrialists. Hopefully,
such bailouts will not forthcoming if the home loan
industry in India is hit by foreclosures. Bailing out homeowners,
while appearing to be the compassionate
thing to do at the time, in the long run has the effect
of destroying the home mortgage market, as such
bailouts send the message to homeowners that it is
better to default on one’s loans than to pay them back.
It would be better for regulators to monitor lending
practices and eliminate predatory lending to poor and
uninformed homeowners.
We also hope that India does not draw the conclusion
DECEMBER 2008 1014 THE CHARTERED ACCOUNTANT
GLOBAL PERSPECTIVE
that nationalizing financial institutions is the solution,
given that America has nationalized or invested in
several financial institutions. Fannie Mae and Freddie
Mac were quasi government agencies to begin with,
and yet failed to adequately discharge their fiduciary
duties. If anything, to avoid the cycle of making poor
quality loans under political pressure and inadequate
control systems, leading to non-performing assets
a few years later that then need budgetary support
from the central government, India should consider
privatizing nationalized banks in a phased manner to
reduce and eliminate the political pressure to make
loans that will never be repaid.
Another lesson from the debacle we are witnessing in
America should be that when a few financial institutions
get too big, it puts the rest of the economy at a
huge risk. Whether these financial institutions are in
the private, public, or quasi-public sector, when they
grow too large with unchecked growth of consumer
loans, they have the ability to take down the whole
economy if they fail. Regulation in financial industries,
then, should carefully monitor rates of growth
in large financial institutions and have some ability
to curb growth that becomes unsustainable or that
moves beyond market fundamentals. Regulatory over
reach in India, however, is a concern. While America
needs both more regulation and enforcement, India,
in general, needs fewer rules but more effective enforcement.
With economic expansion comes increased responsibility.
It is the responsibility of financial institutions
to clearly disclose the nature and risks of the financial
products that they sell, and the responsibility of the
government to insure that regulations are followed.
Government, for example, should ensure that credit
and risk rating agencies are completely independent
and free of conflicts of interest. It should also prohibit
predatory lending practices. In return, it is the
responsibility of the investors, whether they be the
banks of Iceland or a small family saving for retirement
in India, to understand exactly what they are
buying and the risks involved. A well-functioning disclosure
and regulatory environment, an infrastructure
that supports timely, accurate, and clear communications
to investors, coupled with an educated investor
population, will be able to reap the benefits of mortgage
securitization and avoid the worst of the risks.
Lastly, following accounting rules, having high quality
audits, making timely provisions for bad debts, and
writing down impaired assets are all old lessons but
even more critical in the new economy.q