Abstract
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.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
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.
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.
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.
Private-label MBS refers to securities that are not insured by the government-sponsored enterprises (e.g., Fannie Mae and Freddie Mac).
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.
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.
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.
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.
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.
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.
Quotation from John Mack’s testimony before the Financial Crisis Inquiry Commission on January 13, 2010.
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.
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.
See Lehman Brothers (2005).
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.
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.
See Senior Supervisors Group Survey (2008).
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.
References
Acharya, V., & Schnabl, P. (2009). Securitization without risk transfer. Working Paper, NYU Stern School of Business, April.
Altman, E., & Saunders, A. (1998). Credit risk measurement: Developments over the last 20 years. Journal of Banking and Finance, 21, 1721–1742.
Arteta, C., Carey, M., Correa, R., & Kotter, J. (2009). Revenge of the steamroller: ABCP as a window on risk choices. Unpublished Working Paper, Federal Reserve Board, Division of International Finance, May.
Bernanke, B. (2007). The subprime mortgage market. Speech at the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition, May 17.
Bernanke, B. (2009a). Frequently asked questions: How can we avoid a similar crisis in the future? Speech at the Economic Club of Washington D.C., December 7.
Bernanke, B. (2009b). Lessons of the financial crisis for banking supervision. Speech at the Federal Reserve Bank of Chicago’s Conference on Bank Structure and Competition, May 7.
Bernanke, B., Gertler, M., & Gilchrist, S. (1996). The financial accelerator and the flight to quality. Review of Economics and Statistics, 78(1), 1–15.
Blinder, A. (2009). It’s broke, let’s fix it: Rethinking financial regulation. Working Paper, Princeton University, presented at the Federal Reserve Bank of Boston Conference, October 23.
Calomiris, C. (2008). The subprime turmoil: What’s old, what’s new, and what’s next. Working Paper, Columbia University, presented at Jackson Hole Conference, August.
Capuano, C., Chan-Lau, J., Gasha, G., Medeiros, C., Santos, A., & Souto, M. (2009). Recent advances in credit risk modeling. IMF Working Paper 09-162.
Cecchetti, S. (2008). Monetary policy and the financial crisis of 2007–2008: Advances in credit risk modeling. IMF Working Paper.
Covitz, D., Liang, N., & Suarez, G. (2009). The evolution of a financial crisis: Panic in the asset—backed commercial paper market. Federal Reserve Board, Finance and Economic Discussion Series #2009-36.
Dell’Ariccia, G., Igan, D., & Laeven, L. (2008). Credit booms and lending standards: Evidence from the subprime mortgage market. IMF Working Paper 08-106.
Demyanyk, Y., & Hasan, I. (2009). Financial crisis and bank failures: A review of prediction methods. Working Paper 09-04R, Federal Reserve Bank of Cleveland.
Demyanyk, Y., & Van Hemert, O. (2009). Understanding the subprime mortgage crisis. Review of Financial Studies, May 4 (RFS Advance Access), forthcoming.
Dwyer, G., & Tkac, P. (2009). The financial crisis of 2008 in fixed income markets. Federal Reserve Bank of Atlanta, Working Paper 2009-20.
Fethi, M. D., & Pasiouras, F. (2009). Assessing bank performance with operational research and artificial intelligence techniques: A survey. Working Paper, University of Bath School of Management.
Fischer, S. (2008). Preparing for future crisis. Presented at Jackson Hole Conference, August.
Fitch Ratings (2006). 2007 Global structured finance outlook—Economic and sector-by-sector analysis. December.
Gerardi, K., Lehnert, A., Sherland, S. M., & Willen, P. (2008). Making sense of the subprime crisis. Federal Reserve Bank of Boston, Public Policy Discussion Paper, December.
Gorton, G. (2008). The panic of 2007. Working Paper, Yale School of Management and NBER, presented at the Jackson Hole Conference, August.
Greenspan, A. (2002). International financial risk management. Speech before the Council on Foreign Relations, Washington, D.C. November 19.
Hu, J. (2007). Assessing the credit risk of CDOs backed by structured finance securities. Journal of Structured Finance, 13(3), 43–59.
Jimenez, G., Ongena, S., Peydro, J. L., & Saurina, J. (2007). Hazardous times for monetary policy: What do twenty-three million bank loans say about the effects of monetary policy on credit risk? Bank of Spain and CEPR Discussion Paper DP6514.
Kashyap, A., Rajan, R. G., & Stein, J. (2008). Rethinking capital regulation. Working Paper, University of Chicago and NBER, presentation at the Jackson Hole Conference, August.
Keys, B. J., Mukherjee, T., Seru, A., & Vig, V. (2009). Did securitization lead to lax screening? Evidence from subprime loans. Journal of Monetary Economics, 56, 700–720.
Kiff, J. J., & Mills, P. (2007). Money for nothing and checks for free: Recent developments in U.S. subprime mortgage markets. IMF Working Paper 07-188.
Kiff, J., Elliott, J., Kazarian, E., Scarlata, J., & Spackman, C. (2009). Credit derivatives: Systemic risks and policy options. IMF Working Paper 09-254.
Kirkpatrick, G. (2009). The corporate governance lessons from the financial crisis. Financial Market Trends, OECD Publication.
Kumar, R. P., & Ravi, V. (2007). Bankruptcy prediction in banks and firms via statistical and intelligent techniques—A review. European Journal of Operational Research, 180, 1–28.
Lehman Brothers (2005). U.S. ABS weekly outlook. Fixed-Income Research, April 15.
Mayer, C. J., Pence, K. M., & Sherlund, S. (2009). The rise in mortgage defaults. Journal of Economic Perspectives, 23, 27–50.
Mian, R. A., & Sufi, A. (2009). The consequences of mortgage credit expansion: Evidence from the U.S. mortgage default crisis. Quarterly Journal of Economics, 124(4), 1449–1496.
Moody’s Investors Service (2007). U.S. subprime: Overview of recent refinements to Moody’s methodology: July 2007. July 24.
Senior Supervisors Group Survey (2008). Observations on risk management practices during the recent market turbulence. March 6.
Senior Supervisors Group Survey (2009). Risk management lessons from the global banking crisis of 2008. October 21.
Taylor, J. B. (2008). The financial crisis and the policy responses: An empirical analysis of what went wrong. Working Paper, Hoover Institute and Stanford University.
Author information
Authors and Affiliations
Corresponding author
Additional information
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.
Rights and permissions
About this article
Cite this article
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). https://doi.org/10.1007/s11293-010-9240-4
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11293-010-9240-4