Question

The failure of Frannie Mae and Freddie Mac can be attributed to several weaknesses within the internal environment ranging from procedures and system failures to human capacity and ethical issues.

Identify five areas of Risks that the bank failed to mitigate adequately that could have contributed to the crisis at the bank in 2008.

Present one argument for each risk you identified above to demonstrate why the poor management of that risk contributed to the demise of that financial institution.

Provide one sound recommendation for each risk that you identified above that could. have helped to mitigate or prevent the financial failure

Answer 1

In any going concern risk factors are coherent but people associated with such needs to find out methodologies to deal with such factors. In 2008, the global economy was hit by a Tsunami named “subprime crisis’ but deep inside it was a known fact that systems failed because of the inability of the managers governing the system. Ethical norms were not followed which lead to the closure of Lehman Brothers and Frannie Mae and Freddie Mac. We will discuss five areas which lead to the demise of financial institutions along with probable recommendations;

A) Credit Score of the Loan Seekers; Home loans were granted without being aware of the ability of the loan seekers to pay back those funds. Such a risk could have been avoided if banks could have researched in detail about the potentiality of the consumers.

B) Approving inapt projects from big business houses: Financial institutions approved inappropriate projects without realizing the potential loss it could incur. people with inept knowledge about the economic systems passed projects which resulted in a crisis, it’s a lesson to be learned that people who are running the institutions should have apt knowledge in granting projects loans.

C) Investment in risky products: Institutions allowed loan seekers to pay out their bigger loans with smaller adjusted rate mortgage loans and this could have been avoided as adjusted rate mortgage loans had smaller interest rates in comparison to fixed mortgages and this basically ruined the interest receivable part of the banks.

D) Liquidity Crunch: Banks lend to people and in terms, they receive interest and hence loans are treated as an asset. In case of subprime crisis when people defaulted banks wrote off the loan and tried to sell off that loan to numerous investors in a completely complex manner. A vicious circle was created and this could have avoided. Banks while lending money should have created a liquidity pool instead of collateral as lending collateral through a loan would only be meant usage of funds rather than receiving the interest and principal parts of the original pool. A solution to this could be a good hefty amount of upfront fees from the consumers to avoid the probable losses.

E) Job Markets/ Economical Check: while lending the loans to the investor's financial institutions should always keep a track on the job growth and the economic behavior of the markets. It is a necessity as loss of jobs would only result in a takeover of an asset but won’t allow you to have a hand on the liquid cash. Unfortunately, the bubble in 2008 was so strong that no one even cared to check these signals.