1. Knowledge Area Module 5:
Corporate Financial Theory
Student: Thomas P. FitzGibbon, III
Student’s Email: tfitzgib3@ameritech.net
Student’s ID#: 0378491
Program: PhD in Applied Management and Decision Sciences
Specialization: Finance
KAM Assessor: Dr. Mohammad Sharifzadeh Mohammad.sharifzadeh@waldenu.edu
Faculty Mentor: Dr. Mohammad Sharifzadeh Mohammad.sharifzadeh@waldenu.edu
Walden University
June 25, 2008

2. ABSTRACT
Breadth
The purpose of this KAM is to identify the theories associated with Corporate Finance,
particularly risk management strategies in banks and lending institutions. The Breadth
Component focuses specifically on the theories associated with overall risk management as well as
the theories related to interest rate risk, market risk, and securitization. We will also examine
how existing risk management strategies may have been an indirect cause of the current mortgage
crisis in the United States. The risk management theories of Hennie van Greuning, Joël Bessis,
and Dennis Uyemura will be compared and contrasted in their perspectives on risk management
theories for banks.

3. ABSTRACT
Depth
In the Depth Section, we will review and summarize the state of the housing finance market
during the period leading up to the market surge, during the surge itself, and the aftermath
resulting in the current housing and mortgage crisis in the United States. Within the review, we
will examine the contemporary literature and presentations from industry officials on the
challenges in the market related to: the causes of the current situation, the results the market now
faces, regulatory changes under consideration, and industry interventions to address the market
need for a resolution. The intended outcome of this review is to have a greater understanding of
the market dynamics and shortfalls that resulted in the current housing crisis.

4. ABSTRACT
Application
The Application Section will provide an overview of the effective strategies associated with credit
risk and interest rate risk strategies executed by banks that have survived the current mortgage
crisis in the United States. In addition, we will review best practices processes related to new
mortgage product development and mortgage underwriting processes and compare those subjects
between banks that have weathered the current crisis to those that have failed. The outcome of
the Application Section will be a review of the best practices as well as a summary of products
that best balance the needs of the customer to those of the bank.

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TABLE OF CONTENTS
BREADTH .................................................................................................................................1
Introduction.....................................................................................................................1
Credit Risk Management................................................................................................14
Interest Rate Risk ..........................................................................................................23
The Effects of Securitization..........................................................................................27
Conclusions ...................................................................................................................31
DEPTH.....................................................................................................................................34
Annotated Bibliography .................................................................................................34
Historical Context..........................................................................................................50
The Current Crisis..........................................................................................................51
Causes of the Current Crisis...........................................................................................55
Stakeholder Response to the Crisis.................................................................................69
Conclusions ...................................................................................................................75
APPLICATION ........................................................................................................................76
Introduction...................................................................................................................76
Overview.......................................................................................................................76
Establishment of an Effective Credit Risk Strategy.........................................................77
Effective Preparation for Interest Rate Risk....................................................................93
Creating an Effective Product Mix .................................................................................98
Conclusions .................................................................................................................104
REFERENCES .......................................................................................................................105

6. BREADTH
AMDS 8513: THEORY OF CORPORATE FINANCE
Introduction
The focus of this Breadth review will be to compare and contrast the theories of Hennie
van Greuning, Joël Bessis, and Dennis Uyemura as they relate to Risk Management in corporate
finance. Within that review, we will focus on the topics within the banking environment. Finally,
we will examine these theories in the context of the current mortgage crisis in the United States.
Within the review, we will concentrate on the areas of Market Risk, Interest Rate Risk,
overall processes on safety and soundness, and issues related to securitization of loan pools.
Along with that, we will identify and discuss how banks effectively balance risk versus reward and
how that may have led to the current mortgage crisis in the United States.
Overview of Risk Management
Prior to gaining an understanding of the theories associated with the specific risks noted
above, we must first have an understanding of all the potential risks that banks may face in their
operations. Given the diversity of a bank’s operations, there is also significant diversity among
the risks. While some types of risk may not apply to all banks based on their individual
operations, an understanding of the risk environment will allow us to properly compare and
contrast the views of the theorists under review. As van Greuning notes, there are “four major
categories of risk: financial, operational, business and event risks” (van Greuning, 2003, p. 3).
The first risk we will examine is Credit Risk. This is a risk that all banks face during their
operations. “Credit risk is the first of all risks in terms of importance” (Bessis, 2002, p.13).
Simply put, credit risk is the risk that a borrower may default or may be delinquent in their

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obligations to the bank. For most banks, their key asset is credit that is provided to customers of
the bank. As such, any deviation from the anticipated performance of extended credit can have
dire impacts on the overall financial performance of the bank. Additionally, Uyemura (1993)
discusses the risks associated with interest rate fluctuations within the overall credit risk category
as well. Specifically, as interest rates fluctuate, there is a cost associated with the issued credit
against the cost of new credit in the market. Within credit risk there are two areas to consider,
the quality of the banking portfolio and the trading portfolio. As we will discuss in more detail
later, the diversity of the banking portfolio has a direct impact on the quality of the portfolio itself.
In other words, if a portfolio is overly concentrated in a particular industry or in some cases with
a small group of customers, the banking portfolio may be considered more risky and of lower
quality due to the concentration in particular areas of the market. The risks involving the trading
portfolio are quite similar to the banking portfolio. The primary difference is that in situations
where the payment history or other indications of the borrowers credit quality diminish, the value
of the security, the loan for sale, diminishes with it. (Bessis, 2002)
The second type of risk is Country Risk. As Bessis (2002) notes, this is the risk that a
crisis can occur in a country that the bank either does business in or with. While there are many
banks within the United States that are immune from this type of risk due to focusing on domestic
operations within the United States, for many larger banks international operations are within
their line of business. Furthermore, the crisis, as Bessis (2002) discusses, can involve the internal
economy, the central bank of the country or the currency issued by the country. We can see an
example of this today related to the declining value of the United States Dollar. For those banks
who transact in dollars, they are now seeing that the purchasing power has diminished

8. 3
significantly over the past few years. The result of this diminishment is that the market may have
a different understanding of the value of a dollar based portfolio when it is compared to the value
of other portfolios in stronger currencies. Additionally, with the interest income paid in dollars,
this also proves problematic for investors due to the lower quality of the dollar in foreign markets.
Uyemura (1993) treats the foreign exchange risk as a standalone issue and notes that both
international banks and corporations who maintain multiple currency exposures can be subject to
this risk as well. However, the level of diversity of currency can also impact the risk. Those
organizations who have widely diverse investments in currencies may be able to off-set the
weakness of one currency against the improved performance of another. For example, if a bank
has an equal investment in United States Dollars and the Euro, they would likely see that as the
dollar began to lose value, the Euro improved in value, thus the diversity was a benefit. However,
if another institution focused specifically on United States Dollars and several Latin American
currencies, they may find the value of their portfolio dropping as a result of the close tie that
several Latin American currencies have to the dollar. As such, while the portfolio does have a fair
level of diversity, the overall focus is on one particular region of the world, making it inherently
more risky.
The third major component of risk is Performance Risk. This risk is specifically related to
“the performance of specific projects or operations rather than its overall credit standing” (Bessis,
2002, p. 16). In the United States, financing for items such as construction could be considered
to be somewhat performance based. By meaning, the level of risk associated with the financing is
dependent on the performance of the borrower to complete the project and release the property
for sale. In the event that the project is not completed, the true value of the loan would be

9. 4
questioned as the performance required on the project was not completed. Additionally, many
banks typically apply a performance based distribution of funds related to construction projects to
address this issue. In other words, financing will be distributed when certain milestones are
completed during the project. This serves to mitigate the bank’s exposure to performance risk as
the performance is not based on the completion of the project, but only a portion of the project.
Bessis (2002) also discusses how commodities apply to performance risk as well.
Specifically he discusses the financing of the transaction of a commodity sale and how financing
related to transactional sales is not dependent on the credit quality of the buyer or seller of the
commodity, but based on whether or not the transaction occurred.
The next risk component is Liquidity Risk. Liquidity risk is the ability to raise funds at
market costs. (Bessis, 2002) However, liquidity risk as relates not only to the ability of the bank
to raise funds, either by investment or deposits, but also the ability to provide customers with
access to deposited funds on demand from the bank. (van Greuning, 2003) Uyemura (1993)
when discussing liquidity risk refers more to the need for liquid funds to maintain the operations
of the bank. While there is some difference in the level of detail provided by each, the theories are
complementary to each other as well. In order for a bank to operate, it must have access to liquid
funds to pay for all facets of the business. Access to funds must be available for deposit
customers, borrowers, as well as employees and vendors of the operation.
An example of the issues involved with liquidity risk relate to the run on banks in the
United States during the Great Depression. As the economic conditions continued to worsen,
customers began to approach their banks requesting access to the deposited funds. However,
significant portions of those funds were lent out or otherwise invested by the banks. As such, the

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amount of liquid funds available for withdrawal was low. This was made even worse by the fact
that the loans made were defaulting as well. In the event that there was a process of foreclosure,
this left the bank with owned property rather than liquid funds. Additionally, this resulted in
banks closing since they not only could not satisfy the needs of their customers, there was no
access to liquid funds to maintain the business operation as well. The result was that banks had
no money and property that could not be sold, thus, were forced to cease operations.
The next risk category is Interest Rate Risk. As Bessis notes, interest rate risk involves
any related decline in earnings that may result in changes to market interest rates. (Bessis, 2002)
In addition, Uyemura (1993) notes that underlying within the earnings discussion is the mismatch
between the interest expense paid to investors and depositors, and the interest rate charged to
debtors of the bank. Typically, a bank would charge a higher amount of interest to debtors
compared to the amount of interest the bank pays to creditors. This interest rate spread provides
the net income that banks receive to support other parts of their operation along with future
investment opportunities. In subsequent sections of this review, we will discuss the detailed
issues related to interest rate risk and how those issues may have impacted the banking crisis of
both the 1980s as well as the current crisis in the market.
Furthermore, the next risk category is Market Risk. Bessis (2002) defines market risk as
the risk associated with changes in market value of an instrument directly related to movements in
the market. In addition, van Greuning defines market risk more broadly in that market risk
“results from changes in the prices of equity instruments, commodities, money and currencies”
(van Greuning, 2003, p. 232). In other words, there is market risk in nearly every type of
transaction that a bank can participate in. However, where they both agree is that the risk relates

11. 6
specifically to the “during the period required to liquidate the transaction” (Bessis, 2002, p. 18).
As such, if there are changes in market value of the security while the sale is progressing, those
changes would be considered as the market risk of the sale.
The next risk category is Foreign Exchange Risk. As discussed above, this may not be
applicable to all banks if they are not actively involved in foreign exchange markets. (Uyemura,
1993) This risk is directly associated with institutions who conduct business or invest in
operations outside of their country of operation. As such, a smaller community based bank may
consider this risk in their overall strategy, but larger international banks would pay very close
attention to this issue. Bessis (2002) defines foreign exchange risk as the risks associated with
variations in the value of a foreign currency and the related changes in exchange rates of that
currency. However, there is also an impact that the value of assets in general may be valued in a
foreign currency. As evidence of this, van Greuning describes this risk as a “mismatch foreign
receivables and foreign payables that are expressed in a domestic currency” (van Greuning, 2003,
p. 261). Using the example of a weak dollar, banks that recognize foreign assets in the local
currency may see that the dollar value of those assets is no higher than the value in past financial
statements. However, if the dollar should strengthen in the future, there would be an adjustment
lowering the value of the asset in dollars as the foreign currency used in the valuation would be
worth less, on an exchange basis.
However, van Greuning (2003) also provides additional detail on the risks related to
exchange rate risk. She breaks them into three categories: transaction risk, economic or business
risk, and revaluation or translation risk. Transaction risk relates specifically to price changes as
either payables or receivables are exchanged between currencies. Economic or Business Risk

12. 7
relates to the long term impacts on changes to the country’s economy where the business is
located along with any impacts on the business’ competitive advantage related to the issues in the
country of operation. Finally, Revaluation or Translation Risk relates to issues where a bank may
have currency holdings, and how those holdings are reflected on the company, or parent
company’s balance sheet.
The next area of risk is where our theorists have some disagreement. Solvency Risk
involves the ability for a bank to absorb all of its “possible losses generated from all risks with the
available capital” (Bessis, 2002, p. 20). However, Uyemura (1993) sees the issues of capital
adequacy as “very much a creation of the regulatory agencies and public policy considerations”
(Uyemura, 1993, p. 208). Furthermore, his perspective is that the bank should ensure that its
available capital is properly used and returns are in line with the expectations of shareholders of
the bank and are not a risk on their own, but a reflection on the appropriate asset and liability
management structure of the bank. (Uyemura, 1993)
While not specifically a financial performance indicator, Operational Risk does have an
impact on the overall performance of the bank’s internal operations. Operational risk involves the
internal infrastructure, people processes and technology of the bank. (Bessis, 2002) As such, any
processes or procedures that serve to guide the internal management of the bank have a role in the
determination of operational risk the bank may have. These could be matters as simple as
outdated computer or telephone infrastructure as well as procedures related to human resources
management. Any weaknesses in these areas may result in a financial loss to the institution.
What is interesting is that neither Uyemura nor van Greuning discusses this in any detail.
Uyemura does discuss Operating Risk as a component, however, he defines this as “the risk of

13. 8
losses or unexpected expenses associated with fraud, check kiting, litigation” (Uyemura, 1993, p.
5). Additionally, van Greuning (2003) briefly discusses the assessment of infrastructure within the
framework of bank regulatory requirements, but there does not appear to be any indication that
she considers the quality of the internal operations as a component of overall operational risk.
While it may not have a significant impact, the costs associated with weaknesses in operations can
be assessed. (Bessis, 2002) For example, the costs associated with a loss of electricity, telephone
system or other infrastructure failures can be measured after the fact. Additionally, when
developing any sort of a disaster recovery plan, an institution can model the potential costs of an
event as a part of the justification for further investment to avoid the event or mitigate the costs
associated with the event should it occur.
Finally, the last risk is Model Risk. Model risk relates to the accuracy of the financial
models used within the bank. Within the framework of the model, the accuracy of the data and
the formulas used in the model also have an impact on model risk. Additionally, since the models
are used to determine other risk categories in the bank, the quality of the model itself can also
have a downstream impact on the validity of other risk assessments used. (Bessis, 2002)
Furthermore, while not specifically noted as a risk, both Uyemura (1993) and van Greuning
(2003) discuss the value of data in simulation modeling in general, but do not note any specific
issues related to the quality of the data or model as a risk that the bank may encounter. For the
most part, Uyemura (1993) and van Greuning (2003) appear to make the assumption that the data
and model are assessed to be sound when a simulation is completed, as such, they do not consider
this to be a standalone risk, but built into other risks that the bank needs to assess.
Credit Risk Management

14. 9
Now that we have an understanding of the overall risk dimensions for a bank, the next
step is to examine risks that may be considered more common to most banks in the United States.
The first of those risks is Credit Risk Management. As defined above, credit risk is the risk
associated with delinquency or default of extended credit. Furthermore, as van Greuning notes
“credit risk is still the major single cause of bank failures” (van Greuning, 2003, p. 135). As such,
we will review the perspectives on the theorists on all major areas of credit risk management from
the underwriting processes to the policies that banks can establish to effectively manage their
credit risk exposure.
Before gaining an understanding of the individual factors of credit risk, we must first
understand the processes related to managing the credit portfolio of the bank. Overall, the
portfolio management strategy should be directed by the leadership of the bank and should
provide a “sound system for managing credit risk” (van Greuning, 2003, p. 137). Furthermore,
van Greuning (2003) highlights a lengthy set of considerations that a bank should use when
determining their policies on portfolio management.
First, there is a limitation on outstanding loans issued by a bank. The issue is that the loan
portfolio can not be at a higher level than the funds available for lending. However, this does not
imply that all available funds should be lent out. The management process should also consider
factors such as “credit demand, volatility in deposits, and overall credit risks” as a part of the
lending objectives (van Greuning, 2003, p. 137).
Second, geographic limits should also be considered. Banks should focus on the
geographic areas that they know best. This means, unless the appropriate market analysis is
completed in other areas, it would not be prudent for a bank to enter a new market and expect to

15. 10
succeed. However, one should not assume that geographic limits apply to another state or
country, they can be as simple as another neighborhood in a major city. Therefore, regardless of
the location, the bank should focus on identifying productive markets based on their own
research. If it is decided that the new market addresses their particular goals and objectives along
with a relatively low risk potential, than it would be a prudent move. (van Greuning, 2003)
Next, the bank should consider any issues related to credit concentration. Credit
concentration can best be defined as managing the overall portfolio to avoid concentrating on a
specific customer, industry or related group. In addition, in the event that a concentration is in
place, this would also give the bank an opportunity to consider other customer channels outside
of the concentrated group to add diversity to the portfolio. With that, the bank can avoid the
economic possibilities of a market change that could adversely impact the performance of their
customers. (van Greuning, 2003)
Furthermore, the bank should also consider the category distribution of their portfolio.
For example, if a bank found that they had a large portion of their portfolio in commercial loans,
they would have a higher sensitivity to not only a credit concentration, but also a problematic
distribution in commercial loans in comparison to consumer loans or other lines of credit offered
by the bank. (van Greuning, 2003)
Along with an understanding of the loan categories and their portion within the portfolio,
the bank must also have a sound process associated with the type of loans in the portfolio. In
examining some of the failed banks in the current crisis, one could clearly determine that there
was a significant concentration in sub prime home loans in comparison to other credit options. As

16. 11
such, banks became dependent on this loan category alone, and failed to build business in other
loan types that could have served to offset the risk. (van Greuning, 2003)
Another issue related to the current crisis was the establishment of appropriate loan
maturities. The loan maturity determines the payment terms of the loan, by meaning, the length of
repayment and the monthly payment to be received from the borrower. In the event that the
maturity is not realistic, there is a higher chance of default. As such, the bank must develop a
framework for the loan officer to determine the realistic expectations for the performance of the
borrower. (van Greuning, 2003)
The next stage is to develop an applicable framework for pricing the loan. As discussed
above related to interest rate risk, the loan price needs to, at a minimum, cover the associated
costs of the loan. Furthermore, the pricing should also include a reasonable profit to the bank, but
at the same time, must be something that the borrower can be expected to pay back. (van
Greuning, 2003)
Additionally, banks must also have a framework for establishing the level of authority to
approve the loan. From an operational perspective, this process can differ based on the size of the
bank, but the authority process should be defined so as to determine limits as well as particular
type of loans that can be approved by employees of the bank. Along with other factors, this
provides a certain level of central control and limits placed on the performance of individual bank
officers and their ability to meet the needs of the institution. (van Greuning, 2003)
Another area of concern within the recent housing crisis is the establishment of an
effective assessment process. This is the basis for determining the level of recovery the bank
could have in the event of a default. As such, the bank should establish specific policies and

17. 12
requirements related to establishing the value of the asset being financed or the collateral provided
as security for the loan. (van Greuning, 2003)
Along with the appraisal, the bank should also have established guidelines as to the ratio
of the loan amount to the appraised value of the property. Again, this further addresses issues
related to recovery in the event of default. (van Greuning, 2003) As we will discuss in the Depth
Section of this review, we will see specific examples of where the loan-to-value ratio was not
properly managed resulting in the bank assuming nearly all of the financed value of the property.
(van Greuning, 2003)
In addition, the bank should also have a process to appropriately disclose all loans and
credit on the balance sheet of the bank. Typically, this takes place as soon as the contract is
completed and the funds are distributed to the borrower. This does not necessarily apply to items
such as letters of credit where the customer has access to funds, but has not executed and
received the funds. For items such as this, the loan should be recognized when the funds are
distributed to the borrower. (van Greuning, 2003)
The bank should also establish a process to identify and address any issues of impairment
of the loan. (van Greuning, 2003) As discussed earlier, if there are indications that the loan will
no longer be paid on time or the collateral or guarantees are in question, a default proceeding
could be initiated against the customer. However, without an established impairment process, the
identification process could be limited and may increase the risk associated with a given loan or
group of loans.
Along with impairment, the bank must also have an established process and policy related
to loan collections. In the event of delinquency, the bank should have a standard due diligence

18. 13
and collections policy governing what steps should be taken in order to resolve the delinquency
and bring the account current. In addition, the bank should also have an effective reporting
mechanism summarizing the extent of the delinquency in terms of time and balance as well as
documentation related to the completed tasks associated with resolving the delinquency. (van
Greuning, 2003)
Finally, the bank should also have a standard set of required documents from the borrower
as a part of their loan application. This is a critical need in the underwriting process as the
financial information is used to determine not only eligibility for funding, but the borrower’s
ability to meet the repayment terms of the debt as well. Typically, the bank will require different
documents depending on whether it is a commercial or personal loan along with the type of loan
under negotiation. (van Greuning, 2003)
Uyemura (1993) assumes more of a macro-economic approach to portfolio management.
His focus is more on the economic conditions that could be in place that could have an adverse
impact on the loan portfolio. Along with those macro factors, he also considers vacancy rate for
commercial property, interest rate levels, as well as the market value of collateral.
Now that we have an understanding of appropriate credit risk management processes, we
now need to examine the individual steps related to the portfolio. The first of those is the
establishment of underwriting guidelines. Underwriting is the basis for determining credit for a
customer of the bank. Furthermore, effective underwriting serves as the basis for an effective
strategy surrounding credit risk management. An effective underwriting process should be able to
effectively assess a borrower ability to pay the debt back as planned in the terms of the credit
agreement. Additionally, the credit assessment would also provide indicators as to the

19. 14
delinquency or default risk associated with the borrower and the extended credit. As we will
discuss in the Depth Section of this review, ineffective credit risk management tactics were a
direct cause of the current mortgage crisis in the United States.
Moreover, van Greuning (2003) discusses several factors that serve to identify banks that
either do not have formal underwriting standards or are failing to administer standards that are in
the best interest of the bank. The first of these issues is referred to as Self-dealing. Simply put,
self-dealing involves the extension of credit to internal stakeholders of the bank. These can
include investors, members of the board of directors or any of their outside interests. In situations
such as this, there is a clear conflict of interest in the process as some of these same individuals
may hold posts within the bank that can influence the overall performance of the bank.
Second, potentially related to the issues of self-dealing are situations where the established
credit guidelines of the bank are knowingly not followed by those responsible for their application.
As is the case with self-dealing, the lack of credit standard application can inappropriately record
the credit quality of the loan which can result in a higher risk of delinquency or default of the loan.
As we will review in the Depth Section of this review, this is one of the areas that is thought to
have caused the current mortgage crisis. (van Greuning, 2003)
The third factor under consideration is events where there is uncertainty of the potential or
existing income of the borrower. Clearly, the validity of the existing income has a direct
correlation to the potential of repayment for the loan. As such, any concerns about the borrower’s
income can impact the level of risk associated with the loan. (van Greuning, 2003)
The next factor is the lack of appropriate credit information within the applicant’s loan
application. (van Greuning, 2003) An example of this in the current mortgage crisis involves no-

20. 15
documentation or ‘liar’ loans that were originated over the past five years. As is the case with
incomplete income information, a lack of access to valid credit information provides an
opportunity for a borrower to misrepresent their true ability to pay the loan back.
Furthermore, complacency is a factor in that where the bank has a historical relationship
with a customer, that they tend to rely on outdated information when considering the extension of
new credit. By meaning, in a situation where the customer has an adequate relationship with the
bank, the bank fails to examine the current information on the customer’s ability to pay the new
debt back in a timely manner. This issue raises concerns about credit quality in that there is no
assessment of the borrower’s current situation which could be significantly different from when
the relationship was originally commenced. (van Greuning, 2003)
Lack of supervision is another key issue within an effective credit management structure in
that it is the supervision that supports the overall credit management strategy of the bank. If the
supervisors are in effective in their application of the standards, the result will be riskier loans that
will raise doubts as to the overall quality of the portfolio. This not only applies to the processes
related to underwriting, but to proper portfolio management after the loan is originated. As
discussed above, proper supervision and knowledge of the borrower’s continued financial
standing can help to mitigate any future risk of default. Without that customer supervision, the
bank may find that certain delinquent or defaulted loans could have been addressed had the proper
supervisory process existed. (van Greuning, 2003)
Additionally, the level of technical competence is also an issue in the process. By
meaning, whether the bank or its officers have an appropriate understanding of the knowledge
necessary to determine the creditworthiness of a borrower when extending credit. While some

21. 16
might consider this as an obvious need that does not necessarily imply that those bank employees
performing the underwriting process have an understanding of how the process must work to
maintain the safety and soundness of the credit portfolio. (van Greuning, 2003)
Finally, there is the issue that the bank does not appropriately select the risks that it is
willing to accept. In other words, the bank elects to offer credit where assumptions are high and
an effective assessment of creditworthiness of the customer is low. As we will see in several
examples in the Depth Section of this review involving risky loan-to-value ratios and inaccurate
property assessments are indicative of situations where the bank is not using sound judgment
when selecting risks that are in the best interest of the bank. (van Greuning, 2003)
Furthermore, in situations where the borrower is no longer current on its payment
obligation, they can be considered to be either delinquent or in default of the loan. The specific
terms associated with the status would be defined in the credit agreement. However, the payment
history is not the only cause of delinquency or default. A borrower can be in delinquency or
default if they fail to perform against any of the criteria and fail to comply with the required
service requirements of the debt. (Bessis, 2002) This could involve something as simple as not
making timely payments to events where the there was a change in value of an asset held as
collateral for a loan changed. As an example, noted by Bessis (2002), that default can occur is
there is risk to the business survival of the borrower. By meaning, if there is an indication that the
borrower may not be able to maintain their service to the debt, the bank could consider the loan to
be in default and take the appropriate actions, defined by the terms, to address the default. In
either event, the default risk of the loan would increase and would have to be considered within
the overall risk profile of the bank.

22. 17
In the event of a default, the bank must also look at any indications of recovery risk
related to the debt. Recovery risk is the risk associated with the quality of any guarantees made
on the loan. For example, this would include any collateral, third party guarantees or any
covenants discusses in the loan terms related to security of the financing. (Bessis, 2002) Using
an example of home mortgages, the recovery risk is related to the quality of the collateral, the
financed property. As such, in the event of a default, the bank must consider the risks associated
with the guarantees in determining the level of risk related to the recovery of the loan after the
default occurs. Uyemura (1993) and van Greuning (2003) discuss recovery risk in the greater
context of credit risk. However, all the theorists agree that the risks associated with recovery of
the debt should be considered within the overall asset and liability management model of the bank.
However, all of these factors lead to two major areas for consideration. That is the quality
of the banks assets (their loans) and the quality of the collateral that provides security to the asset.
In the event that either quality factor is questioned, the overall quality of the portfolio will also
come into question. This is something that was clear with the current housing crisis.
As we will discuss in greater detail in the Depth Section of this review, the primary drivers
associated with asset quality was directly tied to most of the factors discussed above. However,
the drivers for the highest consideration involve a lack of effective underwriting guidelines as well
as collateral that was of questionable value. With that, as mortgage loan delinquency and default
began to increase in frequency, the perceived quality of mortgage loans as an asset began to drop.
While not necessarily the correct assumption to make, the market made the assumption that any
loan considered ‘sub prime’ should be brought into question, and the perceived value of those

23. 18
loans on a balance sheet was also questioned. Worse yet, the banks that were active in the sub
prime mortgage market also saw their market value decline.
Additionally, to make the situation even worse for the banks was that along with the
declining value of the mortgage as an asset, the collateral used for the mortgage, the residential
property also declined. While there are a wide range of reasons for this decline in value, the fact
that the primary security was losing value was also problematic for banks in that in the event of a
foreclosure, they may find that the recovery value of the property was actually less than the
balance owed from the customer. Along with that, the bank assumed something that they do not
wish to have, property instead of timely loan payments.
Interest Rate Risk
Now that we have an understanding of credit risk and appropriate credit risk management
strategies, we will now examine the impact of interest rate risk on both lenders and consumers.
As discussed earlier, interest is typically the primary source of both income for loans, and expense
for deposit instruments for the bank. “When interest rates fluctuate, a bank’s earnings and
expenses change, as do the economic value of its assets, liabilities, and off-balance-sheet
positions” (van Greuning, 2003, p. 249).
The first step in the understanding is to explore the opportunity costs related to changes in
interest rates from both the bank and the consumer. First, in terms of the performance of a bank’s
assets, in the event of an increase in the market interest rates, the bank would see an opportunity
loss due to the fact that with fixed rate mortgages, they will not have access to the potential
increase in income since the mortgage rate is fixed for the duration of the loan. However, they
will likely see an increase in interest income related to loans with an adjustable rate component.

24. 19
Assuming that the market rate remains at a higher level, the loan interest rate would reset to a
higher rate. With that interest rate increase, the bank would then see an increase in their interest
income associated with that loan. However, most adjustable rate loans currently available in the
market have set caps on the amount of the interest can adjust within a specific timeframe. Given
the caps, the bank may not be able to realize the full potential increase due to the terms of the
loan. (Bessis, 2002)
However, a downward trend in interest rates does not necessarily imply an income loss to
the bank. In the event that interest rates decrease over time, the bank does see a benefit from
their fixed interest rate portfolio. Simply put, if the rate is locked in at a higher rate, the bank will
continue to receive that higher income unless the customer elects to refinance or potentially
renegotiate the interest rate terms of the loan.
From the customer’s perspective, their income or expense is nearly opposite to that of the
bank. Again, using mortgages as an example, with an increase in the market interest rate along
with the customer holding a fixed rate, they will see no change in their payments since the rate is
already locked in at the rate agreed to in the terms of the contract. As such, the bank sees no
increase in revenue and the customer sees no difference in expense. However, this is the only area
where there is commonality. When reviewing the performance of adjustable rates, when an
increase in the market interest rate occurs, the customer will eventually see an increase in their
interest expense. This is perceived to be another cause of the current mortgage crisis where
interest rates reset to a higher amount resulting in a payment that was no longer affordable to the
customer. In the event of a reduction in market interest rates, the customer may then see a
reduction in their expense depending on the adjustment terms.

25. 20
In general, the opportunity costs of interest rate changes behave in a similar manner to any
investment that a bank could make. As such, where a bank may invest in bonds or other
marketable security at a fixed rate, they are assuming a risk where the market interest rate
fluctuations may result in either an opportunity loss or gain. The same is true for depositors in
banks where adjustments in the market rate can result in the same opportunity gain or loss.
However, this does not imply that they are actually losing or gaining new income, it is simply the
cost of the opportunity of making the investment at the set rate. Obviously, there is no way to
reliably predict what interest rates will be in the future and how a current asset or liability will
change in value over time. With that, banks and consumers need to determine what their own
interests are and how those interests can be meet with income expectations from their
investments.
Within interest rate risk, there are several categories of risk that must also be managed by
the bank to meet income expectations. Those internal risks are: Repricing risk, Yield Curve risk,
Basis Risk and optionality. (van Greuning, 2003)
Repricing risk occurs when changes in interest rates expose the value of their investments
to fluctuate. (van Greuning, 2003) An example of this would be the determination of value
related to treasury bonds. As interest rates fluctuate, the value of the treasury bond will also
adjust, and that adjustment would be reflected on the balance sheet, as a change in asset value for
the bank. In addition to the change in value of the treasury bond, the interest income received will
also adjust due to the change. That income change would also be reflected on the balance sheet.
(Uyemura, 1993)

26. 21
Yield curve risk when there are shifts to both the “slope and shape of the yield curve” (van
Greuning, 2003, p. 250) where that change can adversely effect the overall income of the bank.
Furthermore, she notes a specific example where a mismatch in securities with different maturities
can result in a loss to the bank. In the example, “a long position in bonds with a 10 year maturity
may be hedged by a short position in five-year notes from the same issuer” (van Greuning, 2003,
p. 250-1 ) can be adversely impacted by an increase in the yield curve where the bank would have
a loss. The mismatch is that there are two different maturity terms on the bonds, as such, the
different terms may not properly hedge against yield changes and the bank suffers a loss against
the longer term bond.
Basis risk involves situations where the “assets and liabilities are priced off different yield
curves and the spread between those curves shifts” (van Greuning, 2003, p. 251). For example, if
assets are priced on an index to the Treasury rate, and the liabilities are indexed against LIBOR,
any spread between the two indexes can result in a loss to the bank. Additionally, it may not
necessarily have an impact on long term positions by the bank. However, since most major
indices do adjust on a monthly basis, there may be some short term risk associated between any
shifts of multiple indexes. (Uyemura, 1993)
In conclusion, in banking operations, there will always be risks associated with interest
rates. The only exception would be if interest rates never changed, which we know is not a
possibility in an active market. As such, it is the responsibility of the management of the bank to
effectively mitigate the risk while meeting the revenue and income expectations of the
shareholders.
The Effects of Securitization

27. 22
Securitization is a common process for banks in that it provides them with an opportunity
to sell off risk for the portfolio of loans and to generate funds to then lend to new customers or
invest in other options. “The rise of the securitization phenomenon in the United States is closely
associated with the rise of capital ratio regulations, starting with the primary capital rules of the
Federal Reserve Board in the early 1980’s” (Uyemura, 1993, p. 260). With that, there was
increased interest in banks to quickly package loans and other credit instruments for sale to
outside investors.
As we will discuss in greater detail in the Depth Section of this review, there is a four
stage process for loan origination and securitization. First, is the process of extending the credit
to the customer. Secondly, the bank then goes through the underwriting process to determine the
creditworthiness of the borrower. Thirdly, the servicing that is completed after origination of the
funds. Finally, in the securitization process, the willingness of the originating lender to maintain
the risk associated with individual loans in the portfolio. (Uyemura, 1993)
While there are regulatory requirements associated with capital ratios in banks, there are
also some other benefits that banks receive from the securitization process and sale of loan
portfolios to outside investors. First is the ability to free up capital to lend out to new customers.
(Uyemura, 1993) As noted above, banks are required to maintain capital on their balance sheets,
the benefit of having funds to offer additional credit provides an opportunity for the bank to
generate additional income from fees related to the origination process along with the interest
income associated with new loan origination.
Along with that, there are several other benefits that banks can receive through the
securitization process. In addition to the generation of new capital for more loans, the banks can

28. 23
also better manage earnings by recognizing the accounting gains associated with the sales.
(Uyemura, 1993) This is especially true where the portfolio can be sold at a premium. Secondly,
there are the overall benefits from an asset and liability management perspective. (Uyemura,
1993) This is evident in situations where it may be in the bank’s best interest to sell a securitized
loan portfolio and then use the funds from the sale to pay off a liability that may have a fixed
interest that is higher than the current market interest. In this event, the bank would be better
managing their cash asset to lower long term interest expenses by retiring a debt priced above the
market. Third, the bank can create better liquidity in their assets. (Uyemura, 1993) While this is
part of the capital requirements ratios, it also serves to generate cash assets for use in other
efforts. Additionally, the bank can gain access to highly rated funds sources. (Uyemura, 1993)
Finally, both Uyemura (1993) and Bessis (2002) are in agreement in their belief that the issuer, the
bank, will still “bear most, if not all of its original risk” (Uyemura, 1993, p. 261).
As will be discussed in the Depth Section, we will focus our analysis on the issues related
to processes related to mortgage backed securities in the market. In reviewing the process related
to securitizing mortgages from a bank’s balance sheet, there are three different categories of
mortgage backed securities: pass-through certificates, pay-through bonds, and REMIC related
securities. (Uyemura, 1993)
Pass-through certificates are likely the most well known option for banks to use. The
process is quite simple in that the bank would establish a trust that would be the seller of the
security. Prior to the transfer, the bank would create a portfolio of loans that they wish to sell.
Once that portfolio is created, the loans are transferred to the trust. At that point, the trust would
then issue certificates to the bank. The final stage of the process is that the investor then

29. 24
purchases the certificates, through an agent, from the bank. Once the transaction is completed,
the investor then owns the portfolio of loans. However, as discussed above, the bank likely
would maintain the servicing of the loan by collecting payments, sending statements to customers,
and other processes related to the servicing requirements of the loan. While the bank would
continue to receive the funds, those funds, after expenses are deducted, are passed through to the
investor. However, one particular flaw of pass-through certificates is that there is not an ability to
have multiple classes of mortgages or deal with issues where the pool might have different
maturity dates. (Uyemura, 1993)
Pay-through bonds or collateralized mortgage obligations are somewhat similar to pass-
through certificates however the primary difference is that the loans themselves are not owned by
the investors. In this example, the mortgages actually are collateralized for the bonds. Then, the
investors would simply purchase the bonds that are issued. Additionally, since the bond holders
do not have a direct ownership interest in the mortgages, they would not receive the principal and
interest payments collected by the bank in the way that the pay-through certificates function.
However, the design of the bond is that the bond payment that the investor would receive is
normally planned to mirror the actual payment received for the mortgages. Additionally, since
these are bonds, the issuer has some flexibility on the payments to the investor. Where pass-
through certificate payments are typically made on a monthly basis, pay-through bonds can have
varied periods that may not necessarily align with the receipt of the mortgage payments.
However, while these appear to be valid options for investors, the difficulties associated with
matching mortgage payments to payments to investors along with the varied frequency of
payment receipt may prove problematic for some investors. (Uyemura, 1993)

30. 25
Real Estate Mortgage Investment Conduits (REMICs) serve to address some of the
weaknesses in pass-through certificates and pay-through bonds discussed above. The benefit that
Real Estate Mortgage Investment Conduits provide is that they can be based on a pool of
mortgages rather than the legal structures required by pass-through certificates or pay-through
bonds, but they can be “mortgage pools, state law trusts, corporations or partnerships”
(Uyemura, 1993, p. 266).
When considering the current mortgage crisis, securitization was a significant part of the
current issue. As we will discuss in the Depth Section of this review, the weakness was not
necessarily in the process of securitization. The underlying issue that is now clear is that there did
not appear to be a mechanism in place to appropriately assess the quality of the loans that were
part of the securitized portfolio. Along with that, we are now starting to see significant concerns
with the performance of the bond rating agencies and their ratings of Collateralized Debt
Obligations.
When reviewing the performance of the ratings and the actual quality of the rated
securities, it was clear that the rating agencies did not do effective due diligence on the quality.
Furthermore, there are several examples where major credit rating agencies gave superior ratings
for collateralized debt obligations where the underlying mortgages defaulted in large numbers
resulting in significant losses for the investors. As such, the value of the rating agency’s
assessment is now being called into question as the accuracy of their assessment was not in line
with the actual performance of the securities. Furthermore, had the actual quality been clear, the
investor would have been able to better balance their shareholder expectations by expecting a
lower price for their investment to balance the higher risk of poor performance. However, that

31. 26
was not done as the expectations were high and the investor paid a price that was in line with
those expectations.
Conclusion
As we will discuss in greater detail in the Depth Section of this review, there was a clear
process associated with effective risk management strategies in banks. As the basis of this
strategy, the banks focus on maintaining safety and soundness of their operations balanced with
the need to generate income in line with the expectations of their shareholders. While some
standards were followed, what is now clear is that the actual application of those standards was
inconsistent.
There appear to be two primary weaknesses in the risk management process that we are
seeing in the current crisis. First, involved the products that were introduced in the market and
secondly, the underwriting standards that were used in the loan origination process. Obviously,
the intent of many banks was to maintain their business in the industry in an environment that was
becoming more and more competitive due to the wealth of new entrants in the market.
As discussed above, an effective risk management strategy creates a plan that serves to
mitigate risks at the highest level possible, but still maintaining an income stream that satisfies the
shareholders. However, knowing that this was in place was simply not enough. When examining
some of the ‘exotic’ products that were offered in the years running up to the current mortgage
crisis, it was clear that banks were taking on significantly more risk than that of the past. The
intent of course was the idea that if more products were available, it would serve a wider
customer base, bringing in more customers and more revenue. However, the failure in this effort
was that there appeared to be a limited amount of research completed that would give an

32. 27
appropriate assessment of customer viability or propensity for repayment with these new
products. As such, the delinquencies, defaults and foreclosures appear to be the result of a small
set of sub prime loans that were created to meet this specific business need.
Moreover, when reviewing underwriting, there was clearly a mismatch between the stated
process and the application of standards. As we will discuss in more detail in the Depth
component, there are several examples where standards were either not applied at all, or they
were not realistic standards that would balance the business need for revenue to the perspective of
safety and soundness for the institution.
In conclusion, it is clear that the there is room for improvement on the risk management
strategies for banks given the current situation. However, there is no single stakeholder that is at
fault in the process. As we will learn in the Depth Section of this review, where the banks failed
was in the lack of updating their risk management strategies to meet the needs of a changing
market. While there certainly was a need in the community for more options, the overall strategy
should have also built in factors to address these new options. Finally, in the Application section
of this review, we will create a risk management framework that is based on the theories
discussed in the Breadth Section along with the current research in the Depth Section to provide a
realistic plan that will meet the needs of the market in the future.

33. DEPTH
AMDS 8523: CURRENT RESEARCH IN CORPORATE FINANCE
Annotated Bibliography
Quinn, J., & Ehrenfeld, T. (2008). No more financial katrinas. Newsweek, 82-82.
In this article, Quinn and Ehrenfeld (2008) present an extensive explanation of their views
on the reasons behind the current mortgage crisis in the United States. Additionally, at the time
of publishing, the proposals for regulatory changes from the Department of Treasury are also
reviewed and discussed as to their impact on the current situation. Finally, the authors provide
their insight into the market reception to the proposals.
Of particular note is the authors’ prospective that the primary reason behind the current
situation was the lack of effective regulation on the mortgage banking industry. Specifically, the
authors discuss the opinion that the system is drastically out of date and no longer effective given
the dynamics of the current market.
Additionally, the authors discuss the several examples where they feel that the regulators
were complicit in their assessment of lender performance during the run up to the current crisis.
Within that summary, the primary focus of this complicity was on three areas: lenders offering
funds to people who could not afford the payment, ineffective risk management standards by
banks and investment firms, and the lack of response from Congress or the regulators when there
were indications of a pending failure.
Finally, the authors discuss the response that the lending and investment industries have to
the proposed changes. The authors are clear in their conclusion that the investment industry will
consider these changes to be warranted, while the lenders likely would consider them too heavy

34. 29
handed. In conclusion, the authors hold the belief that too much regulation may be a good
solution given the lack of effective regulatory management of the past.
Plosser, C. (2008). Economic outlook. Vital Speeches of the Day, 74(2), 81-85.
In this article, Charles Plosser (2008), of the Federal Reserve Bank provides his insight
into the current economic performance of the United States economy. In addition, he also
provides a summary of the purpose of the Federal Reserve System and how the system works to
address performance issues in the economy. Finally, Plosser also discusses how particular actions
by the Federal Reserve can impact economic performance of specific sectors as well as the
economy as a whole.
After concluding a brief summary of the current economic conditions at the time of the
presentation, Plosser discusses the two primary purposes of the Federal Reserve System,
monetary policy and promoting financial stability. Furthermore, the specific actions that the
Board of Governors take to adjust performance must have these two factors for consideration.
However, one area that Plosser does discuss was the volatility of the of the mortgage backed
securities market and the associated pricing of those securities. While Plosser does note that in
general, the Board of Governors does have responsibility to manage price stability, they could not
have a direct impact on this particular pricing since the market had not truly discovered what the
actual pricing should be.
Furthermore, Plosser also discusses his perspectives on monetary policy of the Federal
Reserve System. First, that any changes that the Fed may make will have a lag in the economy.
Therefore, the market should not expect an immediate economic response to any efforts to change
performance. Secondly, that slow growing economies tend to have lower interest rates than fast

35. 30
growing economies. Finally, that the Fed does not simply focus on a few indicators as a
justification of response. This is with an understanding that in a volatile economy individual
indicators will fluctuate, and having that understanding can serve to temper Fed actions.
Finally, Plosser highlights some of the new changes implemented by the Board of
Governors as it relates to providing insight into the discussions at their meetings. Specifically,
Plosser notes the new quarterly economic outlook disclosures and projections by the Board of
Governors at their meetings.
BERNANKE'S, F. (2008). FEDERAL RESERVE BOARD OF GOVERNORS CHAIRMAN
BEN BERNANKE’S REMARKS TO THE NATIONAL COMMUNITY
REINVESTMENT COALITION ON SUSTAINABLE HOMEOWNERSHIP AS
PREPARED FOR DELIVERY. FDCH Political Transcripts
In his remarks to the Community Reinvestment Coalition, Federal Reserve Bank Chairman
Ben Bernanke (2008) reviews his perspective on the current mortgage and housing crisis in the
United States. Specifically, Bernanke discusses the issues surrounding lax underwriting standards
as a primary cause of the downturn. In addition, Bernanke discusses the increases in subprime
lending as a portion of overall lending. Finally, he reviews the responses the Fed will undertake in
order to address the current problems.
When discussing the issues of lax underwriting standards, Bernanke discusses the actions
of lenders regulated by the Fed as well as those lenders who are not subject to Fed oversight.
However, regardless of the lender, the primary issues he notes relate to the easing of
documentation requirements for borrowers income as well as standards related to the ratio of
payment to income when stated. Furthermore, he notes that while the percentage of

36. 31
homeownership did increase over the past several years, that trend is now starting to go down as
the impact of delinquency, default and foreclosure is increasing.
Additionally, Bernanke also discusses the increases in adjustable rate mortgages that were
granted running up to the current situation. In specific, he discusses how many borrowers did not
fully understand the risks associated with these mortgages and that the upward resetting of the
notes is now resulting in borrowers no longer being able to afford their mortgage payments.
Finally, Bernanke discusses some of the proposed responses that the Fed is considering to
address the problems. Primarily, these responses relate to changes in underwriting requirements
from lenders. For example, the option to consider non-verified income for borrowers is no longer
available. In addition, further regulation of mortgage brokers, not currently subject to Fed
oversight is also under consideration as a high percentage of the now troubled loans originated
from these institutions.
BERNANKE'S, F. (2008). FEDERAL RESERVE BOARD OF GOVERNORS CHAIRMAN
BEN BERNANKE'S TESTIMONY AS PREPARED FOR DELIVERY TO THE
SENATE BANKING, HOUSING AND URBAN AFFAIRS COMMITTEE. FDCH
Political Transcripts.
In his address to the Senate Banking, Housing and Urban Affairs Committee, Federal
Reserve Bank Chairman Ben Bernanke (2008) discusses his insights into the current mortgage
and housing crisis and its impact on the United States economy. Bernanke notes examples of
multiple failures including underwriting, regulatory compliance, and credit access as working
together to cause the current situation. In addition, Bernanke also reviews some additional
actions the Fed is taking to provide lenders with additional credit access in lieu of other options
that are no longer available.

37. 32
Along with the issues consumers are facing in the current crisis, Bernanke also discusses
the issues that lenders are facing in their operations. The primary issue noted is the lack of
available credit as well as an unwillingness of investors to purchase existing loans due to the
uncertainty of the quality of the loan portfolio. This results in lenders having to carry a larger
portion of loans on their balance sheets and lower funds available for new loans. In order to
address this issue, the Fed has provided additional access to funds from the government to
provide a higher amount of liquidity for additional loans.
Finally, Bernanke discusses the impact that the current crisis is having on the housing
market. Even with the decline in new housing starts, the existing market is causing a glut of
available housing with a limited portion of buyers available. Additionally, the increase in
foreclosures also adds to the available inventory with the end result being a downturn in the value
of existing properties in the market.
Hill, P. (2007). Fed forbids ‘liar loans’. Washington Times, The (DC), A01.
Hill (2007) provides a summary of some of the recent regulatory changes from the Federal
Reserve System related to addressing particular issues raised in the current housing crisis. Hill
summarizes some of the recent changes to so-called ‘liar loans’ that do not require verification of
income as well as the increased scrutiny the Fed is paying to adjustable rate and balloon loans.
Finally, Hill discusses congressional reaction to the proposed changes.
One of the primary underwriting requirements under investigation by the Fed was the lax
application of income verification. For these loans, borrowers could simply report their income
on their loan application and no verification of that information was required for the loan. The
result of this was that, in many cases, the information provided by the borrower was not

38. 33
legitimate. As such, the borrower received the loan proceeds without any sensitivity as to
whether they could actually afford the payments.
In reference to loan disclosure, the regulations were implemented mainly to address issues
of adjustable rate mortgages, so-called ‘teaser rate’ mortgages where a promotional interest rate
was advertised, but the actual long-term rate was not disclosed to the borrower. Again, this is
another cause of the current crisis, in that borrowers did not have a clear understanding of the
actual resulting interest rate and they could no longer afford their monthly payments when the
rates adjusted upward.
Finally, Hill discusses the response of Congress to the regulatory changes. As noted in the
article, the response was not favorable. Several Congressmen felt that while the changes were a
step in the right direction, they were not aggressive enough in addressing the issues. Both
Senator Christopher Dodd and Representative Barney Frank are both quoted in expressing their
disappointment of the Fed’s actions and are considering further action directly by Congress to
address the current issues.
KROSZNER, R. (2007). LOAN MODIFICATION AND FORECLOSURE PREVENTION.
FDCH Congressional Testimony.
Robert Kroszner (2007), a member of the Board of Governors of the Federal Reserve
System provides his comments to the House Financial Services Committee on the current
mortgage crisis and some of the causes of the current situation. In particular, Kroszner notes the
decline of housing prices as a factor in the downturn. Along with the housing decline, he
discusses the impact of accessing equity and the impact of unemployment.

39. 34
As housing prices began to decline, many borrowers found themselves with a mortgage
balance that exceeded the actual value of the property. This was especially true with homeowners
who, at the original purchase, financed ninety-five percent or more of the purchase price with a
mortgage. The result of this was that homeowners could neither afford their rate-adjusted
payment, and could not afford to sell the property as they would still owe money on their existing
mortgage.
This issue was exacerbated by borrowers accessing the temporary increases in property
value in the run up to the current crisis by means of equity loans. In cases such as this,
homeowners who discovered increases in equity resulting in improved value would immediately
borrow against that equity to resolve other financial issues. As Kroszner notes, this action likely
hid the problem rather than bringing it to light.
Finally, in reference to unemployment, Kroszner discusses the issues of mortgage
performance in large markets that are also facing unemployment issues. Clearly indicating that
there is a direct correlation between increases in unemployment rates and relative increases in
default and delinquencies in mortgages. Kroszner concludes that there is not one particular action
that should be taken, but the industry, the Fed and Congress can equally play a role in addressing
the current crisis and preventing future problems from occurring.
KROSZNER, F. (2007). FEDERAL RESERVE SYSTEM BOARD OF GOVERNORS
MEMBER RANDALL S. KROSZNER DELIVERS REMARKS AT THE CONSUMER
BANKERS ASSOCIATION 2007 FAIR LENDING CONFERENCE. FDCH Political
Transcripts.
In his remarks to the Consumer Bankers Association, Federal Reserve Governor Randall
Kroszer (2007) provides additional insight into some of the causes of the current housing finance

40. 35
crisis in the United States. Kroszer details three factors that he sees as the causes of the issue,
increases in the unemployment rate, slowing of house prices and loosening of underwriting
standards. While any of these causes on their own would result in increases in delinquency and
default, he sees the combination of the factors as significantly influencing the performance of the
sub prime market.
As discussed previously, any increases in unemployment have a significant impact on a
borrower’s ability to pay their mortgage. Additionally, given the positive performance of the
economy prior to the current situation, many borrowers were confident that their jobs were safe,
and their home was a good investment. However, the combination of job loss and questionable
investment value of the home is now resulting in delinquency and default.
Furthermore, the specific issues related to home prices are also problematic. In many
cases, sub prime borrowers leveraged nearly one hundred percent of the value of the property at
the time of purchase, with the assumption that the value would increase over time. However, as
the market performance dropped, home values either slowed or in some cases lost value. As
such, borrowers became ‘mortgage poor’, by meaning, the value of their home was less than the
outstanding balance of the mortgage. This leaves borrowers with few options to resolve the
issue.
Finally, as discussed, the loosening of underwriting standards was a significant part of the
problem. Kroszner discusses several examples of the loosening standards such as, limited or no
documentation of income, high loan-to-value ratios, loans with early reset terms and inadequate
screening of borrowers. Specifically, he discusses the issues of securitization of mortgages as
giving lenders less need to be stringent on their underwriting standards.

41. 36
BERNANKE, B. (2007). MORTGAGE FORECLOSURES. FDCH Congressional Testimony.
In his statement to the House Committee on Financial Services, Federal Reserve Chairman
Ben Bernanke (2007) comments on some additional views on the current housing crisis.
However, in contrast to other statements, he provides an extensive summary on the issues related
to loan securitization. In particular, Barnanke discusses some of the benefits and concerns related
to this model. Finally, he also provides some insight into potential regulatory and legislative
response to the concerns on securitization.
In his summary, Bernanke provides an overview of the process of loan origination and
securitization. In summary, he discusses where in the past, lenders would keep mortgages on
their books for a significant period of time, the process prior to the current crisis involved lenders
quickly selling off the mortgage and servicing to a third party. At that sale, the loans were pooled
and sold again to investors.
The challenge, as Bernanke notes, in this situation is that lenders found less need to
scrutinize loan applications since they would not see any risk of default. By meaning, since the
loan would be quickly sold off to another party, the default risk went with the loan without
recourse back to the originator. As such, loan quality dropped significantly.
Of the many options that Bernanke suggested, was that the Federal Housing
Administration modernize their programs to encourage borrowers to consider an FHA backed
loan as a better alternative. In the run up to the current crisis, non-FHA loans were seen as more
convenient and quicker to process. As such, FHA loan volume dropped as a percentage of
overall loans. Secondly, he recommended that if any bailout was to occur, that Congress would
need to provide subsidies for support, but also to provide very strict guidelines so as to not

42. 37
bailout speculators and investors, but to focus on individual homeowners with a chance to
improve their individual situations.
Group says originators, wall street share blame for woes. (2007). National Mortgage News.
In this article in National Mortgage News (2007), the author reviews the mortgage
industry’s response and suggestions for improvement related to the current mortgage crisis in the
United States. Specifically, the article provides a summary of one issue related to the problems,
the disconnect between loan originators and those that invested in mortgage backed securities.
Further, the author also provides detailed information about the industry’s perspective on
regulatory actions for future sub prime mortgages.
As noted above, there was a clear difference in motivation for loan originators and
investors. Originators focused on lending out money to address the market demand at the time,
while investors viewed the securities of high quality and a solid long term investment. The
challenge, as the author notes, was that the potential risks were not identified by the originators.
As such, the investors had limited insight into the actual quality of the investment instrument.
The result was that once the true value was clear, the value to the investor dropped
significantly. As such, while these securities were originally positioned as high quality
investments, the global markets began to suffer, resulting in the current situation. However, the
article does not leave the blame to the originators alone, but the blame should also be shared with
those Wall Street firms that sold the securities as well.
Finally, the article also reviews the industry’s response to pending regulatory changes
involving the establishment of escrow accounts and stated income standards for future sub prime
loans. In general, the industry is not supportive of actions like those described above as they feel

43. 38
that this will limit credit access to new borrowers. As such, potentially make the current situation
worse by limiting opportunities for existing homeowners to resolve their situation.
Coy, P. (2007). Why subprime lenders are in trouble. Business Week Online.
Coy (2007) focuses his summary on the impact of bank competition as a cause to the
current mortgage crisis. Specifically, he reviews the impact competition had on the loosening of
underwriting standards and process for a bulk of the lending industry. Additionally, he provides
insight into the perspectives of several asset-backed securities researchers on their thoughts about
the current environment.
Furthermore, the author sees several competitive factors that drove lenders to lower
underwriting standards for loans. The primary factor was that costs were no longer a competitive
factor for lenders. By meaning, interest rates and fees were reduced to a point where the actual
costs were barely addressed let alone providing any profit. As such, lenders were unable to lower
interest rates and fees, so their only other option was to make the underwriting process easier for
borrowers. By easier, the implication is faster with less rigorous standards. The intent in the
effort was to at least balance the volume of loans between 2005 and 2006 without further
reductions to fees and interest.
The result, as the author discusses, is that the loans originated in 2006 appear to be the
lowest in quality in the run up to the crisis. What makes matters worse is that these loans are now
going through their first interest rate resets in 2008 and 2009. Thus, as the author points out,
there could be another downturn in market performance in the near future.
COLE, R. (2007). MORTGAGE MARKET TURMOIL. FDCH Congressional Testimony.

44. 39
Roger Cole (2007), Director of Bank Supervision and Regulation for the Federal Reserve
System provides testimony to the Senate Committee on Banking, Housing and Urban Affairs
related to issues on the current housing and mortgage crisis in the United States. Furthermore,
Cole provides an extensive summary of the risk management assessment process by the Fed as
well as bank adherence to risk management requirements from the Fed.
Cole goes on to discuss the impact of risk management standards on the current situation.
Specifically, he notes that lenders who have a majority of their business focused on sub prime
financing had a relative lack of adherence to effective risk management procedures. As a result,
those organizations are now seeing significant increases in loan delinquency, default and
foreclosure. Additionally, Cole notes that the removal of certain risk management tactics, such as
income verification, minimum credit score requirements and loan to-value-ratios served to
temporarily increase volumes, but in the eventuality resulted the current problems.
Finally, Cole also reviews some of the current tactics the Fed is implementing to address
risk management adherence for the institutions under their review. The intent behind this effort is
that the risk management strategies are designed to fulfill safety and soundness standards not only
required of the Fed, but also organizations in the housing finance industry. To support this need,
Cole provides several examples of lender performance where the standards have been adhered to
with other lenders who are less vigorous in their adherence to the standards.
Hibbard, J. (2005). The Fed eyes subprime loans. Business Week.
Hibbard (2005) provides insight into the broker processes in the sub prime lending market
prior to the existing situation. Specifically, he reviews the models used for compensation of
brokers, the correlation between interest rates and credit scores of applicants and the entrance, at

45. 40
the time, of larger banks into the sub prime market. While the article does not provide any
specific resolutions to the issues, it does identify that the Federal Reserve System was considering
further investigation into the underwriting practices.
As summarized above, the author goes into extensive detail about the conflicts between
broker compensation and interest rates. In summary, the model at the time of publication was
that if a broker was able to charge a higher interest rate to the customer, the broker would then
receive higher compensation from the lender. As such, it was in the broker’s best interest that the
customer paid more, not in the customer’s interest to have an affordable financing product. This
conflict was further supported by a Freddie Mac study in 2001 that determined that thirty-eight
percent of sub prime borrowers actually had credit scores that would normally be eligible for a
traditional prime mortgage.
Additionally, given the positive performance of the sub prime market at the time, many
new entrants began to offer sub prime mortgage products. Those companies included Citibank,
Washington Mutual, Chase, and several other larger traditional banks. The thought was that this
would be a new, highly profitable channel for those banks and could prove to be a better revenue
and profit stream in comparison to traditional prime mortgage products.
Collora, M. (2007). Commentary: Are criminal investigations next chapter in subprime story?.
Massachusetts Lawyers Weekly.
In this commentary, Collora (2007) reviews some of the causes of the housing crisis not
from the perspectives of the lender or customer, but the actions of real estate and closing agents
in the process. The author also provides a comparison of the current situation to that of the bank

46. 41
collapses in the 1980s. Finally, the author provides detail on potentially applicable case law
related to all parties of the loan origination process.
Furthermore, the author discusses the behavior of some real estate agents to encourage
buyers to inflate the actual price of a home in order to mask the fact that no down payment
existed. With that, the borrower would finance one-hundred percent of the actual price by
reporting on loan documents that the purchase price was actually higher. According to the
author, there were two results in this activity. First, that the quality of the loan was hidden, and
secondly that these actions may have played a role in the significant home value increases leading
up to the current crisis.
In reference to case law, the author provides summaries of several cases where bank
officers, closing agents and attorneys were criminally prosecuted for the mis-reporting of
information. Along with that, the author notes examples of several Massachusetts lenders who
failed as a result of offering similar, non-performing loans in the past. In conclusion, noting that
these examples may not be addressed by effective risk management tactics, but could be
addressed by regulating any conflicts of interest.
CADEN, J. (2008). SUBPRIME MORTGAGE CRISIS AND VETERANS. FDCH
Congressional Testimony.
Caden (2008), Director of Loan Guaranty Service at the Veterans Administration office
provides a summary of the impact the current mortgage crisis is having on their clients. While VA
loans are not considered sub prime due to very strict underwriting requirements, that does not
necessarily imply that veterans are not experiencing some of the problems the balance of the
market is seeing.

47. 42
Specifically, Caden notes the impact of home values in the market place. As the downturn
in the housing market began, home values either stagnated or in some cases declined in value.
According to Caden, this impacts all homeowners regardless the loan originator or guarantor. As
discussed above, in the event of a decline in home prices, equity and affordability are also at risk.
However, Caden also provides assurances that the performance of the VA backed loans
will not follow the same trend as the market in general due to the underwriting requirements. In
addition, the VA has taken additional steps to offer foreclosure intervention programs for holders
of VA mortgages in the event of delinquency. Furthermore, the VA has also implemented
programs for veterans who may have received sub prime loans from other lenders with options for
better products through the VA if refinancing is needed.
Danis, M., & Pennington-Cross, A. (2005). A dynamic look at subprime loan performance.
Journal of Fixed Income, 15(1), 28-39.
In this study, Danis and Pennington-Cross (2005) provide their interpretation of extensive
research related to the propensity of a sub prime loan to default or pre-pay based on several
factors. While the authors note that there is an obvious propensity for default when a delinquency
exists, but the authors also wished to determine the propensity for the loan to be pre-paid prior to
default as well.
In addition, the authors also determined the extent of the correlation between credit score
and the likelihood of loan delinquency. What they found was that there was a much higher
propensity with FICO scores less than 650. However, once the score was above 650, the effect
dropped off significantly. Hence, as the authors note, setting a baseline FICO score at this level
for a prime mortgage is statistically sound.

48. 43
The authors also examined the probabilities of pre-payment or default correlated to FICO
score. In this analysis, there was also a statistically significant correlation. In both cases, as FICO
scores were higher, there was a very low likelihood of default and a very high likelihood of pre-
payment of the debt. As was the case with delinquency, once the FICO score was at least 650,
the trend towards default declined as well.
What remained unclear was the definition of pre-payment. Without access to the data, this
was difficult for the authors to define. By meaning, pre-payment could be a loan payoff from the
borrowers personal funds, or it could be a payoff by means of a loan refinance option taken by the
borrower. As such, it may prove difficult to effectively interpret the data specifically related to
pre-payment performance.
DEPTH ESSAY
Now that we have an understanding of the appropriate risk management strategies for
banks, the next step is to determine how those strategies are applied to banks in the current
market. As we will see, there were several areas where some of the strategies and theories
discussed in the Breadth section of this review were either not followed at all or were
inconsistently applied. The result of these errors is what we are now seeing in the current
mortgage crisis in the United States.
With that, we will review the contemporary literature so as to provide greater insight into
where the strategies failed and how that failure led to the current situation. Additionally, within
our review, we will examine the actions by the lenders, the Federal Reserve System and the
Federal Government on their actions taken that lead to the crisis as well as potential areas where
the crisis could have either been mitigated or averted.

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As we learned in the Breadth Section, the primary failures leading up to the current crisis
evolved from theories involving market risk, interest rate risk, and the process of loan
securitization. Furthermore, as we will see in the Depth Section of this review, it was the lack of
application of these theories combined with a fervor to enter a growing market that is now
resulting in the collapse of the housing finance industry.
Historical Context
Beginning in 2002, the economy in the United States was struggling. As such, the Federal
Reserve System took action to reduce key interest rates with the intention of spurring growth in
the housing market. In addition, the Fed projected that the downstream impact of improvements
to the housing market in areas such as construction, retail sales, and improved employment would
have an overall impact of economic growth and long term economic stability.
Initially, the strategy was succeeding. Interest rates on mortgages were going down,
making the idea of homeownership more affordable to a wider range of the population. New
home building surged as well as the subsidiary jobs in construction and commercial retail sales.
Finally, existing property values also increased providing a new sense of economic stability for
existing homeowners.
However, as we are seeing now, what was once a solid performing industry is now on the
verge of collapse. As we will discuss in later sections of this review, a significant portion of the
economic surge was the result of lax risk management strategies from banks, brokers, regulators
and consumers. While many are quick to point out the faults of one particular market participant,
lenders, the reality is that there is plenty of blame to share. Lenders were lax on their
underwriting standards, mortgage brokers were focused more on personal income than satisfying

50. 45
customer needs, regulators did not effectively enforce standards, and consumers had some very
unrealistic expectations of the future value of their home and the affordability of their mortgage.
The Current Crisis
In order to fully understand the extent of the current mortgage crisis in the United States,
we must first review the issues at three historical timeframes in the industry: performance prior to
the housing surge, the time during the surge, and the current climate of the industry. We will
review the basic risk management standards and processes during each of these periods as well as
how those standards may have resulted in the poor industry performance today.
Prior to 2001, the mortgage lending process could be best described as conservative in
comparison to the processes in use prior to the current crisis. This conservative approach focused
on underwriting standards that were based primarily on factors such as credit score, verified
income, purchase price, and an assessment of a borrower’s ability to make timely loan payments.
For the most part, lenders would use their existing deposit and income base to fund mortgages
and maintain the loans until maturity. (Cole, 2007) In this approach, banks were more
conservative from a default risk perspective. The idea was that banks would focus on lending
funds to their best customers at a reasonable interest rate. Clearly, banks could assume that high
quality customers would provide a consistent revenue stream to the bank with very little potential
for delinquency or default. With that, the bank can effectively balance the need for a quality asset
along with providing some level of income improvement due to the new revenue stream of
interest to satisfy the shareholders. As an example of this approach, we can detail the
underwriting standards in place for Veteran’s Administration backed mortgages.

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The Veteran’s Administration underwriting standards call for a satisfactory assessment of
credit score, debt-to-income ratio, and residual income. (Caden, 2008) The intent is that the VA
is using effective default risk management guidelines to mitigate risk. As such, limit their financial
exposure that would result in the event of a foreclosure. Given this, the higher level goal is to
provide a source of credit to veterans, but at the same time ensure that the qualifications are
focused on providing that credit to those borrowers with the highest ability to repay the debt and
the lowest potential for default and foreclosure. While many loans did not have the guarantee of
the Veterans Administration, most banks and lenders applied similar standard to most of their loan
products. Again, with the intent of providing credit to those with the highest potential to pay the
loan back.
The result of this process was that the availability of credit was limited to those with the
highest potential of repayment. While this is a standard risk management strategy, it also limited
credit access to large populations in the United States. For example, those in low- and moderate-
income groups had very few opportunities for homeownership as they would be defined as ‘sub
prime’ borrowers from an underwriting perspective. Thus, lenders had little willingness to extend
credit to these groups as there was a higher potential of delinquency and default in comparison to
their ‘prime’ customers.
In the beginning of 2002, the economy in the United States was struggling and the
perspective of the government was that a strategy needed to be implemented to spur economic
growth. As such, the Federal Reserve took steps to lower key interest rates to encourage lenders
to reduce the interest rates charged to borrowers. Specifically, the Fed reduced the Federal Funds
Rate, the rate for money lent to banks, from 6.5% to 1.0% between 2000 and 2003. The intent

52. 47
behind this effort was that if banks could borrow money from the Fed at a lower cost, they would
likely pass a significant amount of that cost savings to the borrower. In other words, with lower
interest rates charged to consumers, more consumers would purchase homes as it was now a
more affordable option.
In addition, with more customers looking to purchase a new home, there would be an
increase in demand for both new and existing properties. However, in many larger markets, there
was not enough supply of available properties to meet the market demand. As such, new housing
development grew at a fast pace further improving the job market in construction as well as the
industries supplying goods and services to the construction industry. In addition to the need for
new housing development, the property values of existing properties also began to increase
significantly, again as a result of the surge in demand.
Initially, all the major economic indicators did improve. As the percentage of
homeownership improved, so did the other major factors including unemployment, gross domestic
product, and tax revenues. Overall, the improved economic performance appeared to be in line
with expectations.
Beginning in 2004, the Fed expressed concern that with the volume of ‘cheap money’ in
the market, that there was a significant risk of inflation. As such, they took action to increase the
Federal Funds Rate charged to banks. The idea was that if funds were more expensive, inflation
concerns could be addressed and the market could stabilize. These rate increases continued
through 2006 abating the risks associated with increases in inflation.
From an interest rate risk perspective, this was quite problematic for the banks. As
discussed in the Breadth Section of this review, interest rate risk involves a balancing the costs of

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capital paid by banks against the interest income received from debtors. With that, the increase in
interest rates by the Fed served to not only lower the volume of new customers wishing access to
credit, but also served to increase the credit expenses for banks. In other words, the banks were
forced to begin to pay more for capital, but still receiving the lower interest income received from
the previously originated loans. Furthermore, when considering the theories of interest rate risk,
it is clear that the banks were likely not following a sound strategy in that they were ill prepared
to deal with any interest rate increases that did arise as a result of the Fed’s actions. As we will
learn in greater detail below, this situation was made even worse when delinquencies and defaults
began to increase, further hampering the interest income and expense by the banks.
However, this is where the first indications of a crisis began to appear. Since many of the
new mortgages had an adjustable rate component tied to the Treasury rates, interest rates on
existing mortgages began to increase as the loans reset. The resulting interest rate increase
caused mortgage payments to increase as well. Therefore, what was once affordable to a
homeowner now was more difficult to manage. Furthermore, another outcome of the rate
increases was a dramatic drop in new and existing home sales, further slowing the economy. In
effect, this was a retraction from the growth experienced immediately after the interest rate
reductions in 2002. However, when considering the theories of interest rate risk, one could
assume that since the interest rates did reset at higher rates that there would be an improvement to
the revenue stream received from banks. Along with that, the cost of new capital would have
been better addressed since the interest rate spread was improving. However, as we will learn,
that increase in interest income was negated as delinquencies and defaults began to increase.

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Since individuals could no longer afford their mortgage payments, the volume of
delinquency and default began to increase. Additionally, as foreclosures began to increase, the
amount of available housing stock also increased, further impacting the value of existing property.
To make matters worse, those that wished to sell their homes found themselves in a situation
where the value of their home was less than the actual balance of the mortgage, placing them in a
difficult situation where, if a buyer existed, the owner could not afford to sell and still owe money
on the mortgage. Thus, many homeowners were saddled with a mortgage they could not afford
in a property they could not sell. Finally, starting in 2007, the Fed took action to lower the
Federal Funds Rate with the hope that the reductions would be passed back to the consumer
resulting in potential future mortgage interest rate adjustments in favor of the consumer.
However, where the failure lied was that the actions were too late for many homeowners, worse
yet, the banks were ill prepared to address significant increases in default risk associated with the
originated loans. Thus, banks found that that large portions of their loans were not only ill
prepared to deal with the issues of interest rate risks, but now default risk was further lowering
the quality of the assets.
Causes of the Current Crisis
As discussed above, there were many process and risk management failures that resulted
in the current housing and mortgage crisis. Specifically the lack of an effective strategy to deal
with the issues of interest rate and default risks of the mortgages. For the most part, every
stakeholder implemented tactics that were examples of ineffective risk management strategies. As
we will discuss below, lenders, consumers, investors, and the government all played a role in the
demise of the mortgage industry.

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While the reduction of key interest rates made mortgages more affordable, lenders wanted
to expand their customer base further by offering products to potential customers with less than
desirable credit histories, sub prime borrowers. While many lenders have historically offered
options for sub prime borrowers, the market for these customers expanded significantly since
2002. However, along with the expansion of the customer base, lenders were forced to be more
creative with their underwriting standards. Furthermore, when considering the theories of default
risk, this step was problematic in that it had the potential to significantly increase the potential of
default while not building a framework to effectively price the loan to address the higher risk. In
other words, banks for the most part, were lending money at market rates to nearly all customers
regardless of the potential for default. Furthermore, inherent in the theories in default risk is that
the bank would have an opportunity to address that increase in potential risk by charging a higher
interest rate. However, as we will learn later, with the competitive nature of the market, there
was more focus on getting the customer at any cost rather than losing the customer to a
competitor based on price.
As discussed above about loan products offered through the Veterans Administration,
most customers in the sub prime category would not meet the qualifications for VA loans. As
such, to gain access to this customer market, lenders began to be less aggressive on their credit
requirements for new borrowers. With that, requirements such as credit score assessment, income
verification, debt-to-equity ratios were much looser in comparison to historical requirements. The
intent from the lender is that with slightly lower requirements, more customers would qualify for
mortgages providing more revenue, by fees and interest, to the lender.