Big writeoffs for sub-prime losses

From Tan Kin Lian's Blog http://tankinlian.blogspot.com/

Thursday, December 20, 2007

Big writeoffs for sub-prime losses

Mr Tan,

Why are there so much writeoff for bad loans by the big American banks and brokers?

I thought that they package the products to sell to other investors. It seems that they are stuck with a lot of these products in their own funds. Surely, they know the risk and the defaults with the sub-prime mortgages?

REPLY

In a large institution, there are many layers of people:

1. the managers who create and handle the loans
2. the top managers and CEO
3. the board of directors
4. the shareholders.

Under the profit sharing system, the managers and directors received big bonuses and share options during good times by "creating shareholder value". The sub-prime mortgages did contribute to a lot of profit during the past years, which is why the business has grown to be so big.

I do not know at what level the managers should know what is going on. It is difficult to say, when the institution is so big and complex.

When the "crunch" comes, these institutions have to write off several billion dollars of losses. Some of the key managers have to leave their jobs for "destroying shareholder value". But they are not required to pay back the big bonuses that they earn during the good years. The shareholders have to shoulder the losses.

This is not fair, but it is the system of the free market.