Essay on Credit Risk And The Financial Crisis
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Managing credit risk and the financial crisis
are very closely related to each other. To understand this I would first like
to give a simple definition of credit risk:
The risk that an issuer of debt securities or a
borrower may default on its obligations, or that the payment may not be made on
a negotiable instrument.
The financial crisis is believed to be caused by
factors involving credit. First I’m going to explain what caused the financial
crisis, second how credit risk management failed in the financial crisis and
last what could be done to prevent this failure in credit risk management in
the future.
Causes of the Financial crisis 2008:
The Financial Crisis is believed to be caused by
many different factors in both the housing market en the credit market.
Although the biggest cause lies by the housing market and the mortgages that
involves it. One of the biggest problems with the mortgages was the issuing of
the high-risk mortgages. When the housing market in the USA was booming around
2006, it was very easy for people to get a loan. Because of the good conditions
of the economy, banks lent out more and more money to higher-risk borrowers.This essay is an
usefulof a student's work
Disclaimer
A few examples of the higher-risk mortgages are
adjustable rate mortgages and the “payment option loan”. The adjustable rate
mortgage allows people to pay the interest rate over the mortgage on an initial
period. The payment option loan is when the borrower can pay the interest it
wants, but any interest not paid is added to the principle.
Also the guidelines for getting a mortgage
changed significantly. Because the banks wanted to make more and more money on
mortgages in this housing boom, they loosened the guidelines for qualifying for
a mortgage more and more. First the guidelines were changed so that you
wouldn’t need proof of income. You just needed to show that you have money in
your bank account. Then the guidelines changed that you didn’t need proof of
employment anymore. You just needed to state that you were employed and show
that you had money in your bank account.
However, after the peak in 2006, the housing
market began a decline. This meant that house prices dropped and interest rates
were rising. As a great deal of mortgages that were loaned out during the boom
were adjustable rate mortgages, this meant that people were starting to pay
higher interest. Maybe a higher interest that they could not afford and didn’t
think of when taking the loan. Also because of the drop of house prices, many
homes were worth less then their mortgage. This caused banks to enter
foreclosures on a lot of houses.
The result of all this was consumers having less
purchasing power, private financial systems unwillingly to lend out money,
tightening credit and thus decline in economic growth.
Failure in indentifying credit risk:
Multiple failures in risk management are
recognized when looking at the financial crisis. Both the government and
private institutions failed in identifying risk
Government
The government had enabled certain policies that
could make mortgages such as adjustable rates mortgage possible. In 1982 it
passed the Alternative Mortgage Transaction Parity Act, that allowed adjustable
mortgages to be written. These were higher risk mortgages and no regulations
were enabled to prevent a crisis.
Also investment banks and hedge funds were
playing a more and more important role in the economy. They had become almost
as important as commercial banks when lending out money, but were not subjected
to the same regulations. They were providing loans, but didn’t have the same
cushion to absorb loan defaults (when a loan is not paid). The government
should have indentified this risk and regulate these problems. Thus a failure
in risk identification.
Central Bank:
The central bank may have contributed to the
financial risk by actions it had done earlier this decade. In that time the
Central Bank enforced a policy that made interest rates drop. It enforced this
policies, because it indentified a risk of deflation after the “dot-com bubble”
and “9/11”. It seems that the Central Bank had misperceived the rate of
inflation as it seems that the measured inflation was below the true inflation.
This was one of the reasons of the housing bubble. With interest rates that
low, the adjustable rate mortgages seemed very attractive to people. Seeing the
problem of the low inflation, the Central Bank enforced a policy that increased
interest rates between 2004 and 2006. This caused the adjustable rates
mortgages to become expensive and more difficult for homeowners to pay.
The Central Bank did not indentify credit risk
at the right moments. When increasing and decreasing the interest rates it had
not taken sufficient factors in account. It should have indentified the market
for adjustable rates mortgages and the credit risk that involved it.
Investment banks and commercial banks:
Investment banks and commercial banks obviously failed
in identifying credit risk. The management in the companies was focused on
short-term incentive rather than the long-term obligations. Managers often were
rewarded if they assembled financial products. This type of management led to a
company culture that focuses on the short-term high risk and the high returns
that come with that. This type of management led to the many defaults of the
adjustable rate mortgages. Banks should have identified the long-term risk that
came with adjustable rate mortgages and thus failed to identify credit risk.
How can credit risk be improved in the future?
Based on the failures with banking and the
recession it has led to, there are four main points that can commercial banks
can improve regarding credit risk management. These four are:
Company culture, structure and policies
Credit analysis
Credit risk management
Reporting and monitoring
At first companies must establish or improve
their risk managementboard committee. Establishing is not enough, the board
must be effective, containing experienced workers.
The committee must make sure that the company
policies about credit risk is effective. It must make sure the company sets
certain limits that prevents defaults. Certain risk policies such as
scenario-based risk limits and setting risk tolerance levels could be a good
way to do it.
Second the communication between the board and
managers must be very good. That way rules and policies can be adapted much
quicker and managers can report more easily to the board, providing better
information.
Credit analysis
Credit risk management can’t be done without the
right information. Gathering the information seems to be the first step in risk
management as it seems that without the right information, even the most
advanced credit risk analysis systems are useless. That’s why it’s very
important to collect the right data and maintain it good way. Information that
is critical for credit risk management is: borrower financial statements, credit
ratings, background checks, ratio analysis, collateral values, and
borrowing-base analysis. This information about the borrower is very important
and must be updated frequently.
Making the right analysis with the right data
help risk management in improving decisions and thus improving capital,
reserves and liquidity.
Credit risk management
The management must make decision that will
improve the company. Therefore they play a very important role in the company.
The management must use the credit information and analysis models in order to
get to such decisions. When the credit analysis is done in a correct manner,
management must make decision about the following:
Credit granting
Credit pricing
Borrower and portfolio limits
Loan reserves and capital
The decisions directly affect a company’s
risk/return profile. Therefore it’s important that management is improved as
much as possible in order to prevent a future failure in credit risk
management. Improving management takes a lot of time and recourses. In the
short-term it doesn’t look very attractive to constantly be on the lookout for
changes in management. But it the long-term it seems to be more effective.
Reporting and monitoring
Reporting is a very important role in credit
risk management. This can improve the communication between the management and
the board that can improve effectiveness of the credit risk management of the
company. Examples of such reporting can be: loan loss ratios, risk-adjusted
profitability measures, unexpected charge-offs or earnings volatility due to
credit exposures, exceptions to credit policies and limits, and so on.
Reporting could be made more efficient by
improving the processes by which reporting is done. One way could be improving
the technology by which reporting is done. Manual reporting are inefficient and
could contain errors. Making the process more automated could improve both
credit risk management and operational risk management
Example of failure in risk management
Subprime mortgage crisis
In August 2007, the firm closed its subprime
lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took an
after-tax charge of $25 million and a $27 million reduction in goodwill. Lehman
said that poor market conditions in the mortgage space "necessitated a
substantial reduction in its resources and capacity in the subprime
space".[42]
In 2008, Lehman faced an unprecedented loss to
the continuing subprime mortgage crisis. Lehman's loss was a result of having
held on to large positions in subprime and other lower-rated mortgage tranches
when securitizing the underlying mortgages; whether Lehman did this because it
was simply unable to sell the lower-rated bonds, or made a conscious decision
to hold them, is unclear. In any event, huge losses accrued in lower-rated
mortgage-backed securities throughout 2008. In the second fiscal quarter,
Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in
assets.[43] In the first half of 2008 alone, Lehman stock lost 73% of its value
as the credit market continued to tighten.[43] In August 2008, Lehman reported
that it intended to release 6% of its work force, 1,500 people, just ahead of
its third-quarter-reporting deadline in September.[43]
Disclaimer
This On August 22, 2008, shares in Lehman closed up 5% (16% for the
week) on reports that the state-controlled Korea Development Bank was
considering buying the bank.[44] Most of those gains were quickly eroded as
news came in that Korea Development Bank was "facing difficulties pleasing
regulators and attracting partners for the deal."[45] It culminated on
September 9, when Lehman's shares plunged 45% to $7.79, after it was reported
that the state-run South Korean firm had put talks on hold.[46]
On September 17, 2008 Swiss Re estimates its
overall net exposure to Lehman Brothers as approximately CHF 50 million.[47]
Investor confidence continued to erode as
Lehman's stock lost roughly half its value and pushed the S&P 500 down 3.4%
on September 9. The Dow Jones lost 300 points the same day on investors'
concerns about the security of the bank.[48] The U.S. government did not
announce any plans to assist with any possible financial crisis that emerged at
Lehman.[49]
The next day, Lehman announced a loss of $3.9
billion and their intent to sell off a majority stake in their
investment-management business, which includes Neuberger Berman.[50][51] The
stock slid seven percent that day.[51][52] Lehman, after earlier rejecting
questions on the sale of the company, was reportedly searching for a buyer as
its stock price dropped another 40 percent on September 11, 2008.[52]
Just before the collapse of Lehman Brothers,
executives at Neuberger Berman sent e-mail memos suggesting, among other
things, that the Lehman Brothers' top people forgo multi-million dollar bonuses
to "send a strong message to both employees and investors that management
is not shirking accountability for recent performance."[53]
Lehman Brothers Investment Management Director
George Herbert Walker IV dismissed the proposal, going so far as to actually
apologize to other members of the Lehman Brothers executive committee for the
idea of bonus reduction having been suggested. He wrote, "Sorry team. I am
not sure what's in the water at Neuberger Berman. I'm embarrassed and I
apologize."[53]
Related topicsThe role of financial accounting in aiding the decision making processes of different non-management stakeholder groups.
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