U.S. Subprime Crisis: Risk Management's Next Steps
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.
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 firstname.lastname@example.org and
2006. Delinquencies, defaults and foreclosures—key email@example.com, respectively.
APRIL–MAY 2008 BANK ACCOUNTING & FINANCE 23
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
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
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
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
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
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
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
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
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,
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 $120bn, THE
Congress may take action on its own, including, for GUARDIAN, Jan. 23, 2008.
example, imposing new and speciﬁc requirements 2
Postcards from the Ledge, THE ECONOMIST, Dec. 17, 2007, www.
by statute (bypassing the FRB’s rulemaking process); economist.com/opinion/displaystory.cfm?story_id=10334574.
shifting mortgage lending consumer protection re- 3
Will Subprime Mess Ripple Through Economy? Q&A: Looking at
sponsibilities away from the FRB and other banking the Impact of the Mortgage Meltdown, Associated Press, Mar.
regulators to another agency, such as the Federal 13, 2007, www.msnbc.msn.com/id/17584725.
Trade Commission; or clearing the way for indi- 4
Freddie Mac Update: February 2008, Freddie Mac Investor
vidual states to pass and enforce upon all lenders Presentations, slide 19, www.freddiemac.com/investors/pdfﬁles/
their own anti–predatory-lending restrictions. investor-presentation.pdf.
Supra note 1.
The Importance of Stronger 6
Supra note 4.
Census Bureau Reports on Residential Vacancies and Homeowner-
Risk Management ship, U.S. Census Bureau press release (Oct. 26, 2007).
Wannasiri Chompoopet, Existing Home Sales: December 2007,
The path to recovery will not be without signiﬁcant National Association of Realtors, www.realtor.org/Research.nsf/
challenge. Weakening economic circumstances ﬁles/EHSDec.ppt/$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.
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APRIL–MAY 2008 BANK ACCOUNTING & FINANCE 29