Article 1: The Nutshell Series: What happened in the global
financial crisis?
The cause of the global financial crisis was simply due to poor credit risk management
and poor governance standards. It all started with the mortgage backed securities and
how multiple pools of assets were "securitized". In layman terms, hundreds and
thousands of loans which were secured by homes (mortgage backed) were
clubbed (pools) and transferred to multiple investors as highly rated assets (low credit
risk). The whole idea was that maybe 1 home loan borrower could default, or 2 could
default or even 3 could default. But what is the probability that among the 1000, say 500
would default? That's 50% of the entire portfolio.
Well, that's pretty much what happened. Banks such as the Lehman brothers, Goldman
Sachs and the lot entered into a lot of such transactions and loans were given under the
idea that the higher the diversification of retail assets, the lower would be the risk of
default. So banks started aggressively lending to hundreds and thousands of people
who wanted to buy homes without assessing thoroughly their individual capacities to
repay (i.e they didn't assess their credit profile). As a result, the whole financial
system was filled with these highly diversified and secured portfolio of assets. But were
they really low risk? The answer is no. The whole business of banks is to lend money
and ensure that the money comes back. That is the crux and the fundamental piece
of the business. Its not about giving loans to people and businesses who have
adequate assets. Its about giving the money to people and businesses with
adequate capacities to repay.
Once a bank lends money to entities with a lot of assets, but very low capacity to repay,
the banks will have no option but to take over the underlying security. During the 2008
crisis, multiple banks were saddled with homes that they took over as people couldn't
repay due to job losses (that was a time of economic slowdown). Hence, there became a
scenario, that money was aggressively lent and then money had to be aggressively
recovered. How does that make sense?
Another reason was that credit rating agencies bought the fact that diversification was
the key to ensuring low defaults. While that is true in theoretical parlance, what does not
get accounted for is poor credit risk assessments and poor risk management. This is
because credit rating agencies usually do not check with the necessary rigour the credit
assessment process of the banks, until the defaults starts. That becomes too late.
Checking the rigour of the process is generally the functions of management of the
banks, the audit committee, the external auditors and the internal auditors. Quite literally,
everyone bought the "high diversification" story and nobody checked the underlying
state of affairs.
Now this is a dangerous situation because nobody is going to take ownership when the
balloon bursts and the blame game starts. Managements and Audit Committees will say
that we just followed the "High diversification" rule that markets and credit rating
agencies suggested, credit rating agencies will say that managements didn't do their due
diligences and that auditors gave a clean chit, Auditors will say that we had no evidence
of any foul play as all the processes were followed and there were no control failures. So
who is responsible?
financial crisis?
The cause of the global financial crisis was simply due to poor credit risk management
and poor governance standards. It all started with the mortgage backed securities and
how multiple pools of assets were "securitized". In layman terms, hundreds and
thousands of loans which were secured by homes (mortgage backed) were
clubbed (pools) and transferred to multiple investors as highly rated assets (low credit
risk). The whole idea was that maybe 1 home loan borrower could default, or 2 could
default or even 3 could default. But what is the probability that among the 1000, say 500
would default? That's 50% of the entire portfolio.
Well, that's pretty much what happened. Banks such as the Lehman brothers, Goldman
Sachs and the lot entered into a lot of such transactions and loans were given under the
idea that the higher the diversification of retail assets, the lower would be the risk of
default. So banks started aggressively lending to hundreds and thousands of people
who wanted to buy homes without assessing thoroughly their individual capacities to
repay (i.e they didn't assess their credit profile). As a result, the whole financial
system was filled with these highly diversified and secured portfolio of assets. But were
they really low risk? The answer is no. The whole business of banks is to lend money
and ensure that the money comes back. That is the crux and the fundamental piece
of the business. Its not about giving loans to people and businesses who have
adequate assets. Its about giving the money to people and businesses with
adequate capacities to repay.
Once a bank lends money to entities with a lot of assets, but very low capacity to repay,
the banks will have no option but to take over the underlying security. During the 2008
crisis, multiple banks were saddled with homes that they took over as people couldn't
repay due to job losses (that was a time of economic slowdown). Hence, there became a
scenario, that money was aggressively lent and then money had to be aggressively
recovered. How does that make sense?
Another reason was that credit rating agencies bought the fact that diversification was
the key to ensuring low defaults. While that is true in theoretical parlance, what does not
get accounted for is poor credit risk assessments and poor risk management. This is
because credit rating agencies usually do not check with the necessary rigour the credit
assessment process of the banks, until the defaults starts. That becomes too late.
Checking the rigour of the process is generally the functions of management of the
banks, the audit committee, the external auditors and the internal auditors. Quite literally,
everyone bought the "high diversification" story and nobody checked the underlying
state of affairs.
Now this is a dangerous situation because nobody is going to take ownership when the
balloon bursts and the blame game starts. Managements and Audit Committees will say
that we just followed the "High diversification" rule that markets and credit rating
agencies suggested, credit rating agencies will say that managements didn't do their due
diligences and that auditors gave a clean chit, Auditors will say that we had no evidence
of any foul play as all the processes were followed and there were no control failures. So
who is responsible?
