ZCAS UNIVERSITY

MASTERS OF BUSINESS
ADMINISTRATION – FINANCE
MBF/MAF 112 CREDIT ANALYSIS

STUDENT NAME: KLEIN SITWALA

ZCAS STUDENT NO.: 202101484

MODE OF STUDY: DISTANCE EDUCATION

SUBMISSION DATE: 7 OCT, 2021

SUPERVISOR: MR. WEBSTER SIKAZWE

WORD COUNT: (2,989 excl. Cover & Contents

Page)
Table of Contents
1.0 ABSTRACT......................................................................................................................... 1

2.0 INTRODUCTION ............................................................................................................... 1

3.0 MAIN BODY....................................................................................................................... 1

3.1 The Origins of the Crisis .................................................................................................. 1

3.2 How it Morphed into a Global Crisis ............................................................................... 2

3.3 The Standards That Were Breached to Cause the Crisis ................................................. 4

3.3.1 Information Asymmetry by the Unusual Suspects ................................................... 4

3.3.2 Trifecta of Credit Analysis Misdemeanours ............................................................. 4

3.3.3 Failure and Inability to Uphold Liquidity Policy ...................................................... 5

3.4 Lessons That Zambia can Learn ...................................................................................... 5

3.4.1 Increased Regulation ................................................................................................. 5

3.4.2 Due Diligence ........................................................................................................... 6

3.4.3 Risk Appetite ............................................................................................................ 6

3.4.4 Diversification........................................................................................................... 6

3.4.5 Liquidity.................................................................................................................... 6

3.4.6 Credit Risk Lending Standards ................................................................................. 6

4.0 CONCLUSION .................................................................................................................... 7

References .................................................................................................................................. 8
1.0 ABSTRACT
The world of finance is driven by a capitalist machine whose cogs and links are ever attempting
to balance the need for money on one side, and adequately allocate excess money on the other.
Predominantly, this balance is achieved through two main sources of finance i.e., the debt and
equity markets. Those with excess money expect a return on investment, and a reward for
taking risk. As such, they ought to be protected from entities and individuals seeking that
money, and are yet unable to provide a return. In the debt market, there is also a due
consideration for those seeking money. The financial system therefore, relies on all players to
assess their counterparts according to strict standards before permitting exposure. However,
when the standards and rules are bent, the demand for the apparent resulting opportunity can
overtake the priority of scrutiny, resulting in extreme market bubbles with multiple and far
reaching adverse consequences when they eventually burst.

2.0 INTRODUCTION
In light of the context provided in the abstract, this report will provide a synopsis of the origins
of the subprime mortgage crisis of 2008 and how the crisis morphed into a global financial
crisis. The lending standards that were breached by the banks and led to the resulting crisis will
also be identified. Penultimately, the lessons to be drawn by local Zambian Banks from the
subprime mortgage crisis will be outlined before a final conclusion is presented.

3.0 MAIN BODY

3.1 The Origins of the Crisis
The enabling environment from which the 2008 financial crisis stemmed was created years
earlier when the Federal Reserve, under the leadership of then fed chair Alan Greenspan,
sought to spur business and grow the economy following the dot-com bubble of the early
2000s. The United States of America experienced a Recession as tech stocks fell by 78% in a
2 year period from March, 2000 and October, 2002, affecting the wider economy beyond the
hi-tech sector (Stiglitz, 2010). The Federal Reserve therefore, in the wake of the dot-com
recession and the September 11 terrorist attack of 2001 that left the economy reeling, lowered
the federal funds rate from 6.5% in May 2000, to 1% in June, 2003 (Singh, 2021).

With a 1% federal funds rate, borrowing became cheaper and thus across the economy, many
people were confident of their own ability to pay loans back. However, a lot of the borrowing
by the American population wasn’t done to fund business activity but instead to finance home

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ownership – the sudden and increased demand of which, caused a boom in the housing market
(Stiglitz, 2010).

If the lowered interest rate and access to cheap money was the seed of the 2008 crisis, the
widespread housing market securitization and predatory lending that followed could be seen as
the sprouting of that seed. As implied in the abstract, the hunger for opportunity tends to lower
people’s propensity for scrutiny. This lowering of standards first began when the banks
willingly lent mortgage money to subprime borrowers (Singh, 2021) i.e., borrowers deemed to
be at a higher risk of default and/or have a ‘thin’ credit history – meaning there is little to no
information about their prior credit behaviour (Kagan, 2021). By exposing themselves to more
and more subprime mortgages, the banks were taking on ever more risk. The first main reason
for this is that mortgage products were designed specifically to benefit the banks through
transaction fee revenue and variable interest rates (Stiglitz, 2010). These subprime mortgages
lacked any consumer protection or insurance against the risk of home value or job loss (Stiglitz,
2010). Adjustable Rate Mortgages (ARMs) as they are still known, were among the banks’
way of hedging against the loss of home value underlying the mortgages (Stiglitz, 2010). The
adjustable rate mortgages derive their value from market indices based on home prices and
therefore if the housing market boom continued, the interest payments remained low. However,
if housing prices fell, the interest payments rose (Wohlner, 2021).

The effects of this unfettered exposure began to be felt in early 2006 when house prices started
to fall. Within the same period, the federal funds rate reached 5.25%, where it stayed from mid-
2006 to August 2007 (Singh, 2021). The combined effect of the absence of cheap money and
the fact that interest rates on ARMs skyrocketed was that borrowers were left owing more
money than the value of their houses. The American public faced a lot of difficulty in this
period as the effects began to be felt across the entire economy. For the ARM mortgage
borrowers, their home values went further down as their interest rates went up. Furthermore, a
number of banks and subprime lenders filed for bankruptcy (Singh, 2021). The crisis had begun
to take full effect.

3.2 How it Morphed into a Global Crisis

The morphing from an intra-economy boom in the housing market to a global financial and
economic crisis was facilitated by a process called securitisation (Stiglitz, 2010). Securitisation
happens when multiple assets or instruments are packaged into a larger product that derives its
value from the sum of its constituent assets or instruments (Gallant, 2021). By this financial

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engineering, smaller banks could essentially pool bulk quantities of smaller subprime
mortgages into larger assets known as Mortgage-Backed Securities (MBSs) or Collateralised
Debt Obligations (CDOs) (Boyle, 2021). By doing so, they could issue those assets as debt
instruments similar to bonds, acquire money from larger banks and use the debt obligations of
the subprime borrowers as the underlying asset from which the CDOs and MBSs drew their
value. This was another reason that lending standards fell. Because the smaller banks no longer
bore the risk once the mortgages were packaged into MBSs and CDOs, they were able to issue
more and more subprime mortgages to people they knew were unable to pay back these loans
(Boyle, 2021).

In the aftermath of the crisis, many banks would be accused of predatory lending i.e., the
practice of knowingly and willingly offering and or marketing loans and other debt to people
whose welfare will be reduced by taking on that debt. It is associated with scarce competition
among lenders, property owners sitting on a lot of equity and borrowers poorly informed about
risks (Wharton University, 2008).

The secondary market that formed for CDOs and MBSs is what helped spread the effects of
the crisis. Many large banks were attracted to the promise of high interest on these assets and
were convinced to treat them as nearly riskless by the idea that these assets, based on a
multitude of loans, were somewhat diversified given that the risk was spread (Boyle, 2021).
More importantly, they were corroborated in their assertions by credit ratings agencies that
gave MBSs and CDOs high credit scores (Boyle, 2021). These assets were thus sold on the
interbank market, i.e., the global network of banks and financial institutions trading in various
assets directly among themselves (Hayes, 2021).

The crisis finally hit its peak when the fall of housing prices revealed to the entire market that
a majority of CDOs and MBSs were now worthless assets (Lewis, 2010). This left the interbank
market frozen as banks couldn’t trust any offers they received from other banks. They could
scarcely estimate whether their own obligations to depositors could be met by the value of
assets they held (Stiglitz, 2010). A key moment signifying the global proportions of the crisis
occurred in February, 2008 when Northern Rock, a major British bank, was forcibly
nationalised by the British Government (Singh, 2021). The general experiences faced across
the globe as a result of the crisis included, the bankruptcy of medium and small banks and
subprime lenders, the loss of jobs and property, decreased money supply and inflationary
pressure (Stiglitz, 2010).

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3.3 The Standards That Were Breached to Cause the Crisis
3.3.1 Information Asymmetry by the Unusual Suspects
The overarching principle breach of standards was the banks exercising Moral Hazard, this is
the risk the that a party in a financial transaction or agreement knows more about the assets,
liabilities, credit capacity, risks and hazards – or other relevant information – related to said
transaction or agreement, but however, does not disclose such information to the other party,
or willingly withholds and or misrepresents the information in their communication with the
other party (Kenton, 2020). When moral hazard occurs, one party is placed at a disadvantage
as a result of the malfeasance of the other party, and the party at a disadvantage bears the cost
or consequences of the other party’s behaviour.

Normally, banks, insurance companies and other lending institutions have to guard themselves
against moral hazard and adverse selection as part of their credit analysis and protection from
information asymmetry (Nickolas, 2021). In 2008, it was the banks perpetrating moral hazard
– and the consequences of their misinformation were twofold, the higher interest rates borne
by borrowers of adjustable rate subprime mortgages on one hand, and the larger banks buying
highly rated securitized assets (MBSs and CDOs) composed of bad loans on the other (Lumen,
2021). Indeed, passing of consequences to other parties and the ease with which banks had
been bailed out previously increased their appetite for moral hazard and decreased their
adherence to the three key credit risk analysis standards outlined below (Bernstein, 2009).

3.3.2 Trifecta of Credit Analysis Misdemeanours

Character was, as explained prior, not given due consideration and can be considered a breach
of standards in the leadup to the 2008 financial crisis. Character considers the credit history of
a borrower as part of a lending institution’s risk analysis (Joseph, 2013). The issuance of
subprime mortgages saw people with poor credit scores and credit histories being given loans.

Capacity is another standard breached to cause the crisis. A lending institution must study a
borrower’s ability to repay the loaned amount as part of its credit risk analysis. This can be
done through pay slips, financial statements and financial ratios are some tools that can and
should be used to assess ability to pay (Bernstein, 2009). In many cases during the crisis,
borrowers were given what were termed NINJA loans, i.e., no income, no job and no assets –
a clear indication of a borrower’s absolute lack of capacity (Lumen, 2021).

Conditions were the other core standard breached leading to the crisis. Conditions in credit
analysis, refers to the constituent and external terms of a loan agreement. In assessing the

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constituent terms of loan agreement, a bank must ensure that terms are legal first and foremost,
then they must ensure that sufficient and reasonable protections exist on either side of the
transaction (Joseph, 2013). They however, did not design good mortgage products with
favourable and fair conditions, had they ensured more predictable interest rates, created
insurance vehicles alongside the mortgages, and incorporated protection for borrowers in the
event of joblessness or loss of house value (Stiglitz, 2010). They could have done well
(financially) by doing good (morally) (Stiglitz, 2010) and would have thereby averted great
costs to society and ensured permanent and sustainable home ownership.

3.3.3 Failure and Inability to Uphold Liquidity Policy

A bank’s liquidity policy is its set of rules and procedures applied to see to it that it retains
ample funds to meet payments, transfers and withdrawals for bank members (IGI Global,
2021). By having a robust liquidity policy, a bank can manage liquidity risk. Tools enabling it
to achieve this include liquidity ratios and risk management processes. Internal policies like
this are normally above minimum liquidity requirements set by the central bank (Segal, 2020).

In 2008, a criticism of the Basel II Accords was that, inadequate standards to address liquidity
mismatches over the near and long term were given to the banks in the Revised Capital
Framework of 2004 (Bank for International Settlements, 2014). Given this, banks paid lax
attention to the federal reserve capital requirements and in some cases breached their own
liquidity policies (Stiglitz, 2010). Liquidity insufficiencies were pointed to be among the
contributing factors to the crisis (Joseph, 2013). This happened as the banks that were
securitizing subprime mortgages would use substantial portions of the money received for
MBSs and CDOs to issue more subprime mortgages (Stiglitz, 2010). This saw 25 U.S. banks
file for bankruptcy at the height of the crisis (Singh, 2021). Despite this, no depositor lost the
value of money in their accounts as larger U.S. banks bought up the bankrupted banks and thus
depositors simply saw their accounts being held by larger banks (Singh, 2021).

3.4 Lessons That Zambia can Learn

3.4.1 Increased Regulation
As much as the banks were at fault for a number of adverse effects from the crisis, the fact that
virtually no executives were charged or found guilty in courts of law shows signifies a lack of
adequate regulation (Silver, 2021). To avoid such situations in Zambia, the Bank of Zambia
can ensure that measures and requirements are instituted with the view to avoid such crises.
Capital requirements, lending rules, and stress tests are some ways to do this (Silver, 2021).

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3.4.2 Due Diligence
Moral hazard, as explained above, caused a lot of people to enter loan agreements without full
knowledge of their implications and consequences (Silver, 2021). If local Zambian banks
develop practices of fully disclosing all implications to the loan products they offer, and
incorporate protections and insurance provisions, they can stay averse from such crises.

3.4.3 Risk Appetite

Generally speaking, a disproportionate majority of the banking system was exposed to housing
market risk prior to the crisis (Silver, 2021). Calculating and keeping within risk exposure
limits is an important lesson to be drawn from the crisis.

3.4.4 Diversification
Diversifying the customer base, diversifying the sectors of the economy loans are given out to
and diversifying the types of borrowers that are given loans. Those are three key ways to ensure
that the bank’s debt portfolio is sufficiently diversified (Bisio, 2020). In 2008, the banks had
too many of the same kinds of borrowers, low income people who did not borrow for business.
They were concentrated and too exposed to one sector, the housing market (Lewis, 2010).

3.4.5 Liquidity
As discussed above, many banks ended up bankrupt because they lacked liquidity when the
proverbial music stopped – they didn’t want to lend to each other and they couldn’t assess
whether their assets i.e., cash, financial instruments, property etc., could meet the obligations
they had to depositors (Bisio, 2020). An important lesson for local Zambian banks is therefore
to ensure that regardless of their activities, they have robust liquidity policies and adherence to
ratios that they can safely meet their depositors demands.

3.4.6 Credit Risk Lending Standards

Dropping lending standards in search of opportunity was arguably the main driver of the crisis.
Despite many of the other causes, if banks had upheld standards of lending and restricted
mortgages to creditworthy borrowers, rates of default would have been lower and the economy
would have withstood fluctuating market conditions (Stiglitz, 2010). Zambian banks can learn
from this and strictly adhere to the 7 core elements of credit analysis i.e., Collateral, Capacity,
Cash, Conditions, Control, Capital, and Character (West, 2019).

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4.0 CONCLUSION
The pursuit of opportunity can lead to a lowering of standards. This was demonstrated by the
series of events leading to the 2008 financial crisis. The enabling environment was mainly
facilitated by low interest rate intended to spur business and grow the economy. They gave rise
to a housing boom that saw increased demand for mortgages and rising house prices. Banks
saw this demand as an opportunity to increase revenue and began to issue subprime loans to
people who weren’t creditworthy – a lowering of standards. Banks securitised these subprime
mortgages and sold them to larger banks. Housing prices eventually fell, interest rates rose for
borrowers, and the securitised assets lost their value. The crisis had adverse global financial
and economic effects. Credit risk analysis, moral hazard, and liquidity insufficiencies were
identified as the main standards breached to cause the crisis. From there, Zambian local banks
can draw lessons that avoid similar disasters and ensure robust standards are followed in the
issuance and risk management associated with credit.

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