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Checking the Unchecked II

Now the next are the Mortgage lenders and the Credit rating agencies,..

Mortgage Lenders: - The term signifies the financial institutions which lend money to borrowers. These Mortgage lenders either get their client from brokers or through their retail channels and in return they charge interest & other fees from the borrowers. Hence, it is right to say that profit earned by mortgage lender is the interest amount that they get in return on the money lended.

These loans are then sold by mortgage lenders in the form of security termed as ‘Mortgage Backed Security, ‘ these securities are then traded among investors and other Private Equity players. Thus, the risk bore by the lenders while granting loans to the borrowers is further passed on the investors who invest in these ‘Mortgage Backed security’ (MBS).

Thus, the passing of risk from one party to another encourages mortgage lenders to lend to borrowers with bad credit score and limited credit rating. In order to satisfy demand of growing U.S mortgage market, which bought a new era of mortgages called ‘sub prime mortgages,’ where borrower with poor credit score and no or limited credit history received loan from the lenders even when they were incapable of paying back.

The higher fees compensate the lender for the increased costs associated with servicing and collecting such accounts, as well as for the higher default rate. Thus, a need originates on part of mortgage lenders to take appropriate measures while granting loan to borrowers, i.e. do not deviate from the norms specified and allowing no deviation in policies formulated while underwriting loans. In short, lenders should not be selfish to realize only their return and should act more responsibly.

Credit Rating Agencies: - These are independently acting agencies which grant ratings to MBS and other securities instruments, and also grant credit score, i.e. FICCO to the U.S nationals or borrowers.

The possible causes of rating agencies in granting incorrect rating can be attributed to the following factors:

  • The massive volume and complexity of deals lead to errors. Short cuts in procedures and documentation of the rating process were not always disclosed. There was a lack of consistency and transparency in documentation on rating processes, models and rating committee meetings, etc.
  • As to the quality of information underlying the ratings, there was no obligation on rating agencies to verify the information provided by arrangers.
  • Significant aspects of the rating process, including rationale for rating committee actions and decisions, were not always documented.
  • The surveillance process used in the process appears to have been less effective than it should have been.
  • There were issues in the management of conflicts, e.g. analysts taking part in pricing, etc.
  • Internal audit process varied significantly between rating agencies and was ineffective in part owing to lack of documentation.

The problem can be rectified by requiring an agency to disgorge profits on ratings that are revealed to be of low quality by the performance of the product type over time unless the agency discloses that the ratings are of low quality. Such a system would be effective both to the current regime, which relies on market forces backed by antifraud rules, and to the other alternatives, such as the recent proposal to forbid new-product ratings absent prior to SEC approval of the products.

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