Jasjit’s Cyberoughts

I can’t help but wonder how iconic companies like Bear Stearns, Lehman Brothers, Freddie Mae and Freddie Mac can go wrong in assessing credit worthiness and go on sanctioning loans while overlooking key factors such as borrower’s income or capacity to pay. 

Current financial crisis primarily arose because of banks decision to lend money against real estate as collateral. Such decisions to lend money were taken without thorough appraisal of the borrower’s cash flow and current financial health. In a lot of cases loans equivalent to 100% of the value property were sanctioned. Dwindling real estate prices deteriorated collateral value and subsequently led to current liquidity problems. The problem was also compounded by rising interest rates which severely undermined the borrowers ability to pay back their loans.

S A Aiyer has rightly mentioned that in his weekly column What MFIs can Teach Wall Street that the big lesson for Wall Street is that lending against collateral, supposedly prudent, can blind you to the need for checking the repayment capacity of borrowers. US banks happily gave mortgages of 100% of the value of houses during the housing bubble, and suffered when house prices fell. So did august institutions buying mortgage derivatives. Investment banks, like Lehman Brothers, though not lending directly borrowed massively to invest in AAA mortgage backed securities, and went bust when value of these securities plummeted.

Although 70% of the estimated losses were securitised, prof. Jayant R Varma, in his blog Securitization has little to do with crisis argues that “the global financial crisis has little to do with securitization and CDOs and everything to do with real estate lending. The data in the IMF Global Financial Stability Review released this week confirms this view. Of the estimated losses (Table 1.1) of $1.4 trillion, as much as 30% are in unsecuritized loans.”

I can’t get over the fact that Micro Finance Institutes (MFIs) catering to supposedly backward market like India practice more stringent credit controls and have far lower default rates as compared to the leading financial institutions who are facing bankruptcy despite their vast experience and world class controls, business processes and highly educated & smart workforce.

As Robert Green Ingersoll once said “It is a thousand times better to have common sense without education than to have education without common sense.”  I can’t agree with him more in current context.

You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.