US financial crisis which occurred in the year 2008 has been considered as one of the darkest phase in the financial history of the world. It started when housing sector saw a boom in the year 2001. Housing sector in the U.S economy was showing a tremendous growth in the year 2000. The home prices were rising at a steady rate. The market for home loan was prospering and financial institutions were willing to provide easy home loans to the property buyers at affordable interest rates. During this period, the market for Subprime loans became very popular. They gave banks an easy way out to gain extra from the current market scenario. Subprime lending refers to extending housing loans to individuals who have weak credit history and there were high chances of default repayments. Banks charged higher interest rates at such loans along with the complete possession of their property. But the good days didn’t last long and finally the housing bubble busted (Baker, 2008). The reason was banks assumed that the property prices will continue to show increasing trend. As expected, the subprime borrowers were unable to pay such high interest rates and soon the revenue generation scheme of banks stopped. Now they have to recover their loan amount by selling the mortgaged house. But the prices of homes started to decline to number of default payments and as a result they were in huge crisis. They didn’t have any back up plan to mitigate the risk (Holt, 2009).
HSBC one of the largest banks of the world entered into the US subprime mortgage market by buying Household International, who was the largest subprime mortgage and consumer credit provider institution. Subprime mortgages unlike the normal housing loans are offered to individual who have bad credit ratings or who have high risk of defaulting in the repayment of the loans but at a higher rate of interest so as to compensate the risks banks and financial institutions are taking (Sengupta & Emmons, 2007). HSBC too involved in subprime mortgage loans and offered individuals loans with almost no or low down payment options.
In order to earn extra profits and high interest they began buying subprime loans from other small institutions. In the year 2006, HSBC was among the largest lenders of subprime mortgage. The year 2006 was seen a decline in the growth rate of the value of home (Business Today, 2017). Due to high interest rates many borrowers were unable to make the repayment of the loans and as a result their properties which were kept as mortgages were seized but due to fall in property prices, they were unable to recover the debt amount and as a result they drowned deep in the financial crisis. The major organizational factor which was responsible was leniency in the background information of the borrowers. They were more interested in earning profits rather than analyzing the risk involved in such loans. Employees failed to identify the loans which have high risk of default. HSBC while purchasing loans from other parties claimed that there analyst will accept only those loans which met their credit standards but they accepted state-income loans in which individuals were only required to state their income on an application, which they quiet conveniently inflated in order to obtain high value of loans. HSBC used FICO scores to identify the credit paying capacity of an individuals but they were not really effective in differentiating between the borrowers who have taken loans on down payment or not and also FICO does not took into account the effects of fall in housing prices. HSBC did identify the problem in February, 2007 when they realized that the default in the repayment of subprime mortgage loans is more than what they actually anticipated. As a result they had to make a bad debt provision of $10.6 billion. But the damage was already being done and now there was no way back.
In order to evaluate the credit repayment capacity of its borrowers, HSBC used a credit from Fair Isaac Corp. of Minneapolis commonly known as FICO scores. They were used for credit cards, car loans and fixed mortgages. HSBC is too many second lien loans which mean the houses which were kept as collateral is also secured by another loan. FICO scores used by HSBC was not considered reliable for analyzing performance of the second-lien loans or state income loans and adjustable rate mortgages because they didn’t take into account the fluctuation in the housing prices and what will happen if the value of the mortgages increased in comparison to the value of the home. Also, FICO scores were not able to differentiate borrowers who have paid the down payment or the one who have financed their home completely against the housing loans provided by HSBC. In completeness and inaccuracy of available data can be another reason for failure of its information system. But nevertheless HSBC didn’t care about the risk and they were more inclined towards earning more profits (Mollenkamp, 2007).
The right solution was to critically analyze the credit repayment capacity of the borrower and whether they have enough mortgages or not to pay off the loans. HSBC when entered into the subprime business knew that this segment involves a lot risk. Buts still they gave mortgages without verifying their income status and other background information. They kept hoping that high interest rates will compensate the risk and will generate high revenues and if the borrower failed to pay the debt, they will sell out the mortgaged house at a higher price. Due to the competitive pressure from other mortgage institutions, they neglected warning signs. Being the world’s third largest banks, they accepted the state-income loans which only require income declaration on the application and no verification was done to confirm the income status. Behind the negligence and their rise in default payment was the greediness to earn extra profits (Blackburn, 2008). No technique or information system can be effectively implemented or used without the due diligence of the management. Due to their faulty lending technique the mortgage crisis got worse for the HSBC and in the year 2007 the default payment was much more than anticipated. They announced that they have to make bad debt provision for nearly $10.6 billion. The only possible reason that can be identified for not using the right solution was to increase the short term profits and strengthen the market position in the US market (Duca, 2007).
HSBC after realizing their fault became quite strict in their decision making process of lending subprime loans. They had earlier stated that while buying mortgage loans from wholesalers, they consider income and credit scores and after selecting the eligible borrowers their analysts make sure that loan should be given to those who have met the HSBC standards. They are now quite strict in following this method and consider only those individuals who have a repayment capacity (Yerak, 2008). They also modified their policies regarding subprime lending. The company has stopped considering state-income loans and increased the FICO scores for some loans. The responsibility of pulling out the mortgage division from the crisis was given to Tom Detelich. HSBC have now hired a number of customer representatives who are required to do the follow up from the borrowers who have not done the payments on time and they also suggest easy repayment options. With the help of information technology, management at HSBC can forecast which customers can make a default in repayment.
They have also embedded business analytics software from Experian-Scorex so as to support the management decision regarding the processing of credit application and risk management decisions. They are now quite conservative in their approach of lending subprime loans. These decisions will definitely help HSBC to control the risk of default payments in future but nothing can be done about the loans given earlier (HSBC, 2016). They cannot be recovered and loss is huge. It will definitely affect the financial performance of the company in the market. There are certain factors which HSBC forgot to consider the second lien loan and state-income loans. All these policies are effective while giving new loans but the old loans which are struggling debts have no strict provision which will guarantee debt recovery (CFBP, 2017). The major proportion of such loan is second lien loans and stated income loans. Also they didn’t consider future inflation rate. Apart from this the repayment of default loans is mainly dependent on the houses kept as mortgages. The housing priced keep on fluctuating and after the subprime mortgage crisis; other things along with house property should be kept as mortgaged in order to secure debt repayment. HSBC is involved in buying subprime mortgages at a higher interest rate. HSBC have to pay them also and they also bear the final risk. They should try to deal with the customers directly and avoid buying from other institutions.
4. Provide an analytical evaluation of the possible consequences of HSBC changing its approach to subprime lending. How might these changes affect the business? How might they affect the customer? How might they affect the U.S. economy?
HSBC after the subprime mortgage crisis have now become quite conservative in their subprime lending approach. They have tightened their credit norms. Which means that individual may not get easy home loans. It has created a significant impact on the organization’s business, US economy and the prospect borrowers (Inman, 2009). The first and the major consequence of the change in the policies of the subprime lending was Foreclosure. Foreclosure refers to property which was kept as the mortgaged against a home loan by the borrower and in the case the borrower fail to repay the loan; the bank ceased the property and put it on sale to recover their mortgaged amount. The major reason that led to the subprime mortgaged crisis was huge number of default payments and increase in the number second lien loans. The crisis left a number of people homeless (Glaister & Lockhart, 2008). Mortgage foreclosures were increasing rapidly and people were forced to stay in cars. This was a very common problem not just for low income groups but middle class people also. After the crisis even if people want to buy a house property, the formalities and strict credit norms restricted them to avail the loan options as a result number of homeless people kept on increasing. The loan process has now become more complicated and have severely affected customers financially who are in need of loans (Dymski, 2007).
The major impact of the subprime mortgage crisis on the organization was loss of profitability and goodwill. The goodwill written of figure and the provision for bad debts were unbelievably high and created a question on the profitability of the bank. But the positive side to this crisis was the subprime mortgage in the US and in other countries also became more secure and the rules regarding subprime lending became more stringent. The risk of default payment was also reduced. The loan process has now become a more secured and a risk free process with the help of information systems and business analytics tools.
The impact of changed process of subprime mortgage on the US economy was that as the loans process became strict and the interest rates controlled which made the eligibility criteria for qualify for the home loans very difficult. As a result the property prices lowered down and created an economic stability in the country. Also, it gave a warning signs to other financial institutions to evaluate their lending norms again (Kregel, 2008).
The decision taken by the HSBC to pursue the subprime mortgage segment was a semi structured decision. Subprime mortgage is a risky deal for both the lender and the borrower. For the lender it involves a very high risk of bad debts or default payment and for the borrower it involves a very high risk of interest, and the high risk of losing the mortgaged property or asset. The reason that led to the situation of crisis was failure on the part of the management to identify the risk of falling in the prices of housing segment. It was mentioned in the above case study that HSBC used same FICO scores to evaluate the sanctioning of credit cards, loans and mortgages. But it had many limitations; it didn’t consider many factors such as fluctuations in housing prices and second lien loans. The management was quite ignorant towards checking the background of the borrowers and more interested in their personal incentives which was directly related to the profitability of then organization.
The top level management was found guilty in taking wrong decisions and they failed to analyse the housing market and risk associated with it. They were only concerned with earning extra profits by giving loans at a higher interest prices. In 2005, the HSBC executive of US Bobby Metha gave a misleading statement about their mortgage portfolio. He claimed that the mortgages are given after following a conservative approach and returns will be higher than then risk associated with it. A financial institution forms the backbone of an economy. In order to stabilize the economic and financial condition of an economy, the efficient functioning of bank is very important and it can only be possible when they follow a structured regulatory system. Subprime loan market in the US have always been criticised for having flexible regulatory system which is very vulnerable to crisis. Before HSBC purchased Household International Inc. their CEO William Aldinger hyped about their credit risk technique called Worldwide Household International Revolving System for underwriting their credit card debt but subprime loan amount is usually very large and using the same credit risk technique for analysing subprime borrowers were not justified and the same goes with the FICO scores. This clearly shows the negligence on the part of the management (Tas & Hib, 2008). It can easily be stated that the decision making process of the management was faulty and heavily contributed in the situation of crisis.
Conclusion:
The major factor that was responsible in the financial crisis of 2008, which shook the entire US economy and the world was the subprime mortgage crisis of the year 2007. HSBC was one of the US largest subprime mortgage lender which started their lending operations in the year 2002 after purchasing Household International Inc. At that time the US economy was witnessing a housing boom and there were many banks and financial institutions which were actively involved in giving easy home loans with no or zero down payments and it was available to everyone irrespective of their financial history. But this was not going to last long. Banks did not forecasted that the housing prices will decline and the default payments will cross the anticipated amount. There were many factors responsible that contributed in the deepening the crisis amongst them were lending credits to borrowers who had a weak credit score, using FICO scores as credit risk techniques and they burdened themselves with a bulk of second lien loans purchased from the wholesaler. There were many signs that were signalling towards the future crisis but management at HSBC clearly ignored in lieu of earning profits in form of high interest rates. HSBC was stuck with large number of default payment and had to make a provision of $10.6 billion for bad debts (Laudon, Laudon & Dass, 2010). But now they have learnt a lesson and had taken many necessary steps to avoid the situation of crisis in future by making rigid policies and procedures.
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