An interesting revelation in the credit market crisis is how the moral hazard in lending is firmly entrenched in the US system. Compared to what many consider as the ‘developed’ system of the US, the relatively unsophisticated Indian banking system is better in this respect.

The US system tends to incentivise raters of debt to give higher ratings than deserved– a fact underlined by the resignation a few weeks back of a top executive of Moody’s for improperly rating a chunk of securities adding up to $1 billion as AAA.

Mortgage securitisation

How does home mortgage securitisation work in the US? Who are the players in this value chain? Why did the system almost invite borrowers to default? How are things different in India? Let’s try and answer these questions while contrasting the typical value chain in the mortgage lending market in the US with that in India.

In the US, there is the mortgage broker who, for a fee, finds a person to take a mortgage obligation. Obviously, higher the mortgage loan, higher the fee. So, 100 per cent mortgage financing became common (no margin, full loan) — even when the borrower was highly leveraged and had proven bad fiscal discipline record.

This does not happen in India because bankers are barred from giving zero-margin loans. They keep at least 15-20 per cent margin on loans. Besides, even where direct selling agents (DSAs) source loans, borrowers themselves are interviewed by in-house bank staff who ask searching questions about their disposable incomes, and refrain from sanctioning loans beyond conservative limits. In this sense, the in-house credit cells of Indian banks perform a role similar to underwriters in insurance companies — they keep the bank from taking exposures that are riskier than laid-down policy.

Second, there is the home appraiser who, for a fee, certifies the value of the home being mortgaged. Obviously, higher the home value, higher the fee. So, the first reality check on the home value (when the bank tries to sell it off) shows how inflated the value was in the first place.

This does not happen in India because houses are usually valued by the lending banker’s in-house valuation cell. The officers of the cell are paid salaries, not fees, and are, therefore, incentivised to give conservative valuations.

Then there is a chain of investment bankers who, for a fat fee at each stage, securitise bundles of mortgages first, into Mortgage Backed Securities (MBS); then into Collateralised Mortgage Obligations (CMOs), and then into CMOs of CMOs. Sometimes, there are even CMOs of CMOs of CMOs. In India, thanks to a moribund secondary market for private debt, almost none of this happens — and when it does, the securitised bundle of receivables merely changes hands once and rests with the banker who invests in the securitised bundle.

The employees of the investment banks are also compensated by handsome cash bonuses in good years. This incentivises bankers to take reckless positions with scant regard to the risks of over-leveraging, to get higher bonuses. In India, thankfully, this is not so widespread, because super-profits among Indian merchant bankers are relatively less known, because of the less vibrant secondary debt markets.

mortgage-backed securities

Then, there are the credit rating agencies who for a fee, rate the MBS and CMOs, CMOs of CMOs and CMOs of CMOs of CMOs as AAA when sometimes they deserve ratings several levels lower (non-investment grade). These AAA-rated debt securities find their way into the portfolios of pension funds, mutual funds and through them, hands of senior citizens, widows and orphans. The latest story in this regard is that of Moody’s structured finance ratings cell, whose head had to quit following shocking revelations in Financial Times.

It has come to light that even after realising that the AAA rating they gave to certain issues that deserved ratings four levels lower (eventually these proved to be the worst-performing securities wiping off 80 per cent of the investment value), Moody’s structured finance ratings team merely tweaked the assumptions but did not lower the rating. India escapes from harm because there are hardly any mortgage-backed debt issues to rate!

The one common feature is that every player gets a fee — and it is biased in favour of bad lending practices.

All for a fee

Save the DSAs who source borrowers, almost no player in the system is systemically so biased. None of the players has an incentive to monitor the borrower’s creditworthiness after the loan is disbursed. The bank that originally lent the money through the broker and the appraiser is not interested because it has already got its money back from the MBS issue.

This does not happen in India, because, usually, the originating bank continues to hold the loan in its books. In rare cases, a securitised bundle of borrowings changes hands once. Hence, it is always in the interest of the bank that holds the loans in its books to closely monitor borrowers and quickly react to signals of possible default.

What can the US do to reduce or eliminate the incentive to originate bad loans or create incentive to not allow deterioration of good ones?

Eliminating bad loans

One partial solution is that each of the commercial and investment banking players in the value chain should be forced to bear some of the credit risk, by being forced to invest in a small part of the MBS/CMOs they place. However, that is not a complete answer, because, while individual bankers may pass the parcel, a major part of the securities are eventually held by some banking/investment banking players.

Another solution could be to force recasting of compensation structures to investment bankers. Instead of being paid bonuses based on short-term profits made in any year or quarter, they might be given stock options that won’t mature for a few years; or create a bonus fund or pool, which could be paid out equitably over many years, instead of paying high bonuses in good years and nothing or near-nothing in bad years.

This would force them to focus on longer terms than a year, and eliminate or reduce a moral hazard that forces them to take huge gambles to chase super-profits — usually through unacceptably high leveraging.

Even this solution may not help (it did not in Bear Stearns, where 30 per cent of the firm was owned by employees, but that did not stop their taking heavily leveraged gambles) unless bonuses are linked to the investment/lending decisions made by the official concerned. It is by no means clear that a workable system to achieve this effect can even be built. The simply stated objective of any such compensation system would have to be to achieve the effect of granting bonuses only out of risk-adjusted profits seen as sustainable over a longer term than a year.

(The author, a chartered accountant, is Dean and Professor, Finance, at the SDM Institute of Management Development, Mysore. These are his personal views.)

(This article was published in the Business Line print edition dated July 23, 2008)
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