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The subprime mortgage debacle and its linkages to corporate governance

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EXECUTIVE SUMMARY

Two alleged contributing factors of the subprime mortgage debacle are (1) ‘misaligned incentives’ linked to securitisation–disintermediation and (2) ‘asymmetric information’ wherein the most informed assessments of specific individual residential mortgage defaults are held by residential borrowers and not by loan originators, investment banking securitisers, and institutional investors purchasing mortgage back securities. The empirical evidence supports the proposition that the securitisation–disintermediation increased substantially the magnitude of lending to riskier residential mortgages (ie subprime residential mortgages) and, in due course, to a high default rate. One particularly relevant empirical study supportive of the above conclusions is by professors Atif Mian and Amir Sufi of the University of Chicago. They utilise a flow of funds income level–mortgage originations–mortgage default–zip code methodology. As to the ‘asymmetric information’ proposition, there is an abundance of ad hoc as well as survey information suggesting that residential mortgage borrowers were borrowing rate and transaction costs uninformed. A useful and informative survey by two Federal Reserve System economists was conducted by Brian Bucks and Karen Pence, ‘Do Homeowners Know Their House Value and Mortgage Terms?’, Federal Reserve System — Board of Governors, Washington, DC, January, 2006, which indicated that homeowners were unaware of their mortgage terms. Indeed, Mark Zandi, the chief economist of Moody's, feels that the fundamental cause of the subprime mortgage debacle was the financial illiteracy of homebuyers. The most important corporate governance failure of the subprime mortgage debacle was the executive compensation of chief executive officers (CEOs). More specifically, the executive compensation of CEO was not remotely linked to either corporate performance or actual realised returns of the equity shareholders. The three marquis names of excessive compensation in the subprime mortgage area were: (1) Countrywide Financial and Angelo Mozilo, (2) Citigroup and Charles Prince, and (3) Merrill Lynch and Stanley O'Neil. According to Lucian Bebechuk, Alan Greenspan, and Jack and Suzy Welch and others, the culprit in the excessive compensation (ie pay without performance) are the independent directors of public corporations.

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References and Notes

  • For an understanding of the economics of the subprime mortgage market, see Bernanke.2,3 The imbroglios of the subprime mortgage market and, particularly, of subprime lenders are vividly captured by the president and co-founder of Kellner Mortgage Investment, Richard Bitner,4 in a book aptly entitled Confessions of a Subprime Lender: An Insider's Tale of Greed, Fraud, and Ignorance, John Wiley & Sons, Inc., Hoboken, New Jersey, 2008. For an excellent discussion of (1) misaligned incentives and the mechanisms that drove mortgage brokers to encourage not particularly qualified individual mortgage borrowers to borrow and (2) why institutional investors were not sufficiently incentivised to systematically and rigorously assess the risk‘-return trade-offs for subprime debt vís-a-vís prime debt, see Wachter.5

  • Bernanke, B. S. (2007) ‘Subprime mortgage lending and mitigating foreclosures’, Testimony before the Committee on Financial Services, US House of Representatives, Washington, DC, 20th September, 2007.

  • Bernanke, B. S. (2007) ‘The subprime mortgage market’, Speech given at the Federal Reserve Bank of Chicago, 43rd Annual Conference on Bank Structure and Competition, Chicago, Illinois, 17th May, 2007.

  • Bitner, R. (2008) Confessions of a Subprime Lender: An Insider's Tale of Greed, Fraud and Ignorance, John Wiley & Sons, Inc., Hoboken, New Jersey.

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  • Wachter, S. M. (2008) ‘Incentives and the Current Crisis’ before the Hearing entitled ‘Executive Compensation: CEO Pay and the Mortgage Crisis’ before the United States House of Representatives Committee on Oversight and Government Reforms, 7th March, 2008.

  • The empirical test methodology of Mian and Sufi was to ‘identify the effects of shifts in the supply of mortgage credit by exploiting within — county variation across zip codes that differed in latent demand for mortgages in the mid 1990s. From 2001 to 2005, high latent demand zip codes experienced large relative decreases in denial rates, increases in house price appreciation despite the fact that these zip codes experienced significantly negative relative income and employment growth over this time period. These patterns for high demand zip codes were driven by a sharp relative increase in the fraction of loans sold by originators shortly after origination, a process that we refer to as ‘disintermediation’. The increase in disintermediation — drove mortgage supply to high latent zip codes from 2001 to 2005, which led to subsequent large increases in mortgage defaults from 2005 to 2007. Our results suggest that moral hazard on behalf of originators selling mortgages is a main culprit for the US mortgage default crisis’. See Mian and Sufi.7

  • Mian, A. and Sufi, A. (2008) ‘The consequences of mortgage credit expansion: Evidence from the 2007 mortgage default crisis’, Working Paper, University of Chicago — Graduate School of Business, Chicago, Illinois, January 2008.

  • Securitisation–disintermidiation is the process where residential mortgages are placed by commercial banks and other financial institutions with individual home buyers and then pooled and sold to, usually, investment banks. Mortgage backed securities that are claims to the future uncertain cash flows of these pools of these residential mortgages are then sold to institutional investors by the investment banks. Robert Litan, in his book entitled The Revolution in US Finance, quotes Herb Sandler,9 the former Co-CEO of Golden West Financial Corp. as saying that the mere holding of a fixed rate mortgage by a thrift should be regarded as an unsafe and unsound banking practice. This is particularly interesting from a strategic viewpoint given that the Sandlers, Herb, and his wife Marion, recently sold Golden West to Wachovia Corp. in 2006 for $25bn and the Sandlers received $2bn plus from the sale. More specifically, the former CEO of Wachovia, G. Kennedy Thompson, who was ousted due to having a $4.7bn in investment banking losses since Summer 2007 that he attributed mainly to the acquisition of Golden West and that before he left Wachovia, he indicated that he regretted purchasing Golden West Financial Corp. and their accompanying mortgage portfolio.

  • Sandler, H. (1991) ‘A quote on securitization', in Litan, R.E. (ed) The Revolution in U.S. Finance, The Brookings Institution, Washington, DC.

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  • One interesting sidebar to the subprime mortgage debacle is the query of the appropriateness and robustness of mark to market accounting. Alternatively stated, do the billions of dollars of write-downs of mortgage-backed securities provide a better real-time understanding of the gyrations of financial market volatility or does accounting via original cost and its ignorance is bliss view of the financial world to be preferred? Indeed, according to Stephen A. Schwartzman — the co-founder and CEO of the Blackstone Group — a prominent private equity fund, it is FAS 157 of the Financial Standards Board that is accentuating and amplifying potential losses. It is, in short, a significant contributing factor to the subprime mortgage debacle. His reasoning is that the rule mark to market accounting has to be applied even if there is an absence of a market for financial instruments such as collateralised debt obligations (ie CDOs), which contain lots of subprime mortgages. In such cases, FAS 157 indicates the asset must be written down perhaps, to zero value. This leads and can cause, according to Mr Schwartzman, disaster to the financial system. See Sorkin.11

  • Sorkin, A. R. (2008) ‘Are bean counters to blame’, The New York Times, 1st July, 2008.

  • Bucks and Pence13 and Zandi.14 Zandi argues that the fundamental cause of the subprime debacle was the financial illiteracy of homebuyers. Indeed, consumer surveys by the Federal Reserve System — Board of Governors indicate that roughly 50 per cent of lower income home purchasers were not familiar with relevant details of borrowing rates.

  • Bucks, B. and Pence, K. (2006) ‘Do homeowners know their house value and mortgage terms?’ Federal Reserve Board of Governors, Washington, DC, January 2006.

  • Zandi, M. (2009) Financial Shock: A 360° Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis, FT Press, Pearson Education, Inc., Upper Saddle River, NJ.

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  • See Amoroso.16

  • Amoroso, M. (2008) ‘A homeowner battles back: Widow shares some lessons on foreclosure’, The Record, 4th May, 2008.

  • See Schwartz, P. J. (2008) for example, ‘Your Pain, Their Gain: Crumbling Home Prices and $100 bill Helped Wall Street's Highest Earners Pull in $19 Billion Last Year’, Forbes, 5th May, 2008.

  • Quite to the contrary, empirical evidence suggests that shorting improves the price efficiency of the financial markets. See, for example, the empirical study of Boehmer et al.19

  • Boehmer, E., Jones, C. M. and Yang, X. (2008) ‘Which shorts are informed’, Journal of Finance, 63 (2), 491–527.

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  • Angelo Mozilo, the CEO of Countrywide Financial, Charles Prince the former CEO of Citigroup, and E. Stanley O'Neal of Merrill Lynch each presented testimony before Henry A. Waxman's House of Representatives Committee on Oversight and Government Reform of which he is the chairman. Their testimonies, while interesting from the standpoint of personal and company history, were grossly deficient in terms of providing a rigorous and systematic justification of the magnitude of their executive compensation linked to corporate performance that enhanced shareholder wealth. Alternatively stated, none of these individuals focused on justifying the magnitude of their executive compensation over the last few years. Instead, their comments addressed their (1) long-term loyalty to the firm, (2) how much the firm had grown over the long run, and (3) that they were provided inaccurate economic assessment by their corporate subordinates. Also, the executive compensation data used in this paper came from Minow.21

  • Minow, N. (2008) ‘Testimony’ before the Hearing entitled ‘Executive Compensation: CEO Pay and the Mortgage Crisis’ before the United States House of Representatives, Committee on Oversight and Government Reform, 7th March, 2008.

  • See Waxman.23

  • Waxman, H. A. (2008) ‘Opening Statement’ before the Committee on Oversight and Government Reform Executive Compensation: CEO Pay and Mortgage Crisis, 7th March, 2008.

  • See Bebchuk and Fried,25,26 Bebchuk and Grenstein27, and Bebchuk.28

  • Bebchuk, L. A. and Fried, J. M. (2004) Pay Without Performance: The Unfulfilled Promise of Executive Compensation, Harvard University Press, Cambridge, MA.

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  • Bebchuk, L. A. and Fried, J. M. (2005) ‘Pay without performance: Overview of the issues’, Journal of Applied Corporate Finance, Finance, 26 (Fall), 8–23.

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  • Bebchuk, L. and Grenstein, Y. (2005) ‘The growth of executive pay’, Oxford Review of Economic Policy, 21 (2), 283–305.

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  • Bebchuk, L. (2007) ‘The myth of the shareholder franchise’, Virginia Law Review, 93 (May), 676–732.

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  • See Greenspan.30

  • Greenspan, A. (2002) ‘Corporate governance’, Remarks at the Stern School of Business, New York University, New York, NY, 26th March, 2002.

  • Welch, J. and Welch, S. (2006) ‘Paying big-time for failure: Who is really to blame for those fat severance packages given to CEO's who falter?’ Business Week, 10th, April 2006.

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Bicksler, J. The subprime mortgage debacle and its linkages to corporate governance. Int J Discl Gov 5, 295–300 (2008). https://doi.org/10.1057/jdg.2008.20

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