Academic journal article
By Lang, William W.; Jagtiani, Julapa A.
Atlantic Economic Journal , Vol. 38, No. 3
Introduction and Objectives
This paper analyzes the role of risk management and corporate governance in the events leading up to the end of 2007, the first phase of the financial crisis. Extremely high rates of mortgage defaults in 2006 and 2007 precipitated a collapse in the asset backed commercial paper (ABCP) market. This collapse set off a chain of events resulting in the most severe international financial crisis since the Great Depression. (1) The financial crisis that started in 2007, in turn, ignited a deep global recession with enormous consequences for economic and social welfare. This was a direct result of concerns about the solvency of many of the world's largest financial firms that suffered catastrophic losses as a result of the mortgage crisis. This paper explores the following question. Given the tremendous advances in financial risk measurement and management, why was the solvency of large and complex financial firms threatened by large losses in the mortgage market?
We focus on the period through 2007 because the collapse of the ABCP market can be clearly traced to losses in fundamental assets, principally residential mortgage-backed securities (RMBS) and structured financial products backed by those securities. As discussed below, the events leading up to the initial phase of the crisis are precisely the types of events that standard financial risk management methods are designed to mitigate. Later developments in the financial crisis were affected in large part by a general liquidity crisis and contagion, which may be less tied to economic fundamentals and less amenable to standard approaches to risk management. With hindsight, it may seem self-evident that the mortgage crisis would lead to a financial crisis. However, many market analysts at the time doubted that there would be much spillover from the mortgage markets to the rest of the financial system. For example, in a May 2007 speech, when the severity of defaults in the mortgage market was manifest, the Chairman of the Federal Reserve, Ben Bernanke (2007), stated:
... we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. Chairman Bernanke was not alone in this assessment. Kiffand Mills (2007) wrote: Notwithstanding the bankruptcy of numerous mortgage companies, historically high delinquencies and foreclosures, and a significant tightening in subprime lending standards, the impact thus far on core U.S. financial institutions has been limited ... The results suggest that new origination and funding technology appear to have made the financial system more stable at the expense of undermining the effectiveness of consumer protection regulation.
These beliefs were widely held for several reasons. First, the subprime mortgage market was about $1.3 trillion. Even a very high percentage loss in this market seemed manageable, given the overall size of U.S. and world debt markets. Moreover, the world financial markets had undergone numerous shocks of seemingly similar magnitude, such as September 11, the default of Enron and the subsequent accounting scandal, and the collapse of the tech bubble. In these cases, despite severe financial losses, financial markets remained well functioning and stable. Former Federal Reserve Chairman Alan Greenspan (2002) attributed this stability to financial innovation that enabled institutions to better distribute and hedge their risks.
Commonly cited reasons such as high mortgage defaults in 2006 and 2007 do not provide a sufficient explanation for why this particular shock led to a financial crisis and created doubts over the solvency of a number of major financial institutions. There are numerous explanations in the financial press and academic literature for the mortgage crisis. …