First i would like to do briefing about LI’s coupla model (risk management model) and why it failed?
In laymen language, it deals with how much risk is involved while giving any loans or a package of mortgages (started by investment bankers).
This formula is mostly used by all major giant banks and investment companies of world. Actually what happened is like this when bankers started buying mortgage bonds or so called package of mortgages (mortgage pools) from external companies. They used coupla’s formula which is generally for risk mapping involves in any particular loan but they used for group of loans (here the problem rose).
Mortgage pools are not as simple as most bonds. There's no guaranteed interest rate, since the amount of money homeowners collectively pay back every month is a function of how many have refinanced and how many have defaulted. There's certainly no fixed maturity date: Money shows up in irregular chunks as people pay down their mortgages at unpredictable times—for instance, when they decide to sell their house. And most problematic, there's no easy way to assign a single probability to the chance of default. All of this makes it much more difficult to calculate risk on mortgage pools and CDOs than on conventional bonds or old-fashioned home loans.
Wall Street "solved" many of these problems through a process called tranching, which divides a pool and allows for the creation of safe bonds with a risk-free triple-A credit rating. Investors in the first tranche, or slice, are first in line to be paid off. Those next in line might get only a double-A credit rating on their tranche of bonds but will be able to charge a higher interest rate for bearing the slightly higher chance of default. And so on.
They took some assumptions-
First was that one loan is not related to others. If one party does not repay the loan then it does not mean that others will also not pay (even in same category).
Second - risk probabilities are may be different for different kind of lenders but we can calculate an average for all (biggest flaw).
Initially this formula was working well because external factors like growth rate n employment which are basically sources of revenues of lenders were doing well. But at last when eventually these externalities stopped helping out, so consequentially realty or flaw of this formula came out.
The CDOs, based on Li's Copula function and created and traded on Wall street, now account for most of the toxic assets that have turned shares of major banks like Citicorp into penny stocks.
So what is the solution?
Do we have to go back to conventional banking only?
Do we have any another way rather than stop giving loans to sub-prime lenders?
Now i would like to divide this discussion into two parts-
Small lenders and mid class lenders-
By former i mean lenders which generally lend very small amount of loans and may or may not able to payback.
So the solution to insure that they will repay back is grammen banking model (which i have recently studied) or micro finance companies based on trust and lender’s responsibility. They are having unbelievable repayment rate (95-99%). They have to repay their loan from basic salary only which is not basically hiked up due to undue growth in any sector.
So it makes easier for them to repay loan even in financial crisis. On the another way around crisis would not affect much their income.
Other factor- their total loan amount is not that much big that it would lead to liquidity crisis.
Now come to second part mid class lenders-
In this case expectations are high. They are able to take bigger amount of loans than small lenders because of undue advantage of recently hiked in salaries. But what will happen when these sources will not help them out to repay---- REPOSSESSIONS--- FINANCIAL CRISIS----ETC...
How to save or how to manage?
Open for discussion....
Pass your comment it will make your mind work..
Say anything which comes to your mind kya pta that would be a best solution...
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