U.S. Subprime Crisis:
Risk Management’s Next Steps
By Matthew A. Moore and Michael J. Brauneis

Low interest rates, an opt...
U.S. Subprime Crisis

a special-purpose entity (SPE), which then issues       Lynch, ousted executives and turned to sove...
U.S. Subprime Crisis

housing market downturn that many believed            mortgage market. These factors also drove thi...
U.S. Subprime Crisis

tive amortizing mortgages and Alt-A loans, widely        accurate collateral and security documenta...
U.S. Subprime Crisis

experiences or simplify complex circumstances. Of-     Risk Oversight in Focus
ten more important t...
U.S. Subprime Crisis

business activities. Policies that are too restrictive        to “prime” applicants and the “high-c...
U.S. Subprime Crisis

critics most memorably when he said, immediately              control, financial institutions will l...
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U.S. Subprime Crisis: Risk Management's Next Steps

  1. 1. U.S. Subprime Crisis: Risk Management’s Next Steps By Matthew A. Moore and Michael J. Brauneis Low interest rates, an optimistic view of home prices and creative financial structuring created subprime mortgage euphoria. T he financial industry is hard at work trying to measures of mortgage loan performance—increased move beyond the problems that surfaced in sharply. Nonperformance was most pronounced 2007. More than $120 billion in subprime losses among the higher-risk subprime mortgages. or write-downs were reported by financial institutions Mortgage originators had targeted the subprime as of mid-January 2008.1 Optimists contend the bulk of market by offering nontraditional loan features the damage has surfaced, though additional losses will coupled with less stringent loan underwriting stan- likely occur since total subprime defaults are estimated dards. These loan products became popular among to be $200 billion to $300 billion by the end of this both borrowers and mortgage originators in recent crisis.2 As part of the recovery, financial institutions years. They permitted higher-risk borrowers to secure are reconsidering their credit practices, quantitative mortgages, often for amounts much greater than what models, governance structures and risk management was available under traditional mortgage underwrit- activities. Each of these areas will experience change ing standards. For mortgage originators, which often as banks and their boards and executives adapt to the included third-party brokers not affiliated with an current economic and credit environment. Contribut- individual lender, these products provided an ex- ing to this change are legislators and regulators, who panded target market for new loan volume, a major are considering new laws and regulations to curb component of their compensation structure. dangerous and predatory lending practices. Mortgage originators were able to off-load these riskier loans through securitization. Financial in- A Sober Look at the novation has made the practice of originating and selling loans through securitization common, Current State particularly within the residential mortgage as- set class. Subprime residential mortgage-backed As we recover from the challenges faced in 2007, let securities (RMBS) issuance grew from $52 billion us take a sobering look at the current state of this in 2000 to $465 billion and $449 billion in 2005 and crisis. As of March 2007, an estimated $1.3 trillion in 2006, respectively.4 While the mechanics of mort- subprime mortgages were outstanding.3 Subprime gage securitization are straightforward, only now generally refers to loans made to borrowers with are the potential implications becoming more fully tarnished credit histories. These borrowers are con- understood. Mortgage originators, such as mortgage sidered to represent an increased risk of defaulting brokers or mortgage lenders, sell the mortgage to on credit obligations. The existing crisis began with weaknesses in the U.S. housing market and quickly entangled borrowers, lenders and investors. The Matthew A. Moore and Michael J. Brauneis are Associate Directors at housing market began showing signs of stress late in Protiviti, Chicago. Contact them at matthew.moore@protiviti.com and 2006. Delinquencies, defaults and foreclosures—key michael.brauneis@protiviti.com, respectively. APRIL–MAY 2008 BANK ACCOUNTING & FINANCE 23
  2. 2. U.S. Subprime Crisis a special-purpose entity (SPE), which then issues Lynch, ousted executives and turned to sovereign debt securities to investors. These RMBS represent wealth funds for capital infusions to strengthen interests in the future cash flows of the mortgages. their weakened capital positions. Similarly, many When borrowers make their mortgage payments as banks reduced, and in some cases eliminated, their projected, RMBS values hold and investor principal mortgage origination businesses. is repaid with interest. When the housing market slowed and borrowers fell behind on mortgage pay- ments, the cash flows underlying RMBS securities Looking Back: fell short of projections. Inadequate cash flows from A Crisis in the Making these mortgages caused RMBS values to drop. Drops in the value of securities caused investors to realize Before looking ahead to consider how the current sub- significant losses on RMBS investments, totaling prime mortgage crisis will influence future banking $120 million as of January 22, 2008.5 activities, we will briefly reflect on the conditions that An additional conse- led to this point. Revisiting quence of the housing the circumstances that led slowdown was that the An additional consequence of the to this crisis is an important well-oiled mortgage secu- housing slowdown was that the well-oiled part of understanding what ritization pipeline quickly to expect to result from it. dried up. Investors lost mortgage securitization pipeline quickly A dangerous combination their appetite for risky dried up. of low interest rates, rising RMBS, draining much- home prices and creative fi- needed liquidity from the nancial structuring engines markets. Freddie Mac reports that subprime RMBS caused Wall Street and Main Street to indulge in the issuances hit a seven-year low of $12 billion in the subprime mortgage euphoria. fourth quarter of 2007.6 With few, if any, willing Borrowers benefited from historically low buyers for recently originated subprime mort- borrowing costs for much of this decade. With gages, lenders and mortgage brokers were forced access to relatively inexpensive capital, financial to hold these loans on their balance sheets. Given institutions could offer attractive mortgage rates. the increased risk profile of subprime mortgages, Low interest rates enabled borrowers to finance originators found this to be an unappealing prospect. larger home purchases. Popular features such as Accepting and holding the credit risk of these prod- adjustable-rate mortgages (ARMs) and option- ucts were likely not contemplated in their business ARMs further reduced the initial interest rate and strategies and did not align with their risk appetite initial payments, enabling borrowers to qualify or capital plans. for higher mortgages than would have been pos- The lack of liquidity for subprime mortgage paper sible under conventional underwriting methods. drove a number of mortgage finance companies Though the rates on these products would adjust into financial distress. New Century Financial was to market rates in the future, many borrowers the first to fall, filing for bankruptcy in early 2007. placed confidence in their ability to refinance American Home Mortgage followed in July 2007. at attractive rates, given the long-running low- Countrywide Financial, one of the largest mortgage interest-rate environment. companies in the world, avoided bankruptcy by Low borrowing costs and increased access to agreeing to be acquired by Bank of America for $7.16 credit pushed the U.S. home ownership level to an per share; Countrywide shares were trading at over all-time high of 69.2 percent in 2004.7 With robust $37 per share in early July 2007. The commercial and housing markets, home prices continued their investment banking sectors were also hit hard by upward march. Annual growth in sales prices the fallout. Massive losses and asset write-downs on existing U.S. homes, a modest four percent in battered bank stocks and eroded capital cushions. 2000, increased to six percent in 2001, over eight In the face of large exposures to subprime losses, percent in 2003 and exceeded 12 percent in 2005.8 some institutions, including Citigroup and Merrill So much time had elapsed since the previous 24 BANK ACCOUNTING & FINANCE APRIL–MAY 2008
  3. 3. U.S. Subprime Crisis housing market downturn that many believed mortgage market. These factors also drove this home prices would increase perpetually or, at market to excess. The foray into subprime and the very worst, remain flat. Consumers built this nontraditional mortgages proved to be the critical expectation into their personal investment strate- error that pushed the mortgage market too far. In gies, and financiers erroneously embedded this hindsight, few should be surprised that a financial assumption into financial models. Lenders be- crisis resulted from excessive use of risky mort- lieved that borrowers were less likely to default gages, marginal mortgage products and opaque as the properties underlying these mortgages financial instruments. were appreciating and, even if borrowers did default, that rising home values would protect against losses. Facing the Future: Risk Investment banks scaled up their financial Management Evolves structuring operations in order to meet investor demand for RMBS. The strong economic condi- The velocity with which this chain reaction occurred tions experienced in the 1990s spurred growth in left many business models, investment strategies, home purchases. Low interest rates in the early financial models and risk management strategies part of this decade sparked a wave of refinancing exposed. As the financial sector suffers through the that extended mortgage volume growth. Invest- fallout of defaulted loans, failed investments and ment banks’ financial structuring units churned battered stock prices, we are left to ponder how this out RMBS at record rates. Refinancing activity recent crisis will influence banking in the future. slowed when interest rates began rising in 2004; The subprime mortgage meltdown provided the however, few were ready for the mortgage party impetus to swing the risk/reward pendulum in the to end. Lenders and investment banks turned direction of increased risk management. As with ev- to subprime and nontraditional mortgages to ery financial crisis, as they evaluate what went wrong, continue fueling the financial structuring en- executives, risk managers and regulators will modify gines and feed investor appetite for RMBS. In a practices and implement activities to prevent similar low-interest-rate environment, investor demand events from recurring. Credit standards and practices was high as attractive yields were needed to will get back to basics. Quantitative financial models meet return hurdles. This demand led to the and, more important, their key assumptions will re- creation of new financial structures. Innovative ceive additional scrutiny, and improved governance structures known as collateralized debt obliga- practices will result. Risk committees and oversight tions (CDOs) helped reduce investor concerns functions will be reinvigorated. Federal banking over increased default risk inherent in pools of regulators will implement new standards to prevent subprime mortgages. CDOs package multiple abusive and unsafe lending practices. RMBS into tranches reflecting varying levels of risk. The underlying assets are not the mortgages themselves but securities created from the original Credit Standards: Back to Basics RMBS securitization. Risk-averse investors, such With uncertainty about the ability to unload mort- as pension funds or even institutional treasurers gages in the securitization and secondary markets, seeking marginal yield increases, could purchase lenders will continue to rebalance credit policies securities in the highest tranches, which carried to align with their institution’s risk tolerance and the best credit ratings and were most protected overall capital capacity. Lenders began reining in from losses. When borrower defaults spiked in credit standards in 2006, when the housing market 2007, even highly rated tranches experienced first began showing signs of stress. The pullback was losses, thus impairing the theoretical basis of most pronounced in the subprime segment. The pace CDOs’ role in reducing risk. accelerated as housing prices continued to deterio- The combination of relatively low interest rates, rate in 2007 and defaults on subprime mortgages appreciating home values and robust securitization increased. Utilization of marginal credit products markets drove massive volume in the residential is decreasing. Originations of option-ARMs, nega- APRIL–MAY 2008 BANK ACCOUNTING & FINANCE 25
  4. 4. U.S. Subprime Crisis tive amortizing mortgages and Alt-A loans, widely accurate collateral and security documentation prevalent during the height of the housing boom, in minimizing loss given default (LGD). Losses decreased significantly in 2007. Further, lenders are resulting from inadequate or inaccurate loan cutting down on exposure to risk layering resulting documentation will continue to surface. Flaws from multiple mortgages being secured by a single in loan closing and security filing processes will property. This practice often pushes loan-to-value be revealed as the fallout continues. In the mean- ratios far in excess of traditional levels. time, governance functions such as internal audit, Prudent credit underwriting practices are also credit review and postclose quality assurance will returning, replacing the shortcuts taken by lenders continue to be relied upon to ensure mortgage to speed origination engines. So-called no-doc and originations adhere to credit policies, operational low-doc loans, where minimum, if any, documen- procedures and documentation standards. These tation was required to support loan applications, governance functions play a critical role in provid- are being severely restricted. Income, asset and ing feedback to senior and executive management employment verifications, hallmarks of traditional on credit practices and lending processes. underwriting, are once again standard practice. Lenders’ focus is appropriately returning to bor- rowers’ ability to repay obligations over the life of Introducing Model a loan, as opposed to simply meeting payment ob- Risk Management ligations during the initial low-interest-rate period. This transition parallels the relative evaporation With fresh data from this crisis, academics and of demand for subprime mortgage securities in economists are furiously analyzing information to the capital markets. Portfolio lending has begun determine what empirical lessons can be learned. and will continue to return credit risk as a primary The 2007 subprime mortgage crisis will surely consideration in mortgage originations. provide crucial variables that, to this point, were The use of indirect mortgage brokers is also either not accounted for in financial models or slowing. Bank of America announced in October were based on dated or inaccurate assumptions. 2007 that it plans to close its indirect mortgage More important, this crisis reminds us of the in- origination channels. JPMorgan and Wells Fargo herent limitations of financial models. A model is recently reported that broker-originated loans are not a substitute for human judgment; it is a tool deteriorating more rapidly than those originated to aid business decisions. Quantitative models directly. Mortgage brokers play a crucial role in are critical tools in modern finance, though they matching borrowers with lenders. Such brokers are only as powerful as the data and assumptions often work with multiple lenders and, in theory, are underlying them and the business experts using in the best position to match customer needs with them. Institutions will seek to understand and product offerings. As they are traditionally com- better govern their quantitative models through pensated based on origination volume, mortgage enhanced model risk management. Effective mod- brokers have little incentive to consider fully the el risk management requires models that are well default risk a borrower poses. With little incentive developed, managed, validated and appropriately or accountability for default risk, mortgage brokers understood and used by the business. further amplify the risk profile of marginal lending Two flawed assumptions underlying the sub- practices. The indirect mortgage origination chan- prime mortgage boom were exposed in 2007: nel will likely see continued contraction as financial indefinite home price appreciation and diversifica- institutions rein in credit standards and increase tion of default risk through financial structuring. diligence over credit risks they acquire. More active As misguided as these assumptions now seem, they management of mortgage brokers is also highly were widely accepted only a few months ago. The likely by both banks as well as regulators. accuracy of any assumption should be subject to The increase in defaults has caused mortgage debate, and that debate should be updated at least holders to enforce their rights to collateral. This annually or as circumstances dictate. Assumptions has reemphasized the importance of complete and are used to bridge data limitations, forecast future 26 BANK ACCOUNTING & FINANCE APRIL–MAY 2008
  5. 5. U.S. Subprime Crisis experiences or simplify complex circumstances. Of- Risk Oversight in Focus ten more important than the individual assumption is the process for developing, vetting, evaluating Risk avoidance is a natural response following major and stressing assumptions used in financial models. financial crises. Initially, there will be an overcorrec- Disciplined assumption development and review tion toward risk aversion within some institutions. processes increase the understanding of both the Fear of additional large, high-profile losses will implications and limitations of using a particular constrain risk-taking activities. As confidence in assumption. This knowledge is critical in evaluat- risk management capabilities grows, behavior will ing the output produced by the model. moderate and return to normalized levels. Risk Quantitative models are typically built upon his- oversight and management will play an important torical data sets that represent actual experiences role in facilitating a balanced recovery from the under certain economic conditions. Modelers take subprime mortgage meltdown. Reinvigorated risk this historical data and assess the degree to which management functions and risk management com- it fits the model’s intended purpose of forecasting mittees will exert increased influence over critical future performance. Models using underlying business decisions. data that is less reflective of the scenarios being Risk committees of the board of directors at many modeled will produce results that are less reli- financial institutions, alarmed by the reminder of able. During the subprime lending surge of the the damage that can result from imprudent risk mid-2000s, lenders ventured outside of traditional decisions, will increase scrutiny of risk activities. mortgage practices. Relatively robust data sets Audit committees followed a similar path following exist for traditional mortgage products; however, the corporate scandals of 2002. Strengthened risk data for subprime mortgages and nontraditional committees will set the tone for risk management mortgage products is limited to the past few activities throughout the institution and will con- years. Data limitations increase the difficulty of tinually evaluate the institution’s risk profile and predicting how such borrowers would perform risk appetite. They will ensure that risk manage- in challenging economic conditions. A common ment functions are operating effectively to support mitigant to this type of model risk involves ap- accurate risk assessments, provide reliable risk in- plying an appropriate degree of conservatism formation and produce prudent risk strategies. when inadequate or insufficiently relevant data is Risk committees and risk executives rely on their available. Failure to account for data limitations agents embedded in the organization to understand can result in grossly inaccurate estimates of risk and evaluate the institution’s risk-taking activities. and lead to regrettable business decisions. Credit review, portfolio management, model valida- Overcoming faulty assumptions and data limi- tion and business-line risk managers are the line-level tations are just two challenges of using financial eyes and ears to ensure policy is followed, risks are models, yet they underscore the importance of adequately considered and prudent practices are effective model risk management. In addition, employed. The concerns raised by these groups will there is a natural knowledge gap between “quants” receive greater attention and consideration. Their and executives regarding the models used. Model warning signals should carry more weight as insti- knowledge is generally concentrated within a tutions strive to prevent repeating the errors of the small number of quants within the institution. recent past. At the same time, board committees will Executives regularly use these complex models to seek validation that these control functions are operat- make significant business decisions. Greater trans- ing effectively, appropriately staffed and adequately parency and enhanced governance of institutions’ equipped to fulfill their roles of providing independent, quantitative models will help close the gap be- objective assessments of risks and risk management ac- tween quants and executives and will lead to more tivities. Expect an increase in independent assessments informed decision making. Armed with improved of risk management functions in the near future. understanding of models’ structure, purpose and The challenge risk oversight will face is promoting limitations, executives will be better able to apply prudent, disciplined risk management policies and their expert business judgment. strategies without completely inhibiting necessary APRIL–MAY 2008 BANK ACCOUNTING & FINANCE 27
  6. 6. U.S. Subprime Crisis business activities. Policies that are too restrictive to “prime” applicants and the “high-cost” thresh- may be successful in preventing losses but could im- old under the existing HOEPA regulations. For pair the institution’s competitiveness in the market. loans meeting the new higher-cost threshold: Risk oversight groups will need to work diligently (1) Lenders would be prohibited from engaging to strike the right balance as they navigate the post- in a pattern or practice of disregarding ap- subprime crisis environment. plicants’ ability to repay from sources other than the collateral itself. (2) Lenders would be required to verify income Regulatory Reaction and assets. Increased regulation of the mortgage finance in- (3) Prepayment penalties (PPPs) would be pro- dustry is an inevitable consequence of this crisis. hibited unless certain conditions are met. Although lenders in this industry are already subject (4) Escrow accounts would be required (al- to myriad laws and regulations, a key theme of the though borrowers would be able to opt current crisis has been sharp criticism by lawmakers out of the escrow account 12 months after that regulators, and in particular, the Federal Reserve loan origination). Board (FRB), have not done nearly enough to prevent Create three new protections for all consumer- even the most egregious practices that have led to purpose mortgages secured by owner-occupied borrowers being offered unaffordable loans. principal residences: On December 18, 2007, the FRB issued proposed (1) Lenders would not be permitted to pay a changes to its regulations implementing the Home mortgage broker more than a borrower had Ownership and Equity Protection Act (HOEPA) previously agreed the broker would receive. of 1994. HOEPA is the primary federal vehicle by (2) Creditors and brokers would be prohibited which Congress intended for subprime borrow- from attempting to influence the outcome of ers to be protected from predatory lending. Under an appraisal. HOEPA, the FRB is charged with the authority to (3) Mortgage servicers would be prohibited implement anti–predatory-lending regulations that from “pyramiding” late fees, failing to credit apply to all mortgage lenders in the United States. payments as of the date of receipt, failing to Although various HOEPA requirements have been provide loan payoff statements upon request enforced under the FRB’s Regulation Z for more within a reasonable time or failing to deliver than a decade, the view of many U.S. congressmen, a fee schedule to a consumer upon request. state lawmakers and industry observers is that the Impose a variety of new restrictions on mort- existing regulations have had little if any effect to- gage loan advertising and require new and/ ward preventing the types of abuses that Congress or enhanced consumer loan disclosures. These had intended to be prevented. Indeed, because the changes, collectively, are intended to improve existing HOEPA regulations generally apply only borrower understanding of the risks associated to the very highest cost segment of the mortgage with various types of loan products and provide industry, it has become common practice for many more valuable information to encourage bor- lenders to price their loans just under the applicable rowers to comparison shop among different HOEPA threshold, thereby originating loans that brokers and lenders. most reasonable observers would consider to be According to FRB policy makers, the proposed subprime without having to comply with burden- guidelines have been carefully drafted to protect some HOEPA restrictions. consumers from the types of practices that led to With the recently proposed changes to the regu- the subprime crash, while avoiding the unintended lation, the FRB would seek to expand significantly consequence of cutting off access to credit for re- both the coverage of and the restrictions and prohibi- sponsible and creditworthy borrowers. In spite of tions imposed by HOEPA. Broadly, the new rules, if this, critics immediately and harshly criticized the adopted, would accomplish the following: FRB proposal as not going nearly far enough in ad- Create a new class of “higher-cost” mortgage dressing the risks associated with subprime lending. loans, or those priced in between the rates offered Rep. Barney Frank (D-MA) perhaps represented the 28 BANK ACCOUNTING & FINANCE APRIL–MAY 2008
  7. 7. U.S. Subprime Crisis critics most memorably when he said, immediately control, financial institutions will look internally following the release of the proposal, “We now to strengthen internal risk management practices. have confirmation of two facts we have known for Simplified credit standards, enhanced model risk some time: one, the Federal Reserve System is not management and reinvigorated risk oversight will a strong advocate for consumers, and, two, there is be early steps taken by financial institutions on no Santa Claus. People who are surprised by the one their road to recovery. Risk is an ever-present and are presumably surprised by the other.”9 ever-changing element of the business environ- As it stands, the FRB proposal will remain open to ment. Major risk events underscore the necessity public comment until March 2008. However, given for risk management to remain vigilant and con- that public commentary to date suggests a consensus tinuingly evolve. that the proposal may not be aggressive enough, it seems unlikely that the final rules, once issued, Endnotes will be much if any less restrictive than what was proposed. This also leaves open the possibility that 1 Big Banks Announce Writedowns that Swell Total to $120bn, THE Congress may take action on its own, including, for GUARDIAN, Jan. 23, 2008. example, imposing new and specific requirements 2 Postcards from the Ledge, THE ECONOMIST, Dec. 17, 2007, www. by statute (bypassing the FRB’s rulemaking process); economist.com/opinion/displaystory.cfm?story_id=10334574. shifting mortgage lending consumer protection re- 3 Will Subprime Mess Ripple Through Economy? Q&A: Looking at sponsibilities away from the FRB and other banking the Impact of the Mortgage Meltdown, Associated Press, Mar. regulators to another agency, such as the Federal 13, 2007, www.msnbc.msn.com/id/17584725. Trade Commission; or clearing the way for indi- 4 Freddie Mac Update: February 2008, Freddie Mac Investor vidual states to pass and enforce upon all lenders Presentations, slide 19, www.freddiemac.com/investors/pdffiles/ their own anti–predatory-lending restrictions. investor-presentation.pdf. 5 Supra note 1. The Importance of Stronger 6 7 Supra note 4. Census Bureau Reports on Residential Vacancies and Homeowner- Risk Management ship, U.S. Census Bureau press release (Oct. 26, 2007). 8 Wannasiri Chompoopet, Existing Home Sales: December 2007, The path to recovery will not be without significant National Association of Realtors, www.realtor.org/Research.nsf/ challenge. Weakening economic circumstances files/EHSDec.ppt/$FILE/EHSDec.ppt. or unexpected geopolitical events could further 9 Press release dated December 18, 2007, Frank Statement on complicate financial institutions’ business envi- Federal Reserve Proposed Rules on HOEPA, www.house.gov/apps/ ronment. With such events largely outside their list/press/financialsvcs_dem/press121807.shtml. This article is reprinted with the publisher’s permission from Bank Accounting & Finance, a bimonthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher’s permission is prohibited. To subscribe to Bank Accounting & Finance or other CCH Journals please call 800-449-8114 or visit www.CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH or any other person. APRIL–MAY 2008 BANK ACCOUNTING & FINANCE 29