Conflict of Interest

For the construction of DND, IL&FS and NTBCL were given a solitary charge of the flyway. NTBCL was guaranteed a 20% profit as the reports in TOI suggested and was even allowed to fix the toll rates by itself and it was also permitted to collect for at least 30 years. It was in 2012 when The Federation of Noida Residents Welfare Associations (FONRWA) took the matter to the Judiciary, that was the Allahabad High Court, and sought an order to limit NTBCL from gathering toll on DND. The matter, however, didn’t receive justice at Allahabad High Court, and the plea was carried forward to the Supreme Court, which eventually looked into the matter. In 2015, NTBCL raised the toll from Rs. 25 to Rs. 28 for one-way car traffic, that induced large scale protests and even caught the attention of Akhilesh Yadav, former CM of UP, who ordered a probe to find out if it was still relevant to collect taxes on DND Flyway.

While presenting the case to Judiciary, Ranjit Saxena, the advocate of FONRWA, claimed that NTBCL had collected about Rs. 2000 crore in toll, and had profited more than Rs. 408 crore (90 crores more than the contract amount), but was still collecting toll from the public (TNN, 2016).

The plea of FONRWA finally received justice in 2016, when the court said,

“The amended agreement between NTBCL and Noida permitting the company to collect toll till April 1, 2031, was arbitrary and violative of April 14 of the Constitution (right to equality) and involved excessive delegation and was thus unfair and unjust. ”

Fig.1 - Diagram showing the relationship between the nodes in financial mechanisms of infrastructure projects

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Conflict of Interest

In the above-mentioned financial processes of infrastructure development, it is understood that a major conflict of interest lies in the role of the private sector entity that is given the task of investing in and developing infrastructure. Their participation reduces the load on the government, but their main interest lies in making profits. To that end, they risk an asset-liability mismatch for better profits, which is not prudent finance. Nonetheless, the private sector’s participation is crucial for infrastructure development for governments lack the funds and the expertise for the same.

A major conflict of interest also lies in the appointing of credit rating agencies. In the “Issuer Pays” business model, the debtor appoints the agency to provide their securities with a rating. The CRAs (credit rating agencies) are thereby incentivized to over-rate these securities in order to retain their clientele in subsequent years. Another conflict is that the CRAs rate the securities based on the information willingly provided by the debtor. They have no means of verifying this information and any concealed fraudulence is automatically over-rated (Rafailov, 2011).

The example of Lehman brothers case shows possible conflict of interest between investment banks and other players in the mechanism.

Subprime Mortgage Crisis

The Lehman Brothers Crisis is the economic crisis that shook the world when uncreditworthy parties defaulted on low-rated loans they had taken against their house mortgage. This impending adversity festered for almost 10 years before it came to light and consumed Lehman Brothers (the 4th largest investment bank then) in its wake.

In the early 2000s, the real estate market was on fire fueled by cheap credit and low-interest rates. The investors seeking better returns found an opportunity to create new investments. They started investing in mortgage-backed securities and CDOs (collateralized debt obligations). These CDOs are numerous small mortgages and loans packaged as one product that combines mortgages of different risk categories (AAAs, Bs, and unrated). Small banks sell these mortgages to large investment companies in the form of CDOs, thereby transferring the risk of default from banks to the investors. Investment companies bought a great many of these CDOs as they were sold as AAA-rated and they could sell the mortgaged property in case of default. The excess cash available to the banks allowed them to make new loans, which meant easy access to mortgages for home buyers. Eventually, banks started making subprime mortgages to borrowers with impaired credit history as it would not affect them directly if they sold these mortgages as CDOs. As a result, everyone could buy his/her dream house, and as real estate prices were consistently and steadily increasing since forever it was a great investment.

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Fig. -Diagram showing the process linked with CDOs

This process was profitable to everyone from home buyers, banks, to investment banks until these unreliable subprime mortgages started defaulting and investment banks began putting the mortgaged properties on the market. Increasing defaults led to excessive supply in the housing market, and the bubble finally burst with real estate prices plummeting more than ever. Since a large portion of investments by Lehman Brothers were in CDOs, they posted multiple losses and share prices dropped.

By 2007, subprime mortgage brokers started becoming bankrupt and real estate funds began to fail. In 2008, U.S. investment bank Lehman Brothers collapsed unleashing a global financial crisis. It is known to be the biggest bankruptcy in American history leading to the worst economic crisis since the 1930's “Great Depression” .

The problem of making subprime mortgages remained unnoticed from the early 2000s until the bubble finally burst in 2008 and it created a domino effect that took down not only the world’s largest economy but also many other economies. This unchecked growth of the problem could be blamed on the Federal Bank for lenient regulations, but the complex structure of these organizations made it difficult for corporate boards, regulatory authorities, and even the auditors to understand the problem. Likewise is the case of IL&FS and its hundreds of subsidiaries (Lioudis, 2019).

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One of Lehman’s closest competitors, Bear Stearns, was the first to collapse which was saved from bankruptcy by sale to J.P.Morgan Chase (backed by the federal government). Next to fall was Lehman Brothers in the aftermath of Bear Stearns’ sudden collapse. It’s reliance on short term funding deals called repurchase agreements or “repos” to raise money for business made it vulnerable to a crisis in market and investor confidence (“Lehman Brothers declares bankruptcy, ” 2020). An announcement was made on September 10, 2008, showing that the firm is expecting a “toxic” asset of $5.6 billion in write-up and a loss of $3.93 billion. After this Lehman Brothers was threatened by a major rating agency Moody to downgrade it’s debt ratings. Despite concerns about the consequences that Lehman Brothers collapse would bring, the government refused to bail out yet another investment bank. The government’s decision to not bail out Lehman Brothers and let it fall was questioned by many (“Lehman Brothers declares bankruptcy, ” 2020).

Lehman Brothers had employed Ernst & Young as their independent auditor to review its financial statements, for a long time before its demise. EY was supposed to try to detect fraud and communicate certain issues to Lehman’s Board audit committee. But after the bankruptcy of Lehman Brothers was filed, EY’s questionable accounting with regard to unorthodox financing transactions was discovered. It used ‘Repo 105’ to make the results better than they actually were. EY also knew about Lehman’s impaired liquidity pool. But when questioned by the authority, EY said that it hadn’t done anything wrong (Wiggins et al., 2014). However, Anton R. Valukas, the Lehman bankruptcy examiner, concluded that “EY had not fulfilled its duties and that probable claims existed against EY for malpractice” .

The credit rating agencies (CRAs) had a central role in the development of this complex crisis network. The transformation of a subprime mortgage from low-rated into AAA, allowed everyone to enter the subprime mortgage market which seemed very profitable at that time. An AAA-rated corporate bond had never been downgraded lower than A by Moody’s. However, an AAA-rated investment had become susceptible to failure. This led to a huge loss of faith in rating agencies.

Therefore, The adequacy of auditors and credit rating agencies is crucial in the functioning of financial debt markets.

“Hopes of a sale to another bank fell short as well: One prospective buyer, Bank of America, decided to buy Merrill Lynch instead, while British regulators blocked a last-ditch deal to sell Lehman to Barclays of London. Out of options, Lehman Brothers declared bankruptcy early on the morning of September 15. The firm declared $639 billion in assets and $613 billion in debts, making it the largest bankruptcy filing in U.S. history” (“Lehman Brothers declares bankruptcy, ” 2020).

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