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

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.

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.

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

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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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-

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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

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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.

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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

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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.

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.

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)

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

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

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

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)

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

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

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.

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

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

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

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.

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

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.

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

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.

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

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

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.

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

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

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.

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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.

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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

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

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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.

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Credit score requirements have played an integral role in the underwriting process ever

since the information was made available to lenders. Lenders would use both the credit score and

credit report information to give them an indication as to whether the borrower has a proven

history of consistent debt repayment. The intent being that if a customer was consistent with

other debts, they would also be consistent in repaying their mortgage debt as well. Along with

the role that the credit score had in the underwriting process, there was also significant historical

information that demonstrated a link between credit score and default.

As Danis and Pettington-Cross (2005) noted in their study as credit scores decreased,

there was a clear correlation to the likelihood of default of the note. Along with the correlation to

the likelihood of default, there was also an equal correlation to higher credit scores and pre-

payment of the debt. In other words, those with lower credit scores were more likely to default,

and those with higher credit scores were more likely to pay their debt off early.

However, when the mortgage market became more competitive and there were fewer

customers looking to purchase a home and qualify for a mortgage, many lenders decided that the

best opportunity to access the customer was to be less aggressive on their credit score and history

requirements. As such, customers with questionable credit histories were now qualifying for

mortgages. Furthermore, lenders could mitigate some of this risk by charging a higher interest

rate in comparison to their prime customers, but in the end, the lenders relaxed the requirement

and assumed a greater level of risk with a higher potential for default and delinquency.

As with credit score requirements, verification of borrower income was also a key part of

the underwriting process. Many would consider this as a basis to determine whether the borrower

could actually afford the payments. However, many lenders saw this as a barrier to credit access

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for the customer, as such, they began to offer loan programs that required limited or no

documentation of reported income. The removal of this criterion significantly increased the risk

of fraud on the part of the applicant in that with no verification of the information, the applicant

could list any amount, at their discretion as reflective of their income. Ironically though, there are

several examples where a customer’s credit score would normally qualify them for a prime rate

loan. However, they would find that the lender would offer a sub prime loan instead simply due

the higher potential income received from the loan as well as a better perceived value to the loan

when purchased by an investor. As such, it was no longer a matter of whether or not the

customer would receive the loan, but it was more a matter of what the actual cost of the loan

would be. (Hibbard, 2005)

To make matters worse, the lender would then rely on the income information as a basis

for determining the terms of the loan as far as interest rate, and the amount to be lent based on the

reported income. Additionally, if the income was much higher than the actual amount, the

borrower could quickly become delinquent, or worse yet, default on the mortgage. While lenders

did charge slightly higher interest rates for these no-documentation loans to mitigate some risk,

many of these loans ended up going into default due to the borrower’s inability to afford the

monthly payments.

To address this situation, the Fed took action to at the end of 2007 to forbid the allowance

of ‘liar loans’ or no-documentation loans for any of their regulated institutions. (Hill, 2007) In

this action, the Fed was attempting to address the fraudulent cases where applicants clearly

provided incorrect information on their loan applications, but to also address the potential for

lenders to collude in the fraudulent effort as well. As such, the Fed’s goal was not specifically to

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address the issues of affordability or incorrect underwriting resulting from no-documentation

loans, but more to address several examples of fraud. Regardless of the Fed’s intent in the ban,

the purpose of their actions was to improve the risk management strategies of their regulated

institutions. In other words, the Fed observed this tactic to be excessively risky in terms of both

the probability of repayment and fraud as such, banned the use of it. Additionally, when

considering the issues of default risk, the Fed’s action forced to the banks to be more conservative

on the borrowers qualifications. What is interesting is that it took government intervention to

encourage banks to address safety and soundness issues rather than the banks taking the

appropriate action by creating a more effective default management strategy to reduce risk while

maintaining shareholder value.

Related to the verification of income, lenders also became less stringent on their

application of the debt-to-income ratios when determining affordability. In this requirement, the

percentage of total income is balanced against the total existing debt, including the mortgage

payment that the borrower would have if the financing was offered. However, in some situations,

a reasonable case can be made to support some flexibility on this measurement. For example, if

an applicant had a lengthy rent payment history where the rent payment was higher than the

maximum available payment for a mortgage, an assessment could be made that since the borrower

is accustomed to making a larger payment in the form of rent, they would be equally as likely to

be able to afford a similar payment towards a mortgage.

However, there are several examples where not only was the stated income inflated, but

the anticipated income was also inflated. For example, this was often used when financing

multiple unit properties where rent could result. In situations such as this, lenders would add the

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anticipated rental income that the borrower would receive from the property. However, in many

cases, that anticipated income was not based on any verified information. As an example, in

2004, a multi-unit property owner in Massachusetts was offered a mortgage of $894,000 at

eleven percent interest even though the borrower only had $25,000 per year in verifiable income.

(Collara, 2007) In this case, the lender assumed that there would be an additional $5,000 per

month in rental income from the property which was never realized. As a result, the borrower

was never able to afford the monthly payment and the property was foreclosed a year later. While

this is clearly an example of a fraudulent practice, it is also an example of a lender that is not

applying a sound default management strategy. However, as we will learn below, fault did not lie

with the bank only. In cases such as this, the parties underwriting the loan could also be called

into question. While they could defend their actions by referring to the information provided by

the borrower, what was needed was a default risk strategy that would question the validity of the

information provided in the loan application. Again, with the desire to penetrate a dwindling

housing finance market, the focus was on getting any customer available rather than application of

the specific theories of default risk in focusing more on the customers with little or no propensity

for default.

Clearly, an institution using appropriate risk management strategies would not have

approved the loan. Assuming that the lender would normally use a thirty-six percent debt-to-

income ratio, with the stated income, the borrower would not have been able to afford a payment

any higher than $750 per month. With certain assumptions, the actual payment on the originated

loan would be nearly $11,000 per month, nearly fifteen times what the borrower would be able to

afford.

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Additionally, another critical underwriting process under examination was the loan-to-

value ratio that lenders use to determine the amount of mortgage funding. Historically, lenders

would require borrowers to provide a down payment on the purchase of at least ten percent if not

more. The intent was that the down payment would mitigate some of the risk since the lender and

borrower were both investing in the property. While not at an equal share compared to the

lender, the loan was perceived to be of better quality since the borrower would not wish to risk

losing their investment in the property.

However, as the market began to surge, the required down payment began to drop. As

such, lenders were funding increasingly higher portions of mortgages. Additionally, lenders were

also offering customers both first- and second-mortgages where the second mortgage would be

used to fund a majority of the down payment. (Kroszner, 2007) The result of this is that the actual

risk related to the loan was hidden since on the surface, it appeared as though there was a lower

loan-to-value ratio related to the first mortgage. In addition, another outcome of this tactic was

that the borrower could potentially avoid paying a mortgage insurance premium since the first

mortgage funded less than eighty percent of the appraised value.

Another more fraudulent tactic that some lenders would use to address a high loan-to-

value ratio was to collude with an appraiser to artificially increase the assessed value of the

property. This would result in the mortgage value being a lower percentage of the home value.

To make matters worse, this fraudulent practice actually played a role in inflating property costs

in general. (Collara, 2007) While there was an initial benefit to purchasers early in the surge

where they did see an appreciation in value, it was short lived as prices are now starting to level

off or depreciate. (Kroszner, 2007)

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The result of all of these factors was that standard risk management tactics were either

avoided or ignored for the sake of customer access and loan generation. Lenders elected to

assume a significantly higher amount of risk of default in order to address what they perceived to

be the demands of the market. Furthermore, it appears that while there were a few lenders who

had a significant share of the sub prime business, it became the general practice throughout the

industry. As previously discussed, lenders found themselves with few options. They could either

follow a more conservative approach in being risk averse and lose market share, or they could be

aggressive, as many were, and enter the market at all costs. While the former may have been a

better approach from a safety and soundness perspective, banks were continually finding that the

shareholders were focused more on entry into a growing market than the potential risks

associated with default.

However, this was not simply a matter of avoiding proven standards of underwriting

strategies. Another cause of the current crisis was the range of new loan products that were

introduced in the market as well. Lenders were offering products that required little or no down

payments, interest only options, varied types of adjustable rate mortgages, and even loans where

the customer could select the payment amount they wished to pay. Again, the intent was to

provide customers with more options, but some of these products proved to be detrimental to the

market.

Adjustable rate mortgages have been available for years as an option to provide customers

with a lower initial interest rate with the chance that the interest rate could adjust in the future if

market conditions changed. However, there were also a wide range of adjustment rate periods

available for customers to select from. Mortgages were available that would adjust after one,

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three, and five years. Additionally, there were also mortgage products that would adjust once

only and others that could adjust every year after the adjustment period expired. These adjustable

rate mortgages turned out to be quite popular during the improved housing market. The interest

rates were typically much lower than a standard fixed rate loan and resulted in a lower monthly

payment as well. Therefore, since the payment was lower, consumers were under the impression

that they could finance a higher balance on the mortgage and get a better property. Even more

concerning with the assumption is that it allowed customers to potentially purchase property that

was beyond their means of affordability. (Bernanke, 2008) However, the optimism was based on

one assumption, that rates would never increase, and even if they did, the increase would be so

inconsequential that it would still be affordable. As we have learned now, that risks of that

assumption were high, and the assumption turned out to be flawed. What is interesting with this

situation was that the customer failed to follow an interest rate risks. As discussed in the Breadth

Section of this review, both the bank and borrower need to address issues on interest rate risk.

As the theory states, there is always some level of interest rate risk for the bank or the customer,

and either should be prepared to respond to changes in interest rates. As the current crisis clearly

defined, neither the bank nor the borrower were using a sound strategy in their assessment of

future interest rate risk.

Regardless of the adjustment period, starting in 2005, the market started to see the first

indications of a problem based on increases in loan delinquency. Clearly, this was an indication

that, as the first pool of mortgages began to reset, that the payments were no longer affordable.

To make matters worse, this particular issue is not over yet. As Bernanke (2008) noted in his

address to the National Community Reinvestment Coalition that nearly 1.5 million loans are

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scheduled to reset in 2008 alone. As such, while a bulk of loans have already reset with many

going into delinquency or default, there is still a large volume of loans that have yet to reach that

level.

Beyond the risk of a higher interest rate after reset, another confusing factor for the

consumer was an understanding what the realistic expectations for repayment were. In other

words, not only did borrowers not understand what the interest rates could go up to, but when

and if the changes would occur. This left the borrower with a limited understanding of the true

risk and outcomes associated with the reset. (Kroszner, 2007) The result of this is that

borrowers were unprepared to deal with the challenges of an increase in their payment amount

after reset and could not create a realistic long term budget for the household. As such, when

rates did adjust, customers had limited advance notice from the lender in order to prepare for the

increased expense. Without that preparation, borrowers found themselves in situations where

they could no longer afford to maintain the mortgage payments and quickly became delinquent.

Furthermore, the resulting delinquencies since 2005, when some loans began to reset, have

increased dramatically. As Bernanke (2007) discussed in his report to the House Financial

Services Committee that there has been a significant increase in delinquencies related to recently

originated sub prime loans. He goes onto further state that there was nearly a fifty percent of the

foreclosures in the first half of 2007 were from sub prime mortgages. Additionally, the increase

of delinquency after the first few payments was much higher in 2005 to 2006 in compared to any

previous historical data. This was a clear indication that mortgage payments were not affordable

by the consumer.

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A secondary assumption that many consumers made was simple overconfidence in how

the market performed in the future. As discussed above, customers made very risky assumptions

about the consistency of interest rates. However, consumers also made the assumption that

property values would continue to increase over time and that they would be able to quickly build

equity in the property. Additionally, many borrowers elected to borrow against their equity to

address other financial needs, some wise investments, others not. For example, some

homeowners would use equity to make improvements on their home and realize an increase in the

property value from the investment. On the other hand, many homeowners would access their

equity to pay off credit cards, buy cars and take vacations which would not be considered wise

investments or a good use of their equity.

Furthermore, when interest rates began to reset upward, demand for housing started to

drop as it was no longer as affordable an option. Even worse was that there was still a significant

of available property for sale. This resulted in home prices leveling off and in many cases

declining in value. Additionally, as Bernanke (2008) discussed, the mortgage performance data

clearly show that there is a direct link between price changes in hosuing and loan performance.

By meaning, even in a normal market where the stakeholders are risk averse, a problem can occur.

However, given the risky nature of this particular crisis, the issue of the relationship between price

changes and delinquency is made worse.

As discussed above, sub prime mortgages tended to be originated with much higher loan-

to-value ratios already. Additionally, we also need to take into account the common behavior of

accessing equity when the market was much more favorable in comparison to the current market.

As such, many borrowers now find that their mortgage is actually more than the real value of their

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property. Finally, in many cases, owners would walk away from these loans as there was no other

viable option to address the situation. (Bernanke, 2008)

The final major cause of the current crisis was the surge of securitized mortgages sold to

investors. Generally, in order to have access to funds to lend, lenders would package a portfolio

of loans and sell those loans to another bank or investor so as to generate more funds for future

mortgages and loans. This originate-to-distribute model was used widely in the mortgage

industry to provide increased access to capital markets beyond other banks and lenders.

(Bernanke, 2007)

However, there was an underlying challenge in this process. If the lender could quickly

sell off the mortgages to someone else, they would be less concerned about the risks associated

with the quality of that loan. As such, lenders were less concerned with adherence to generally

accepted risk management processes since the risk was to be assumed by someone else. To make

matters worse, it appears that this model of originate-to-distribution may have allowed lenders to

be looser in their underwriting standards. (Bernanke, 2007) Ironically, these are now the loans

that are going through their first interest rate resets in 2007 and 2008 and appear to be the bulk of

the loans now in delinquency and default.

Furthermore, what was lacking was a thorough understanding from the investment

community about the quality of the loans they were purchasing. In other words, the investors

failed to require information that would normally be in any risk management strategy for an

investor: detailed information about the quality of the loan. As with the lenders, the investors

viewed the investment in housing to be stable and would provide a consistent revenue stream. It

is clear that the idea of default, at least at levels we are seeing now, was never considered to be an

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outcome. As such, the investment community failed to effectively analyze the risk of the

investment, and made some inappropriate risk assumptions prior to acquiring the mortgage-

backed security. (National Mortgage News, 2007) Then, when investors began to ask whether

or not lenders changed underwriting standards to be less aggressive, the lenders denied that they

had many any substantive changes to their standards. (Coy, 2007) With that, the investors made

the assumption that these loans would perform at the same level as historical performance since

the same standards were used in the underwriting process.

Even more troubling is that the Wall Street firms who were the initial investors packaged

these securities and sold them to other investment firms outside of the United States. (National

Mortgage News, 2007) This took a problem in the United States and made it a global issue. This

global investment resulted in several investment firms and banks failing due to their significant

investment in poorly performing securities.

The result of this now is that we see that capital markets are much less willing to invest in

mortgage backed securities. Clearly, they have implemented some rather aggressive risk

management tactics as they are no longer willing to bear the significant risk they are now

experiencing. As such, lenders have less access to new capital for new loans to support any future

growth. Furthermore, this also impacts borrowers who wish to refinance as they are finding

lenders who are less willing to lend since they have less available capital available and limited

options for generating new capital. In effect, this has shut down the sub prime market completely.

(Bernanke, 2008) Additionally, this hesitancy of the capital markets to invest also had a negative

impact on the ability for lenders to sell prime loans to investors as there was a reticence to

purchase any type of mortgage backed security, whether it was sub prime or not. (Plosser, 2008)

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Finally, the last potential cause of the crisis was the action, or lack of action from the

Federal Reserve System to address the problems when the issues began to evolve and impact

market performance. While less than half of the sub prime loans originated from lenders regulated

by the Fed (Cole, 2007), the Fed can influence the performance of lenders outside of their

regulatory authority as well.

Some might conclude that the fluctuation of key interest rates between 2002 and 2006

was a cause of the current situation. While that may have played a role in the level of financial

confidence of consumers and developers, there were other issues related to the Fed’s regulations

that could also be considered as a cause. As discussed above, the indications of a problem began

to appear as early as 2005, but the crisis itself was not clear until 2006.

Quinn and Ehrenfeld (2006) provided a commentary on the inaction of the government on

addressing the issues in 2005. In their summary, they indicate that not only the Fed, but the

Securities and Exchange Commission, and the Office of Comptroller of the Currency also hold

some responsibility.

Specifically related to the Fed, they could have forced lenders to cease providing loans to

people who could not afford them in the first place. (Quinn and Ehrenfeld, 2006) Again, this

clearly is a part of loosened underwriting standards used by lenders to access more customers.

When the standards are not applied, the lenders have more ability to be creative with the standards

that they use in the process. Without effective supervision by the Fed, the lenders originated

loans that had nearly no potential for repayment.

Furthermore, they question the ability of the Securities and Exchange Commission to

effectively manage their regulated investment firms. In specific, the authors state that the SEC

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should have maintained a higher capital ratio on the loans that had a higher risk profile in

comparison to the capital requirements of prime loans. (Quinn and Ehrenfeld, 2006) In the event

that more capital was covered, the firms could maintain solvency at a better level since they did

not leverage their capital assets to purchase what turned out to be very risky investments. As

such, when the investment value plummeted, the investment firms did not have sufficient capital to

maintain their operations. With that, they failed.

Furthermore, the authors also indicated that the Office of Comptroller of the Currency

failed in its regulatory efforts. Specifically, they note that several state governments attempted to

take action against predatory lending practices, but the states were prevented from taking action

by the OCC. (Quinn and Ehrenfeld, 2006) With that, lenders were allowed to continue their

practices, unchecked, until the Federal Government took action to address the problems.

Stakeholder Response to the Crisis

Obviously, the stakeholders needed to take action to address the weaknesses that caused

the current crisis, but also to stop the crisis from worsening over time as well. As such, we will

examine the tactics by the government, lenders and investors to address the challenges going

forward.

Initially, the Fed elected to address the issues involving underwriting practices utilized by

their regulated institutions. In his speech to the National Community Reinvestment Coalition,

Bernanke (2008) described the proposed regulatory changes under consideration. The first step is

to address the issues of lenders providing financing to borrowers who clearly could not afford the

payments after purchase. The intent of this rule change is to address concerns over inappropriate

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loan-to-value ratios, income verification as well as realistic appraisals of property value and future

income if applicable.

Secondly, specific rules related to stated-income or no-documentation income loans are to

be addressed and eliminated. (Bernanke, 2008) Clearly, this is designed to address issues related

to the application of debt-to-income ratios and general disclosures of payment amounts over the

term of the loan. Along with the first rule change above, this also addresses borrower

affordability of the loan. The initial application of this rule took place at the end of 2007 when the

Fed elected to ban ‘liar loans’ which allowed for no verification of borrower income on the

mortgage application. (Hill, 2007)

Third, there would be a requirement for the establishment of an escrow account for taxes

and insurance on higher priced mortgages. (Bernanke, 2008) This rule is designed to address a

problem with borrowers having a lack of understanding of the true cost of the property. By

meaning, the customer may be able to afford the principle balance and interest payments, but may

not have set aside funds to pay for property taxes and insurance. As such, while they may make

their payments in a timely fashion, they may not be able to afford any assessed taxes or insurance

premiums on the property. This is especially true for loans that are already high priced in nature

where the customer is simply budgeting funds to make the required payments with nothing set

aside for other expenses. As such, the implementation of this rule would force the bank to set

aside those funds, as a part of the customer’s payment, to pay these fees directly.

The final rule reviewed was the elimination of pre-payment penalties for borrowers.

(Bernanke, 2008) Loans with pre-payment penalties would often force borrowers to be burdened

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with a loan they could no longer afford simply because they would be charged an excessive

penalty if they attempted to refinance or pay the loan off in full prior to the term ending date.

The Fed has also partnered with several industry groups to build a mechanism to license

mortgage brokers. This change is under consideration primarily to address the lack of consistent

training and regulatory non-compliance issues related to loans originated through mortgage

brokers. As the market surged, mortgages increased and more people were employed in the

mortgage industry. However, many of the people who worked with the consumer and limited

knowledge as to the process of loan origination beyond the application and some tertiary

qualification. With the establishment of an effective licensing and training model, performance of

mortgage brokers will be consistent with the legal framework of the industry. (Bernanke, 2007)

Finally, one area that the Fed continues to have challenges managing is the pricing models

for interest rates. As discussed above, the growth in the industry was primarily due to reductions

in key interest rates managed by the Fed. Then, once the market seemed to be getting too

volatile, they took action to increase interest rates to stave off any fears of inflation. Now, more

recently, the Fed has reduced rates again in order to limit the decline.

However, Plosser (2008) clearly indicates that the Fed does not see this as its

responsibility. What he is attempting to address is that throughout the downturn, the market

stakeholders would continue to look to the Fed for guidance and interest rate adjustments. The

underlying problem was that lenders were now facing difficulty in determining what interest rates

they should charge their customers as they had little insight into the true quality of the loan given

the lack of effective underwriting. The Fed can influence the market by adjustments to the

interest rates they control, but that the market would have to effectively assess the quality of the

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loan and how that quality or risk, would influence the actual interest rate assessed to the

borrower.

Furthermore, it was clear that lenders needed to change their internal processes or face

continued poor performance. As such, changes to underwriting requirements and their product

mix also needed adjustment. While many of these changes were the result of interventions from

the Fed, the lenders also needed to examine the changes and how the business would stabilize as a

result.

Underwriting standards were the first step in the process. Lenders became much stricter

on their standards and options such as no-documentation or stated-income loans soon disappeared

from most major lenders. While in many cases, lenders did not see significant losses investors

realized, they clearly understood that they would not be able to sell these loans in the future.

Along with the improved standards on income and value determination, standardized

requirements for minimum debt-to-income ratios for the borrower and loan-to-value ratios for the

mortgage and assessed property values were better managed.

Along with underwriting adjustments, the lenders also needed to examine the mix of

products they offered. As discussed above, there was a wide range of different adjustable rate

mortgages available with varied features. While most lenders will continue to offer adjustable rate

mortgages in the future, most of the creative features such as interest only payments, early reset

loans, or loans where the customer could determine the payment or even skip a payment were no

longer available in the market. For example, many loans that eventually defaulted were interest-

only loans where the customer would have the option of paying a significantly lower payment for

up to the first five years of the loan. While that is certainly an affordable option, none of the

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payment was satisfying the principal balance on the account. As such, when the five year period

expired, the customer now had the same balance at origination, but only twenty-five years to pay

the loan off. The resulting payment was much higher than the customer could afford. Along with

the declining property values, many customers found that they had made five years worth of

payments and built no equity, with a property that was now worth less than the mortgage owed.

Again, giving homeowners little alternative than defaulting on the mortgage.

Investors also took aggressive steps to address their exposure in the market. Where in the

past there was little oversight or understanding of credit quality of the loans, the investors were

now actively involved in the process. Not only did investors expect to have set standards for

underwriting and origination, but would also build in recourse provisions into any securitized debt

instrument. In these provisions, investors would be able to send the loan back to the originating

lender if it was no longer performing. (Cole, 2007) In other words, that the loan was no longer

current or in default. While this provision may not be generally applied to all lenders selling the

securitized instruments to investors, lenders with historically poor quality mortgages would find

that this recourse provision was now a requirement prior to any sale of the security.

While these changes would certainly improve credit quality of future loans, it also limited

the potential for those with questionable loans to resolve their financial difficulties. Lenders were

less willing to provide financing to sub prime borrowers who they had lent funds to in the past. If

a loan was available, it would likely be at a higher interest rate in comparison to the previous

mortgage, which would leave the borrower with very few options outside of foreclosure.

Finally, it was clear that the last step in the process was that all stakeholders needed to

work together to address the needs of borrowers who found themselves in difficult financial

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situations as a result of the crisis. With that, the Fed along with lenders and servicers have

developed programs to address customer requests for assistance as well as develop models that

might identify more risky loans that have yet to go into delinquency or default. (Kroszner, 2007)

The intention with these programs is two fold. First, to identify borrowers who may have

a higher risk of future delinquency and secondly, to work with customers nearing default. As

discussed previously, there is a large portion of loans where the first interest rate reset will occur

in 2008. As such, there is a significant pool of potential risky loans that have yet to be realized.

Since that is the case, the industry is taking steps to address the problem now rather than waiting

for the delinquency to occur.

These loss mitigation techniques and programs are designed to address an obvious

conclusion, that keeping the owner in their home is much less costly than foreclosure. (Kroszner,

2007) Lenders do not wish to own property which is the result of the foreclosure, they would

much rather have a steady payment stream from the borrower rather than no payment and

property that may not even satisfy the balance on the original note.

However, one challenge that has arisen is that the lenders are having difficulty getting the

borrower on the telephone to attempt to resolve the problem prior to foreclosure. The thought is

that the borrowers are under the impression that the lender does not really intend to help them and

is simply focused on getting paid. As such, the borrower avoids the contact all together. Given

that, the industry has taken steps to build relationships with local community advocates that are

more familiar to the borrower and may be able to serve as an intermediary in the process.

(Kroszner, 2007)

Conclusion

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Clearly, there are several examples where different stakeholders failed in their efforts to

make the market and industry successful. Customers were too optimistic about the future value

of their property and their monthly payments. Investors did not do sufficient due diligence to see

what they were investing in. The government failed in its effort to effectively address the

problems at the first sign of trouble. Finally, lenders were too lax on their standards of

underwriting and origination.

In the Application section of this review, we will examine the tactics and strategies of

lenders who have survived the current crisis as a basis for the development of a set of

recommended strategies to avoid this crisis from happening again.

APPLICATION

AMDS 8533: PROFESSIONAL PRACTICE: APPLICATION OF CORPORATE FINANCE

Introduction

As we have learned in the Depth Section of this review, there is a significant opportunity

for improvement for banks and lending institutions to not only address the current financial crisis,

but to better prepare their internal processes to avoid a crisis like this again. With that, we will

determine a set of best practices for banks that will effectively balance the needs of their

customers and shareholders. The rationale of this plan is to focus on the correct structures

necessary to support more effective credit and interest rate risk policies along with creating a mix

of products that provides sufficient selection for customers while at the same time creating more

stability for lenders.

Overview

As discussed in the Depth Section, the banks that clearly failed in the lending effort did so

primarily due to the fact that they had ineffective credit risk processes in place supporting their

lending programs. This was evident in the fact that lenders focused more on making the loan

regardless of quality compared to making a loan that was in the best interest of the bank and the

customer. Along with that, banks offered products that may have worked in the short term, but

failed to address any potential changes in the overall economy that could have put the loan at risk.

Some may conclude that this was a result of a saturated industry with lenders everywhere that

focused more on beating the competition, but in the end, this was more a structural failure in

nearly every step of the marketing, origination, and customer support processes used by most

banks.

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Establishment of an Effective Credit Risk Strategy

An effective credit risk policy must provide guidance that discusses the entire process of

loan origination. This would include the general lending philosophy of the bank, loan approval

processes, general rules governing all loans that a bank may choose to offer, loan pricing, required

documentation, appraisals and collateral, employee responsibilities, and after-origination support

for customers.

In the establishment of a lending philosophy, the bank is setting the major guidelines for

their lending business. For most lenders, this will define the market, by area and industry, where

the bank desires to provide credit. Additionally, the bank will review their performance standards

on effective community support and their performance to selected regulations that govern their

operations.

As an example of a lending policy, the bank would delineate the particular communities

they wish to serve. This delineation is typically at the branch and corporate levels. Once the

market is determined, the policy should also include a summary of the revenue and income goals

for the effort. Ideally, this summary should discuss the needs of the bank to provide quality

products and services to meet the needs of their customers, but to also focus their products and

services in areas where the bank can receive the best potential returns with the lowest risk of

delinquency or default.

If we refer back to the Depth Section, this is one area that clearly was not consistently

followed. As stated above, the banks that are now in financial difficulty failed on both parts of

this statement. The products that were offered to the market neither met the long term needs of

the customers nor the revenue and income needs of the shareholders. What was delivered,

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especially for the sub prime mortgages, focused more on short term generation of fee revenue

rather than long term income stability for the bank. Given the resulting delinquencies and defaults

in the sub prime market, the resulting loss for the banks far outweighed the gains in fee revenue

received.

The lending area is another area for consideration. Defining the lending area focuses the

bank on the areas where they have the best depth of knowledge and can make appropriate

decisions on extending credit. Typically banks will determine their lending area to resemble the

area where they accept deposits and other forms of business or in areas where the bank possesses

a depth of experience to effectively support their business operations. In addition, the lending

area is also defined within the requirements of the Community Reinvestment Act as noted in the

bank’s assessment area.

However, in looking at some of the challenges of the current crisis, this was another area

where lenders failed to fully apply. This is especially true with many of the virtual banks that

provided mortgages throughout the United States. The intent with these institutions was to gain a

foothold at the national level rather than focusing on a specific region or community. (Anderson,

2008) With this national exposure, the belief was that the bank would be able to get a larger

market share with significant revenues with little need for overhead expenses like branch

operations typically found with traditional lenders. However, this also opened the banks up to

significant risk as they had little opportunity to research particular areas of their operation. As

such, originated loans turned out to be quite risky as there was limited understanding of the local

economics or the potential for delinquency.

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As discussed in the Breadth Section, loan diversification is also a crucial part of the

lending policy. Most successful lenders will create a diverse portfolio of loans so as to avoid

situations where a downturn in a specific sector of the economy can have an adverse impact on

the bank’s performance. With that, most successful banks will offer commercial credit to a wide

range of businesses along with credit extensions to individuals on a range of products from

consumer loans to lines of credit. In addition to the product and customer mix, banks should also

determine their acceptable credit exposure to any one individual client or business. In other

words, it is not simply the number of loans that are offered to a particular group, but it is the

balance of those loans that are under consideration in the process.

This is another area where lenders failed to follow an effective diversification process. In

assessing the current crisis, the lenders with the most difficulties are those that focused specifically

in the sub prime market. Initially, this market was clearly underserved, and there was a need for

new entrants to the market. However, many of the lenders that entered focused on offering any

product to sub prime borrowers that they could qualify for. The result was that thousands of

borrowers found themselves with a mortgage that they could no longer afford. Thus, as

delinquencies began to rise, the sub prime lenders had few options in their credit portfolios that

could serve to offset the decline for these customers. As such, they found that they overall

financial position of the bank was deteriorating with very few options to effectively resolve the

performance. This issue further serves to justify the need for the bank to determine the specific

goals to diversify their credit portfolio.

Finally, the loan policy should provide an overview of all applicable government

regulations that pertain to the loan process. For the most part, there are two regulations that

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banks focus their performance on, the Community Reinvestment Act and the Home Mortgage

Disclosure Act. Given the influence these regulations have on the bank’s operations, management

should continually review the banks performance against the regulatory requirements and provide

a mechanism where operational adjustments can be initiated to address any deviations from the

regulatory requirements.

The next step in the process is to detail the steps necessary for loan approvals. Generally

speaking, banks should have different levels of approvals that are dependent on an individual

officer’s position within the bank. By meaning, the President of the bank would normally have a

higher level of approval authority in comparison to a loan officer.

In addition to the determined approval levels, the overall responsibilities of loan officers

should be developed and implemented. This is a critical step in the process as the loan officers are

typically the first and only contact that a loan applicant will have with the bank and their

performance is an integral part of loan origination. In most banks, the loan officer works with the

individual borrower to determine needs and the applicable products that would meet their needs

and qualifications.

Within those requirements, the loan officer is the individual responsible for determining

whether an applicant meets the specific underwriting standards for the loan they are applying for.

As such, the loan officer must be responsible for customer adherence to the credit standards

determined by the bank. Within the credit requirements are areas such as income verification,

credit score, previous payment history on other debts and several other areas that determine the

creditworthiness of the borrower.

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However, this is another example of where a process was either not followed or not

implemented appropriately in several banks leading to the current crisis. In the Depth Section, we

have noted several examples where the credit quality of loans was either not considered an issue,

or the standards used were not properly followed. Additionally, there are several examples were

loan officers participated in fraudulent activities where the credit quality was actively ignored for

the sake of making the loan. With that, it is necessary that the loan officer be expected to manage

credit quality and their individual performance be measured, in part, on this factor.

Once the loan has been originated and disbursed to the borrower, the next responsibility of

the loan officer is to monitor the payment status of the borrower. In other words, the loan officer

needs to manage the receipt of principal and interest payments received and ensure that the

payments are received in line with the expectations in the loan agreement. While some might

think that this requirement should not apply to loan officers as it might be challenging for a larger

bank, it should still be considered a responsibility as it is a direct reflection on the quality of debt

that the loan officer is managing. By meaning, it is in the loan officer’s best interest to ensure that

the loan that they agreed to offer is current on payments.

This is yet another area of weakness for many of the troubled banks in the current crisis.

Furthermore, it is especially true of banks that worked through, or purchased loans from brokers.

As we discussed in the Depth Section, there was less incentive for loan officers or brokers to

manage payments as they were more focused on the next new customer applying for a loan.

While from an efficiency perspective, this ‘hand off’ to other departments, such as loan servicing

operations, may have helped maintain a flow of new business, the lower level of loan officer

accountability on payments may have also been an underlying cause to the current crisis. With

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that, it would be prudent to consider moving this responsibility back to the loan officer as they

have the closest relationship with the customer.

In general, loan officers should also be responsible for maintaining the appropriate

documentation for their pending and completed loan applications. The specific documents should

be tailored to the specific loan type and general requirements of the bank. At a minimum, this

should include items such as the loan application, credit and income information, detailed

collateral summary including appraisals and documents completed at the closing of the loan. In

addition, in the event of a commercial loan, the documents should also include information on the

company, its owners or shareholders, as well as research on the related industries where the

customer is a participant. The intent with this information is to serve to justify the extension of

credit from the bank to the customer and the terms of that credit extension.

The next step in formulation of the bank’s credit policy is to determine the types of

desirable loans the bank wishes to originate. This list should be correlated to the general business

practices of the bank and their related areas of expertise. For personal lines of credit, desirable

loans can include first and second mortgages, car loans and credit cards. For commercial loans,

these loans can include construction and equipment loans as well as secured letters of credit.

However, regardless of loan type, desired loans are typically secured with some form of reliable

collateral and are extended based on an established credit history that would fairly indicate that

the loan would be paid back to the bank.

Additionally, it would be advisable for the bank to establish a summary of potential

exceptions as well as the processes associated with addressing exceptions to the stated credit

policy. Exceptions can be defined as loans that would normally meet the bank’s credit risk

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requirements, but there may be certain subjective indictors that may call into question the

propensity for the loan to remain current after disbursement. Some of these exceptions would

include any conditions that may impact repayment of the debt. As an example, if the repayment is

contingent on an individual receiving payment from another source where that source may be

questionable. For commercial loans, an example would be where the bank is facing difficulty in

establishing the actual value of the collateral used to secure the loan. In any case, if repayment or

purpose of the loan is questionable, the bank should have a process in place for secondary

approval or denial of the loan. While there is no ability to justify every exception that could

occur, the bank should rely on its experience in the community and related industries to identify a

reasonably conclusive list of exceptions to give the proper guidance to the loan officer.

Once the customer has been approved, the next step in the credit risk policy is to establish

guidelines for collateral for loans. Ideally, a bank should have collateral that is equal to the value

of the loan to provide the needed level of security for repayment. Obviously, in the case of a

home mortgage, the collateral, the house, is clear, but there are a wide range of other collateral

options that a bank should consider for the different loans that it chooses to offer. However, as

with other parts of the credit risk policy, the bank should possess deep knowledge as to the

appropriate valuation of the collateral, as well as the type of collateral under consideration.

The first type of collateral for consideration is marketable securities. Securities can be in

the form of stock, bonds or other securities the borrower may possess. In situations such as this,

it is not advisable for the bank to consider the present value of the security to equate to the

amount of the extended loan. By meaning, if a customer holds $100,000 in marketable securities,

it would not be appropriate to extend a $100,000 loan based on that as collateral. The challenge

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with marketable securities it that their value can change over time, and in the event that the value

drops, the applicable credit risk increases resulting from the disparity between collateral value and

loan value. With that, banks should adopt a valuation method that properly accounts for

fluctuations in collateral value so as to more effectively align it with the loan value. While there is

not a specific method that banks should use, they should first determine what discounted value

they wish to consider for the security.

In addition to marketable securities, commercial loans can also be collateralized against

items such as accounts receivable or inventory. In reference to accounts receivable, the bank

should establish methods of consistently evaluating the quality of the receivables as far as amount,

source and duration of payment. Additionally, as discussed above, this may also be considered

within the framework of a credit exception plan in the event that loan repayment may be

contingent in receiving payments due from customers of the borrower. In regards to inventory

and equipment, the actual value can come into question as well. For example, depending on the

type of inventory, there may be a shelf life of the product that may expire within a specific

timeframe. Equipment behaves in a similar manner to inventory items in that it does depreciate

over time, as such, the useful life of the equipment needs to be considered to determine its current

value and ability for that value to be used as collateral for the loan.

While somewhat related to using inventory or accounts receivable as collateral for a loan,

Asset Based Lending processes are focused on inventory and receivables as the primary source of

repayment. By meaning, the resolution of accounts receivable or the sale of inventory will

generate the funds necessary for the loan repayment. As discussed above, these loans can also fall

into the exception categories. This is not to say that banks should not consider asset based loans

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to their commercial customers. However, as the values of receivables and inventories for sale can

fluctuate wildly, there should also be an established process of monitoring the performance of

receivables and inventories for sale so as to assess any changes in the risk profile of the loan.

Finally, and one of the more common forms of collateral are loans that are secured by real

estate. This is where the processes associated with home mortgages or mortgages for commercial

property. For the most part, the assessed value of the property can serve as adequate security.

However, this is another area where a weakness in process led to the current mortgage crisis.

As discussed in the Depth Section of this review, the quality of the property assessments

for many homes was called into question. This is primarily due to issues of fraud where assessors,

real estate agents, and loan officers colluded to artificially raise property values so as to generate a

higher loan value. As we are starting to see now with the drop in property values, the quality of

the property as security is coming into question. While the fluctuation in home value is not as

volatile as other forms of collateral, most banks will establish a list of reliable assessors who

would be able to provide the most realistic expectation of either residential or commercial

property value for use as security for the loan.

The next step in the process is to identify the primary guidelines for underwriting loans.

Clearly, the bank should focus on providing loans that have a have level of security as well as a

propensity for repayment in line with the terms of the loan. (National Mortgage News, 2008)

While those are very standard goals, the bank must also take steps to properly define the

guidelines and apply those into the specific underwriting standards related to each loan type and

applicant.

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Furthermore, the primary focus for any reliable underwriting framework should be defined

by the level and quality of collateral provided to secure the loan and the related documentation of

the collateral. There should also be documented access to the sources of repayment of the loan.

Finally, if applicable, the process should include information related to any recourse provisions

related to the loan in the event that the loan was originated by an outside lender.

Now that we have the established framework for underwriting, we now need to identify

the specific standards required for underwriting loans. For the purposes of this review, we will

focus on the standards necessary to effectively underwrite owner occupied residential property.

As discussed above, a borrower’s creditworthiness is defined by two factors, the

borrower’s credit history and their likelihood that they will repay the loan according to the terms

in the loan agreement. Beyond that, the bank will consider a wide range of underwriting criteria

in assessing overall creditworthiness of the borrower. The criteria can range from selected ratios

to credit scores that can give insight into the quality of the borrower along with the applicable

mortgage products that would be available.

The first stage of the process is that the customer completes a loan application that details

their income and employment history as well as information about established credit. Along with

the income, the application will also ask the applicant to provide details on their debts or other

payment obligations to outside parties. With the information detailed on the loan application, the

bank can begin the assessment process to determine the creditworthiness of the borrower.

With the completed application, the bank then begins its assessment of borrower income.

This income information serves as the basis for determining the ability for the borrower to pay the

loan back is documented history of their income. Typically, banks will require at least three

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months of income information from the applicant. In this information, the bank is able to

determine consistency of the income and make a fair assessment that the income will continue into

the future. In addition to income information, it is often advisable for the bank to request copies

of the previous year’s tax return to further document the consistency of income.

The next step in the process is to identify the other expenses the borrower is currently

obligated to pay. This is usually included as an item on the loan application. These

responsibilities should include other non-utility debts such as credit card payments, car payments

and any other debt that requires a monthly payment to satisfy an outstanding balance. The bank

should also collect information on the minimum payment required, the remaining outstanding

balance and the anticipated date that the loan will be paid in full. It is also advisable that the bank

solicit information on non credit payments such as utilities, cable television and cellular telephone

bills as these obligations will likely remain consistent over time. With that information, the bank

can assess the maximum monthly mortgage payment that the borrower could afford. In addition

to the overall balance available for the mortgage, any existing debt held by the borrower can also

limit qualifications for certain mortgage products based on potential risk indicated by the existing

debt and how that debt will be managed when the mortgage is added as a new obligation.

In order to effectively standardized affordability, the bank will consider two ratios that will

examine expenses and income to assess affordability. Those ratios are Expense to Income and

Debt to Income. (Lerner, 2007) The expense to income ratio specifically relates to the total cost

of home ownership. The expenses would include the principal and interest payments, mortgage

insurance if applicable, property taxes, homeowner’s insurance premiums and any homeowners’

association dues if applicable to the property. For the most part, banks that have survived the

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current crisis used this as a standard to determine an affordable payment as well as the total

mortgage available for the borrower. However, as we learned in the Depth Section of this review,

several banks would focus only on the principal and interest costs and ignored the other factors.

The result of this was that when property taxes and other expenses were figured in, the borrower

could no longer afford the payment and soon became delinquent. (Mortgage Line, 2007)

The debt to income ratio builds upon the expense to income ratio to include all other debts

and obligations that the borrower currently maintains. This ratio typically includes items like

credit card debt, car payments, alimony and any other monthly obligations outside of the

obligations required of the mortgage. While some of this information may appear on a credit

report, the intent is to get a full understanding of all obligations that the borrower may have in

order to fully assess the maximum monthly mortgage payment they can afford.

While the information the customer provides on the loan application is self reported, the

bank must also retrieve the customer’s credit history from at least one of the three national credit

bureaus. This information not only serves to verify the information that the customer included on

the loan application, but it also serves a secondary purpose of assessing the applicant’s historic

payment performance, delinquencies, defaults, foreclosures or judgments against them. Along

with providing details on the applicant’s payment history, the bank should also request a detailed

credit or FICO score that the bank would then use as a benchmark assessment for their

qualification for a mortgage.

Along with the general qualification process, the credit or FICO score is also used to

determine the eligibility for particular loan products as well as the interest charged for the

mortgage. The idea being that with a lower credit score, there is inherently more risk associated

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with the loan. As such, the bank will likely charge a higher interest rate in an attempt to mitigate

that risk. In addition, in the event that a bank will eventually sell the loan to a third party, that

third party will set specific standards on minimum credit scores and related products as a

qualification process to purchase the loan.

Along with that, the FICO score should also determine what additional steps in the

underwriting process may be necessary in order to offer the loan to the customer. By meaning,

those applicants with a significantly high credit score will go through a simple review in

comparison to those with a lower than average credit score that would require further research

before determining whether the applicant would qualify for the loan.

In the event that there is derogatory information about the applicant from the credit

report, the bank should provide guidance to the applicant as to the specific information provided

from the report. From there, the bank and the applicant can discuss the information to determine

the causes and the validity of the information provided on the report. In the event that the

information is in dispute, the bank should provide the information necessary to dispute the

information with the applicable credit bureau. In most cases, it is often better to attempt to

resolve the discrepancy rather than continue with the underwriting process. In the event that the

dispute can be resolved in the applicant’s benefit, the resolution may result in an improved credit

score that may provide eligibility for other products that may not have been available with the

previously existing credit history. However, the bank should not make their own assumption or

judgment about the validity of the information on the credit report as it is at the discretion of the

reporting credit bureau to investigate the dispute and take appropriate action to correct the error.

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Furthermore, this qualification process is designed to address several issues of

securitization that arose in the current mortgage crisis. As discussed in the Depth Section of this

review, thousands of risky loans were passed off to investors with those investors now seeing

their investment plummet in value due to the increase in defaults that could have been addressed

and identified in the underwriting process rather than after the fact when the loan was sold to the

investor.

Finally, the bank will also examine any liquid funds available in savings or checking

accounts as well as retirement accounts that could not only serve to provide funds for a down

payment, but can also be available for making monthly mortgage payments if other sources of

income are not available. Typically, the customer will provide the account information in the loan

application, but the bank should also take steps to verify the balances on account. Ideally, these

savings or retirement accounts may also be with the bank that is providing the mortgage, but it is

not required that the mortgage customer also be a savings customer of the bank.

Once the product is determined and offered to the customer, the bank can then go through

the processes associated with pre-qualifying the customer for the loan. Based on the credit score,

income information and existing obligations, the bank can determine a maximum amount that the

customer could have financed in their home purchase. This maximum purchase price should also

include assumptions about the amount of funds that the borrower will be providing as a down

payment towards the property purchase.

The down payment requirement for mortgages has been consistent, even in the run up to

the current mortgage crisis. However, there is a clear correlation between the quality of the loan

in reference to repayment and the percentage the customer provides for their down payment on

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the purchase. By meaning, customers who typically provided a higher percentage down payment

on the property were much less likely to become delinquent or default on the mortgage.

This is another area where the process failed in the lead up to the current mortgage crisis

in the United States. As discussed in the Depth Section of this review, many of the sub prime

mortgages offered in the market required little or no down payment from the customer. As such,

the customer failed to establish any equity in the property and would bear minimal risk in the

event of a default and foreclosure. (Lerner, 2007) This could be completed by having the bank

finance one hundred percent of the mortgage or in more creative options offer a combined first

mortgage that would provide eighty percent of the financing with a second mortgage that would

provide the other twenty percent necessary to purchase the property. Not only did this remove

the requirement of the borrower to pay a monthly mortgage insurance premium, but when the

loan was securitized and sold off to an investor, it would appear that the borrower had provided

twenty percent of the purchase price of the property as a down payment when that was not the

case.

As such, banks are now becoming stricter on their down payment requirements for new

mortgage applicants. However, different products require different down payments from the

borrower. For example, the borrower may see that they would qualify for a lower interest rate

mortgage if they provided a higher portion of funds for the down payment, and perhaps a higher

interest rate with a lower down payment. In this case, the bank is using interest rate as an

indication of risk aversion. With this pre-qualification information, the borrower can now begin

the process of selecting the property they wish to purchase. (Lerner, 2007)

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Once the borrower has selected a property that they would like to purchase and finance,

the next step in the process is to complete an assessment of the property to determine the actual

value and applicable mortgage loan value. However, there is much more detail to the assessment

than simply determining the value of the property. With the detailed analysis provided in the

property assessment, the bank can appropriately identify whether the property value will be

consistent over the term of the loan.

The first stage of the assessment is to provide a narrative description of the property. This

should identify whether the property is a single dwelling or multiple unit building such as a

condominium. The summary should also include an overview of other properties in the

neighborhood as well as the mix between commercial and residential property in proximity to the

property under review. Finally, the summary should include information, where known, about

changes in the neighborhood such as new construction of commercial or residential property as

well as any infrastructure changes that are planned in the near future.

The next stage in the assessment summary would include a description of the property

itself. This should include information such as usable square footage in the interior, number of

bedrooms and bathrooms as well as any land that is associated with the property. Finally, the

report should also include information that would have a negative impact on the value of the

property including items such as conditions of the roof, major appliances or plumbing.

At the conclusion of the assessment, the assessor will draft a report that provides the

information noted above as well as the estimated or appraised value of the property. Also, if there

are any items requiring repair or improvement, the report will include an estimate of those costs as

those improvements will have an impact on the overall appraised value of the property.

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Finally, the bank will then review the assessment and make any adjustments to the offered

mortgage where applicable. Assuming agreement between the borrower and the bank, the final

stage of the process is to complete the origination of the mortgage and proceed to the closing and

purchase of the property.

Effective Preparation for Interest Rate Risk

Along with the risks banks face in the loan origination process, they also must tightly

manage their balance sheet to address the issues related to interest rate risk. As we discussed in

the Breadth and Depth Sections of this review, interest rate risk relates to the analysis of how the

fluctuating value of interest paid and interest received can impact the performance of the bank.

As interest revenue is the key revenue generator for a bank, changes in value can have a

significant impact on the bank’s overall performance.

The part of an effective interest rate risk management strategy is the formulation of the

management structure that oversees the strategy. For most banks, this falls under the

responsibility of the Asset and Liability Management Committee of the bank. The function of the

Asset and Liability Management Committee could be best described as the managers of the

balance sheet for the bank. They tightly manage the revenues and expenses as well as the

performance of income generating assets of the bank.

Following a standard Asset and Liability Management strategy, the Asset and Liability

Management Committee will regularly examine the current interest rate risk profile of the bank.

The first stage of this analysis involves an examination of the current net interest income received

by the bank’s assets. Using the current status as a benchmark, the bank will also model scenarios

where there may be an increase or decrease in interest rates in the future. That model will then

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summarize how changes in the interest rate have the downstream impact on interest rate margin as

well as net income received by the bank.

As we discussed in the Breadth and Depth Sections of this review, key interest rates have

had significant adjustments in the past ten years. Under the leadership of Alan Greenspan and

Ben Bernanke, the Federal Reserve has taken actions to reduce key interest rates to spur

economic growth and then raised interest rates to address concerns of inflation. While there have

been times where the key interest rates have been consistent over time, banks still need to prepare

for future actions by the Fed and markets in general, and how those actions will impact interest

rates.

As an example, we can consider the interest rate issues in the 1980s where interest rates

for mortgages and deposits were quite high. As such, the Fed took action to significantly reduce

interest rates to improve the housing and related credit markets in the United States. However,

many banks did not effectively prepare for those changes and found themselves with significant

reductions in interest income from new mortgages at lower interest rates while still being forced

to pay higher interest rates on existing deposit accounts originated when rates were much higher.

The result of this was that many banks failed primarily due to the liabilities, deposit accounts,

costing more than the assets, loans and other credit.

We witnessed a similar issue in the lead up to the current mortgage crisis where the Fed

took a similar action to reduce interest rates to improve the performance of the housing market.

However, in this situation, the banks were better positioned to deal with the fluctuation, but the

borrowers were not. The result, as discussed, was that mortgage payments were no longer

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affordable. In this case, most banks properly managed their assets and liabilities, but the

customers did not.

In general, interest rate adjustments have a direct impact on credit where the interest rate

can change based on the performance of the market. In the mortgage industry, this would be an

adjustable rate mortgage. In the event of upward adjustments or resets to a borrower’s loan, the

bank would build that adjustment into the model for their asset and liability management strategy.

Clearly, there is a benefit where the bank’s liability costs remain consistent, but the interest

income increases due to the adjustment. However, the same is not true where interest rates

decrease.

In the event that key interest rates go down, the bank may be limited in their ability to

reduce the interest expense as most of their liabilities may have fixed interest rates. However,

there is significant risk to the interest income. In the event that there is a significant reduction in

interest rates, borrowers may consider refinancing existing debt so as to lower their interest rates

and related monthly payments. As such, the Asset and Liability Management model will also

include calculated tolerances to predict the point that certain customers would refinance and the

impact that activity has on the overall performance of the bank.

The result of these models is normally a modeled statement of cash flow that will typically

forecast financial performance into the next twelve month period for the bank. With this

information, the Asset and Liability Management Committee can better assess what interventions,

if any, they should recommend to better position the balance sheet to avoid a significant change

due to interest rate fluctuations.

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From the statement of cash flows, the Asset and Liability Management Committee would

then examine all sources of funding available to the bank and how the model forecasts any costs

adjustments for those sources. The Asset and Liability Management Committee can then use this

information to determine whether certain funding sources should be reevaluated by the bank.

Finally, the Asset and Liability Management Committee will then use the model

information to determine pricing updates for their credit products. In other words, if they are

seeing a likelihood of increases in interest expense, they will adjust pricing for future loans to

adjust for that cost. These actions are clearly evidenced by the management of the net interest

margin measurement where this margin is the difference between the cost of funding and the

income received from extended credit.

This is another area where several banks are currently facing financial difficulty resulting

from the mortgage crisis. This is especially true of banks that focused their product offerings in

the sub prime market. While for a significant period of time, these banks prospered due to low

interest rates and significant improvements in customer and loan volume. However, once rates

began to increase, the customer interest dropped. With that, these lenders found themselves in

situations where cash flows began to drop.

In the normal operations, these lenders would originate loans and quickly package and sell

them off to third party investors. This would then generate new cash for future loans. With that,

instead of interest income being the primary source of income to the bank, these organizations

focused more on fee income. Since the loans were quickly sold off after origination, there was

limited access to interest income, but the lenders would often maintain loan servicing and would

continue to generate fees associated with that from the owner of the loan.

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However, as the industry began to sour, the lenders found that their fee revenues began to

drop due to the lower number of new loans originated by the banks. Additionally, the net income

from servicing revenues began to drop as well. This was due to two primary factors. First, as

loans became delinquent and eventually defaulted, there was no longer a need to provide servicing

from the originating lender. As these loans became increasingly larger portions of the servicing

portfolio, the revenues received steadily decreased. Secondly, in the process of delinquency, there

was much more work involved with the customer to attempt to resolve the delinquency or to

complete the default and foreclosure processes. This extra work resulted in extra costs associated

with the servicing of the loan. As such, the profit margin decreased or was eliminated as the costs

began to overwhelm the revenues received.

Even more troubling was that the sub prime lenders found that they were no longer able to

sell many of the loans they maintained on their balance sheet to investors. As investors became

more aware of the issues with these loans, they were much less willing to purchase them. While

there were still investors involved, the requirements of the sale were significantly different in

comparison to the past. The days of purchasing any loan regardless of the underlying quality

were no longer available. The investors still participating would build in requirements such as

recourse provisions that would allow the investor to return a delinquent loan to the originator and

allow the investor to keep the loans that were current and of better quality.

This left the originating lender with a portfolio of low quality loans that investors were not

willing to purchase. Along with that, the borrowers were not making the monthly payments to

the lender either. With that, the lenders had significant low quality assets on their balance sheets

that were not generating the anticipated interest income. In addition, they also found that they

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were no longer able to satisfy either the interest or principal of their liabilities with the significant

decrease in their income. As such, many lenders failed. What is interesting though is that the

failure was not the result of an imbalance of assets and liabilities; it was due to a failure in

liquidity.

The result of this is that many of the previously successful sub prime lenders failed and

sold their existing portfolios to other institutions. An example of this is the acquisition of

Countrywide Financial by Bank of America. At one point in its existence, Countrywide Financial

maintained nearly twenty four billion dollars in assets. At the conclusion of the sale, Bank of

America bought the assets of Countrywide Financial for roughly four billion dollars, a fraction of

its original value. If anything, this is a reflection on the perceived value of the assets. While the

face value of the loans was significant, Bank of America needed to consider how the acquisition

of the portfolio could impact their overall Asset and Liability Management strategy. As such,

Bank of America examined the realistic quality of these loans and the likelihood that they would

continue to generate interest income as well as the potential that the loans could eventually be

sold off to a third party. Seeing that the quality was low, Bank of America was only willing to

pay a significantly discounted price in order to account for risk and build that risk into their Asset

and Liability Management Models.

Creating an Effective Product Mix

In order to create a product mix that best addresses the risk management needs of the

bank while managing the needs of customers has proven to one of the primary causes of the

current housing crisis in the United States. For the most part, the banks that are surviving the

crisis focused their efforts on providing a limited number of exotic products, but not focusing

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their entire business on that operation. This is in contrast to sub prime lenders who concentrated

their efforts on products that were tailored to their particular audience. As discussed above, this

focus on a smaller market with higher risk resulted in the collapse of many lending institutions.

In order to gain an understanding of the market prior to the crisis, we must first review the

different mortgage products originally in the market. While some of these products are still

offered to customers, most of the flexibility in underwriting is no longer available.

Adjustable Rate Mortgages or Hybrid Mortgages have been available in the market for

many years. In general, these loans will offer a lower initial interest rate at the start of the loan

and then have the potential for interest rate adjustments or resets depending on future market

conditions. Most lending institutions will offer a variety of adjustable rate mortgages that can

have reset periods that occur after one, three or five years of life. Additionally, after the reset

period, the loans also include the option where the interest rate adjustment can occur annually

after the initial reset period. Generally, these resets are based on changes to the Treasure Bill

rates or the London Interbank Offered Rate or LIBOR. In the event of an upward adjustment in

either of these indices, the interest rate charged to the customer will reset at an equal pace.

However, adjustable rate mortgages are not considered sub prime in nature. They typically offer

customers a lower initial interest rate in order to compensate for the risk associated with the

potential for a future upward adjustment. While there has been significant criticism of adjustable

rates in general as a cause to the current crisis, however, there were only a few types of adjustable

rate mortgages that proved to be of low quality.

An example of an adjustable rate mortgage that could be considered low in quality would

be products that offered an excessively low ‘teaser rate’ for the initial period of the loan with the

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potential for a much higher adjustment resulting from market changes. (Mortgage Line, 2007)

As an example, most traditional adjustable rate mortgages will call for a cap of a two percent

upward adjustment if justified by the market. These more exotic adjustable rate mortgages

offered a lower initial rate with the risk of a three percent or more adjustment if market conditions

changed. As we see now, those significant adjustments did occur for thousands of customers who

saw their monthly mortgage payments increase much more than anticipated.

As such, the successful banks focused on providing adjustable rate mortgage products that

would offer a more realistic initial interest rate with a two percent cap on adjustments. Along

with that, the successful lenders would proactively disclose the upward risk of future payments in

the event that an adjustment was called for. This would allow the customer to have a complete

understanding of what the current obligation would be as well as what the future worst case

payment could occur as well as the timing of the adjustments. While delinquencies for adjustable

rate mortgages did increase in the lead up to the current crisis, the portion of the delinquencies

related to the more traditional adjustable rate mortgages were insignificant compared to the

delinquency rates of the exotic adjustable rate mortgages discussed above.

Another variant of adjustable rate mortgages were mortgages that provided an

opportunity for borrowers to either pay only the accrued interest or so called ‘pay option’ loans

that would provide customers to pay either the principal and interest, interest only, or a minimum

payment that in many cases did not satisfy the accrued interest. As we are now seeing, these

loans were quite problematic as the majority of customers would choose to make a lower payment

and not satisfy the amortized portion due that would eventually pay off the loan within the stated

terms. The result was that the borrower eventually found themselves with less time to pay off the

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interest and principal than planned. Additionally, they found that with the lower remaining period

of amortization, their mortgage payments increased significantly, in many cases much more than

they could ever afford.

While variations of these pay option loans still exist, they go through a much more

stringent underwriting process. For example, the Federal Home Loan Mortgage Corporation, or

Freddie Mac offers a five year interest only mortgage. However, this loan requires underwriting

that takes into account the fully amortized monthly payment in their standards. (Mortgage Line,

2007) In other words, in order to qualify for the loan, the borrower must be able to afford the full

monthly payment of principal and interest rather than simply focusing on whether they can afford

the interest only payment offered during the first five years of the repayment period. As we have

discussed previously, this underwriting method was not used by most sub prime lenders. As such,

loans of this type have seen much higher delinquency rates. However, even with Freddie Mac

endorsing these loans with the new underwriting criteria, most banks are not offering these pay

option or interest only products to their customers due to the continued perception that these

loans are much riskier in comparison to more traditional mortgages.

The next loan type would offer borrowers the opportunity to finance up to one hundred

twenty percent of the appraised value of their property. This was commonly used when

borrowers wished to make additional upgrades to the property and needed funds to pay for the

changes. However, these loans were inherently risky from the start in that the borrower would

not be required to provide funding for a down payment, and the recovery value of the loan was

limited as it was already over leveraged in the first place. As such, this was a loan product that

the more successful banks avoided all together. Clearly there was a market for the product given

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the volume of the issued loans leading up to the current crisis, however, an effective Asset and

Liability Management strategy would need to incorporate the higher risks associated with the

loans and the limited ability to sell off the loans. Like the other loans discussed above, these high

leverage loans were typically offered by mortgage brokers and rarely offered by traditional banks.

As discussed above, loans that require little or no down payment will naturally have a

higher propensity for default. Beyond the fact that the customer has a very limited investment in

the property, these products run the risk of being over leveraged in the event of a decrease in

assessed value of the collateral for the loan. For the most part, loans that provide financing for

greater than one hundred percent of the property value are no longer generally available.

However, there are several providers that will offer a one hundred percent product to qualifying

customers. For example, Freddie Mac provides products that require down payments from zero

to three percent of the purchase price. However, these loans also require a high borrower credit

or FICO score to qualify for the mortgage. (Mortgage Line, 2007)

Another type of formerly common loan product were stated-income mortgages. When

applying for these mortgages, borrowers would simply be required to provide their income

information on the loan application and would not be required to fully verify the validity of that

information. Again, quite risky as there was significant opportunity for fraud or incorrect

information. As discussed in the Depth Section above, there were several examples of stated

income loans that borrowers stated a much higher income in order to qualify for the loan. While

many banks still offer stated income loans, the underwriting process has changed significantly.

(Mortgage Line, 2007)

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As banks complete the underwriting process for stated income loans, they are now

soliciting previous tax records along with requiring verification of employment. While the intent

of these loans was to provide a financing option for sole proprietors or self employed applicants,

the need to adjust the underwriting requirements was clear. In other words, there continues to be

a strong market for a product of this type, but the more effective banks followed a more risk

averse underwriting strategy to avoid the risks associated with these loans. As such, those banks

that followed a more rigorous underwriting process found that the risk of delinquency and default

was minimal. Those organizations that did not follow as stringent an underwriting process found

that stated income loans were very poor performers.

Finally, the consistent performers for most banks are fixed-interest rate mortgages. Both

the borrower and bank received benefits from these loans. The banks could appropriately manage

not only the risk, but the long term income from the asset within their asset and liability

management models as well. Borrowers received the benefit of a consistent mortgage payment

over time that was not sensitive to market conditions and provided them with a much easier

household budgeting process. In general, fixed interest rate loans performed much better during

the current crisis compared to both adjustable rate and sub prime loans in the market.

Therefore, lenders that were able to balance a consistent income from their fixed interest

assets along with a conservative approach to the sub prime customer base with products that were

more realistic for the borrower to afford and pay over time. Those banks that failed found that

they focused too much of their business on the riskiest customers and products and did not

effectively balance that risk with a wider variety of more traditional products that could have

served to mitigate the risk and loss that eventually occurred.

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Conclusion

It is clear that there were varied causes for the current mortgage crisis. The successful

banks were able to effectively project the risks before they occurred. The result of this was that

the successful banks were able to offer loan products that addressed the market need but based on

underwriting criteria were of much higher quality and had minimal risk of delinquency and default.

In addition, the successful banks closely managed their asset and liability strategy to balance both

the needs of the customer and the bank.

The banks that failed clearly did not manage to a long term strategy. In part this was due

to the process of immediately selling the loans to outside investors shortly after origination.

However, the challenge those banks discovered was that they did not effectively prepare for the

potential that some external event would put that process at risk, which is exactly what happened.

As such, the failed banks found that they were no longer liquid and failed.

The result that we see now is that the remaining banks are providing similar products but

being much more conservative on their underwriting criteria. (Anderson, 2008) The intent is to

offer the customer a product that will best meet their individual needs and limit default risk for the

bank. This was clearly in contrast to history where the focus was on the product that would get

the customer to commit, regardless of the terms or risk.

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REFERENCES Anderson, M. (2008). Bloomington-based U.S. Bank’s old-school mortgage biz thrives. Finance

and Commerce (Minneapolis, MN). Bessis, J. (2002). Risk management in banking. New York: John Wiley and Sons. The B&C blame game: many victims, many culprits. (2007). Mortgage Line. BERNANKE, B. (2007). MORTGAGE FORECLOSURES. FDCH Congressional Testimony. 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.

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.

CADEN, J. (2008). SUBPRIME MORTGAGE CRISIS AND VETERANS. FDCH

Congressional Testimony. COLE, R. (2007). MORTGAGE MARKET TURMOIL. FDCH Congressional Testimony. Collora, M. (2007). Commentary: Are criminal investigations next chapter in subprime story?.

Massachusetts Lawyers Weekly. Coy, P. (2007). Why subprime lenders are in trouble. Business Week Online. Danis, M., & Pennington-Cross, A. (2005). A dynamic look at subprime loan performance.

Journal of Fixed Income, 15(1), 28-39. Farm credit system bucks market trend. (2008). Mortgage Line. Group says originators, wall street share blame for woes. (2007). National Mortgage News. Hibbard, J. (2005). The Fed eyes subprime loans. Business Week. Hill, P. (2007). Fed forbids ‘liar loans’. Washington Times, The (DC), A01. Industry warns new rules may spark credit crunch. (2007). Mortgage Line.

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KROSZNER, R. (2007). LOAN MODIFICATION AND FORECLOSURE PREVENTION.

FDCH Congressional Testimony. 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.

Lenders refocus on borrowers capacity to pay. (2007). Mortgage Line. Lerner, M. (2007). Best loan is the one that’s comfortable to pay. Washington Times (DC), F01. Plosser, C. (2008). Economic outlook. Vital Speeches of the Day, 74(2), 81-85. Quinn, J., & Ehrenfeld, T. (2008). No more financial katrinas. Newsweek, 82-82. Uyemura, D. (1992). Financial risk management in banking: the theory and application of asset

liability management. New York: McGraw Hill Companies. Van Greuning, H. (2003). Analyzing and managing risk: framework for assessing corporate

governance and financial risk. Washington: The International Bank for Reconstruction and Development.

Wells gets tougher on its subprime underwriting. (2007). Mortgage Line.