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The Mortgage and Financial Crises: The Role of Credit Risk Management and Corporate Governance

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This paper discusses the role of risk management and corporate governance as causal factors in the onset of the financial crisis. The boom and bust in the housing market precipitated serious strains in financial markets. These strains resulted in the onset of the financial crisis in August 2007 with the collapse of the asset-backed commercial paper market. This collapse occurred because the solvency of a number of large financial firms was threatened by huge losses in complex structured financial securities. Why did these firms have such high concentrations in mortgage-related securities? Given the information available to firms at the time, these high concentrations in mortgage-related securities violated basic principles of modern risk management. We argue that this failure to apply well-understood risk management principles was a result of principal-agent problems internal to the firms and to breakdowns of corporate governance systems designed to overcome these principal-agent problems.

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  1. See Cecchetti (2008) or Covitz et al. (2009) for a description of the events of August 2007.

  2. Fitch (2006) reports that the number of subprime downgrades during July–October 2006 was the largest in its history. Despite a large number of defaults and downgrades in subprime securities, according to Calomiris (2008), both subprime and Alt-A originations continued to rise in 2006 and early 2007.

  3. This concentration in subprime mortgage-related structured securities is the other side of high leverage. While many people speak of high leverage, it is useful to note that assessing the appropriate level of leverage depends on the level of risk being supported by a given level of capital. Prior to the crisis, many analysts argued that large financial institutions were very well capitalized.

  4. We use the term proximate cause, since developments in the housing market were a result of underlying macroeconomic factors such as low interest rates and large international flows of savings into the developed countries. Discussing the macroeconomic factors underlying the housing boom is not directly relevant to the issues discussed in this paper and goes beyond the scope of the paper.

  5. Private-label MBS refers to securities that are not insured by the government-sponsored enterprises (e.g., Fannie Mae and Freddie Mac).

  6. Taylor (2008) argues that there would have been no housing boom and no subsequent bust if interest rates had been set according to the Taylor rule (rather than too low) during 2002–2005.

  7. Hu (2007) found that residential mortgage-backed securities (RMBS) accounted for approximately 85% of the underlying assets in an asset-backed CDO in 2006 as compared to only 15% in 2000. In addition, other CDOs made up about 12% of the underlying assets in an asset-backed CDO, and these CDOs were probably also concentrated in residential mortgage-related assets.

  8. The ABX.HE index was created in response to demand for a tradable instrument that represents the market for subprime RMBS. The ABX.HE index is a series of credit-default swaps based on 20 bonds that consist of subprime mortgages. To help make the index representative of the universe of deals, the index includes no more than four deals from the same loan originator and no more than six deals from the same master servicer.

  9. Covitz et al. (2009) demonstrate that ABCP programs are subject to a bank-like panic. In addition, they find that the ABCP market may be a source of systemic risk, since the runs were relatively indiscriminate at least in the early part of the panic, which started in August 2007.

  10. This is less likely to be true when talking about the continued slide in house prices. It is not clear that house price depreciation scenarios used for tail analysis would have included the kinds of price declines that had occurred by the fall of 2009.

  11. That investors were buying more subprime mortgage loans is not by itself evidence of moral hazard or adverse selection problems. Investors typically had information indicating that they were buying subprime mortgage pools as well as information about risk characteristics of those pools, such as average loan-to-value ratios.

  12. Quotation from John Mack’s testimony before the Financial Crisis Inquiry Commission on January 13, 2010.

  13. Acharya and Schnabl (2009) also find that banks that were more exposed to these conduits had lower stock returns and greater widening of credit default swap spreads around the August 2007 crisis—consistent with the risk-taking motive in securitization.

  14. A large number of research articles have been written on predicting default risk. See Demyanyk and Hasan (2009), Kumar and Ravi (2007), Fethi and Pasiouras (2009), and Altman and Saunders (1998) for comprehensive reviews of studies on the predictions of default risk models.

  15. Capuano et al. (2009) summarize some of the recent advances in an effort to improve credit risk modeling: modifications of structural models and reduced-form models, reassessment of default correlations using copulas, pricing of credit index options, etc.

  16. See Lehman Brothers (2005).

  17. There is some evidence that many large firms did independent modeling of complex structured financial products backed by mortgage-related assets. Nevertheless, it is probably the case that some did very little.

  18. Calomiris (2008) argues that rating agencies intentionally understated the risk of CDOs and inflated the ratings for securitized products so that institutional investors would be able to invest in these products without being bound by the constraints of regulation.

  19. See Senior Supervisors Group Survey (2008).

  20. Kiff et al. (2009) discuss the role of credit derivative markets in increasing systemic risks (due to the lack of transparency) and the increasing inter-connectedness of large financial institutions.


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Correspondence to Julapa A. Jagtiani.

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This article has been previously published as doi:10.1007/s11293-010-9221-7 in Volume 38, Issue 2, 2010.

The opinions expressed in this paper are the authors’ and not necessarily those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. Thanks to Ali Canoni and Vidya Nayak for their research assistance.

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Lang, W.W., Jagtiani, J.A. The Mortgage and Financial Crises: The Role of Credit Risk Management and Corporate Governance. Atl Econ J 38, 295–316 (2010).

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