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The subprime mortgage market:
familiar lessons in a new context
Lewis D. Johnson and Edwin H. Neave
School of Business, Queen’s University, Kingston, Canada
12 Abstract
Purpose – The purpose of this paper is to examine the recent subprime mortgage market meltdown
from a theoretical and practical perspective.
Design/methodology/approach – The authors apply the principles of transaction costs economics
to critically evaluate the roles of lenders, borrowers, institutions, and investors.
Findings – It is found that a combination of need, greed, perverse incentives, inadequate risk
controls, lax regulation, and lax oversight caused a bubble in the subprime mortgage market which
has inevitably burst. The principles of transaction cost economics provide a template for analysis and
corrective action.
Research limitations/implications – The subprime mortgage market provides a useful example
of where theory can provide helpful insights. The example has implications for future research in
other financial market settings.
Practical implications – The results provide insight and guidance to lenders, borrowers,
institutions, investors, regulators, and central bankers in how to identify and handle potentially toxic
financial scenarios.
Originality/value – The theoretical perspective has not been applied to the subprime market or
other similar financial settings. It offers both academic and practical contributions.
Keywords Governance, Risk management, Mortgage default
Paper type Research paper

1. The changing subprime market

This paper analyzes current difficulties in the subprime mortgage market. Our
examination shows that the difficulties are attributable to familiar mistakes (albeit
made in a somewhat novel context) rather than to new features of the financial system.
Essentially, we attribute the difficulties in the subprime market to an evolving
mismatch between loan quality, as measured by default risk, and the loans’ governance
as measured by the combined risk control capabilities of lenders and investors. The
difficulties have been compounded by the use of collateralized debt obligations (CDOs)
with varying exposure to the default risks and the further use of default insurance. The
situation has become still more complex because in the growing subprime market
default risks have increased dynamically, first as a result of responses to competitive
pressures, and second as adjustable rate mortgages have been reset to require higher
Although the subprime market grew rapidly with the advent of credit scoring
techniques, the problems are not simply the consequences of using a new technology.
Rather, the problems arise from a failure to recognize: (i) the incentives affecting
different participants, (ii) how those incentives changed with the dynamics of market
growth, and (iii) the need for tougher forms of risk control as the quality of the
borrower pool changes. In a nutshell, the sequence of developments is the following.

Management Research News

Vol. 31 No. 1, 2008
pp. 12-26 The authors would like to thank the Editor and the anonymous referees for their valuable
# Emerald Group Publishing Limited
contributions to the paper. They would also like to thank Candace Smigelski for her assistance
DOI 10.1108/01409170810845921 with graphic arts.
Technological change in the form of credit scoring was first implemented in the Subprime
subprime market during the late 1990s. Combining the use of scoring technology with
online investigation of potential borrowers’ credit ratings sharply reduced application
processing costs, meaning that the profitability of placing new mortgages soared. The market
increased profitability of new placements led to soaring competition for new business,
and as competition heightened both mortgage brokers and mortgage lenders relaxed
their approval standards in a search to maintain newly established profit rates.
Since mortgage lenders usually sold their portfolios of new loans to a trust, which
then financed its acquisitions through CDOs and other similar instruments, lender fees
for securities placements rose rapidly even as the need for greater risk control was
obscured. Dividing the portfolio financing instruments into tranches tailored investors’
risk–return exposure, and at the same time made it difficult for institutional investors
to ascertain the exact nature of the risks they were taking on, even as those same
investors became particularly eager to buy what they regarded as high-quality debt
instruments with attractive interest rates.
Still further, default insurance on the mortgage portfolio meant that neither the
original lenders nor institutional investors faced strong incentives to monitor
the default risks. At the same time, some insurers eager for business under-priced the
default insurance they sold[1]. Compounding the problem, expanding mortgage
volumes and increasingly slack approval procedures meant default risks were growing
even as it became increasingly less clear which institutions would have to shoulder the
fallout from any defaults.
There is an old lesson in finance that as a business’ riskiness increases, especially if
the increase occurs during a time of unusually rapid growth, risk control capabilities
should also be increased. If not, subsequent defaults are likely to be greater and longer-
lasting than popular opinion believes. Ironically, risk control of subprime mortgage
portfolios, both new and existing, actually decreased at the same time as loan quality
was decreasing.
As mortgage brokers responded avidly to attractive placement profits, lenders
reduced standards in order to enhance the brokers’ and their own incomes. As brokers
and lenders publicized their relaxed standards, they also offered teaser loans that made
the loans look unusually attractive to borrowers. The teaser loans with their initially
low but subsequently adjustable interest rates further exacerbated adverse selection
problems when interest rates began to rise.
Lenders and their trusts used CDOs and similar other instruments to fund the
portfolios of newly placed mortgages. These methods of funding obscured both
the extent of the portfolios’ default risks and the identity of the players who would be
ultimately responsible for bearing them. The original lenders were attracted by
lucrative placement fees, and their risk control concerns softened by readily available
default insurance. Institutional investors responded to attractive portfolio interest rates
and to the tailored risks they expected to bear, sometimes without fully understanding
the nature of the residual risks they also took on. At the same time, insurers under-
priced the default insurance policies they wrote against mortgage pool securities.
There is a relevant checklist of warning signs when a form of lending, new or
traditional, grows rapidly. The signs include growing competition for new loans,
relaxation of quality screening, and under-emphasis of residual risks. All these
warning signs are familiar to lenders, but in the subprime markets they were
overlooked or ignored by nearly all the participants – mortgage brokers, mortgage
lenders, the mortgage pools they created, and the institutions from which the pools
MRN raised their funds. In part the risks were overlooked because, in different ways, each of
the concerned parties faced incentives to do so. In addition, existing regulatory
31,1 jurisdictions were both slow to issue cautionary commentary and hampered in their
ability to control the evolving problems once they detected a need for greater caution.

1.1 The subprime market in context

The American residential mortgage market consists of some $10 trillion worth of
14 mortgage loans. Approximately 75 per cent are securitized, mainly by the government-
sponsored mortgage agencies, Fannie Mae and Freddie Mac. Most of this market
involves little risk, either to the original lenders or to subsequent investors in lender-
created mortgage pools. The original lenders face relatively minimal default risks
because two-thirds of conventional mortgage borrowers enjoy good credit, have
arranged an insured fixed-rate mortgage, and have a significant equity investment in
their houses. When mortgages are securitized, default risk remains either the
responsibility of the original lender or the specialized trust to which the mortgages are
sold. In such cases, the role of the originator (post-securitization) is to simply service
the payments, and there are few incentives to monitor repayment patterns unless the
original lender continues to carry a substantial proportion of the default risk. Even the
incentives to screen the mortgages in the first place are attenuated if the original
mortgages carry borrower default insurance.
Institutional and other investors depend on both the high-quality of the underlying
mortgages, the default insurance covering the mortgage pool instruments they
purchase, and high-credit ratings provided by rating agencies. In addition, purchasers
of mortgage pool securities are not directly concerned with the original mortgages’
default risk because pool-issued securities are usually tailored using different risk
tranches. Partly, the incentives of the institutional investors are attenuated because
they are only exposed to whatever default risk in the mortgage portfolio is borne by the
tranche of securities they buy. When an insurer bears most or all of the default costs,
the incentives of institutional investors are further attenuated. Yet the securities the
institutional investors purchase may be subject to losses if: (i) the particular mortgage
pool absorbs enough mortgage defaults to jeopardize the pool’s solvency and (ii) the
particular tranche is structured to absorb some of that residual risk.
Investors in mortgage pool securities are, of course, not unaware of investment risk.
They are familiar with the prepayment risk they may bear if the original mortgages are
paid down more rapidly than expected, since the aggregate repayments into a
mortgage pool are normally passed directly through to the investors. Although it is a
less common feature, investors are also familiar with the extension risk they can bear if
maturities are extended at the original term when rates increase. Investors also face
price risk on portfolios of fixed-rate (or slowly adjusting flexible-rate) mortgages as
interest rates increase. On the other hand, they have been less familiar with the
liquidity risk that can arise from thinly traded instruments, and have little expertise to
assess mortgage pool default risk. Rather, institutional investors tended to rely on
rating agency classifications of the pool securities.

1.2 Technology and the subprime market

Although it is popular to identify the difficulties of the subprime markets with
technological change, the story is actually more complex. Automated or semi-
automated loan processing has been used in other markets, without similar difficulties,
since the 1970s. Early applications of the technology, known as credit scoring, were
used to assess the acceptability of car loan and credit card applications. By the mid- Subprime
1990s, software for home buyers with good credit had been installed at Fannie Mae and
Freddie Mac as well as at some larger private sector lenders.
Credit screening technology was not used in the subprime market until 1999, when a market
private company designed the first software program to acquire mortgage applicants’
internet credit histories and then score the proposals’ creditworthiness in a process that
came to be known as automated underwriting. The new software was initially installed
at First Franklin Financial, then one of the biggest lenders to home buyers with 15
subprime credit ratings. Prior to the change, First Franklin loan officers collected
income statements and credit histories in a process that typically required several
weeks. By moving to retrieve real-time credit reports online and using screening
programs to gauge the risks of default, the new software both decreased mortgage
processing times significantly and increased radically the number of applications that
could be processed. Between 1999 and 2005 First Franklin increased sevenfold the
number of subprime loan applications it processed, to a total of some 50,000 every
month. The new technology made the subprime placement market much more
lucrative than it had previously been but, as the rest of this paper will show, that did
not in itself create the subsequent problems.

1.3 Cost-effectiveness of automated underwriting

The number of software companies developing automated underwriting systems has
proliferated since 1999. With small staffs, the software companies typically sell their
systems to lenders with networks of call centers employing hundreds of thousands of
loan officers. Some large Wall Street banks and mortgage lenders developed their own.
Subprime lenders like automated underwriting because it offers a cheap, fast way of
screening out the riskiest applicants and automatically approving the rest. A 2001
Fannie Mae survey found that automated underwriting reduced the average cost to
lenders of closing a loan by $916.
Automated underwriting generated up to 40 per cent of new subprime loans in some
years[2]. By mid-2004, Countrywide Financial, a major subprime lender, used
automated underwriting to double the number of loans it made, to 150,000 monthly[3].
For the industry as a whole, the processing software had been used to produce $450
billion in subprime loans by the end of 2005. Automated underwriting is vulnerable in
that it accepts whatever loans meet the standards incorporated in the software, and if
these standards are set too low the default risks of accepted loans rise accordingly.
Moreover, automated underwriting programs do not inspect the property, verify
borrower income, and carry out other prudential details requiring the attention of a
loan officer. Passmore and Sparks (2000) discuss the adverse selection effect of poor
screening with automated underwriting and, using a game-theoretic approach, show
that, taken too far, automated underwriting can lead to loan losses that nullify the
efficiency gains. We use this finding in developing the theory of section 2.

1.4 Changing standards of approval

There are several reasons why the subprime market exhibited the fastest growth of
any mortgage market over the past decade. Once the new technology was applied,
originating subprime mortgages became much more cost-effective, thereby increasing
the supply of funds to the markets. At the same time, demand for subprime mortgage
financing also increased, setting the stage for rapid growth of mortgage broking,
mortgage lending, and institutional investors’ financing of mortgage pools.
MRN On the supply side institutional and other investors were eager to purchase the
securities issued by mortgage pools, particularly because they faced shortages of other
31,1 attractive investment opportunities. Individual mortgage brokers were eager to place
new mortgages, partly because of the fees they earned from originating mortgages and
partly because the new technology made processing cheaper[4]. Original mortgage
lenders earned additional income by creating mortgage pools and (usually) selling
them on to specialized trusts, which in turn issued securities against the mortgage
16 pools. At the same time, default insurance on the pool securities was cheap at first,
meaning that the pools’ creators had even less incentive to monitor credit standards.
Investors in pool securities did not object, as they were hungry for high-yielding assets
that from their point of view were subject only to prepayment, interest rate, and
extension risks. They took comfort in believing that their securities were insulated
from other losses by the tranches that delimited particular buyers’ exposure and by the
high ratings the mortgage pool securities commanded.
Demand for mortgage financing increased in part because new borrowers found
they could qualify for what appeared to be cheap loans, and were actively encouraged
by mortgage brokers and original lenders to do so. Borrowers were encouraged by low
down payments, second mortgage financing, and adjustable rate mortgages with
initially low interest rates. In 2005, subprime borrowers – previously denied access to
mortgage financing – accounted for one in five new mortgages and ten per cent of all
new mortgage loans. Low short-term interest rates earlier this decade led to much
greater use of adjustable-rate mortgages (ARMs), but borrowers did not always
understand that payments on ARMs could increase substantially if and when interest
rates subsequently rose. Some of the ARMs were known as ‘‘teaser’’ loans bearing an
introductory interest rate as low as 1 per cent.
With rapidly increasing demand and equally rapidly increasing supply the stage
was set for rapid growth of both the original lending and the securitization that raised
the funds from institutional investors. Once the incomes from rapid growth had
become established, mortgage originators came to rely heavily on maintaining the new
forms of business. When the demand for new mortgage financing began to slow in the
early to mid-2000s, originators worked to buttress their loan volumes by increasing
their competitive capabilities. They dramatically loosened credit standards, lent more
against individual properties, and cut the need for documentation. In evidence of
competitive pressures, subprime lenders began to boast of how fast they could process
and generate a loan. For example, New Century Financial (second to HSBC in subprime
lending in 2006 and now bankrupt) promised to approve applications within 12 s.
Standards fell furthest for subprime mortgages and the slightly lower risk loans
known as Alt-As. A recent report by analysts at Credit Suisse estimates that 80 per
cent of subprime loans made in 2006 included low ‘‘teaser’’ rates. Nearly 80 per cent of
Alt-A loans were ‘‘liar loans’’, based on little or no documentation. Their loan-to-value
ratios were often over 90 per cent, and a second mortgage was also often provided[5].
Some of America’s weakest borrowers were thus able to buy a house without even
making a deposit. It should be noted that ‘‘no doc’’ loans, and subprime loans in
particular, do play an important role in giving a second chance to those individuals and
families with previous credit problems, but such loans require proper risk management
including careful monitoring and follow-up (Franzini, 2007).
In addition to competitive pressures that lowered lending standards, some
observers maintain that automated underwriting gave comfort where it was not
deserved. Problems arise not from generating the useful information provided by credit
scoring, but rather from sole reliance on it. ‘‘Automated underwriting put the credit Subprime
score on such a pedestal that it obscured the other important things, like is the income mortgage
actually there’’, said Professor Nicolas P. Retsinas of Harvard[6]. Moreover, inputs to
the automated screening software – borrower income and other forms of market
documentation – are supposed to be verified by a credit officer, but that has not always
been the case.
At the same time, default risks were changing as a result of both moral hazard and 17
adverse selection. ‘‘Before automated underwriting, down payment mattered a lot.
Where we’ve crossed the line in recent years is to say, we don’t need down payment[7].’’
Moreover, some lenders moved to customize the software so that it would ignore
warning signs and focus entirely on credit scores, thus approving still riskier
Finally, even as the industry attenuated lending standards, default risks themselves
were changing dynamically on existing loans. ARMs and ‘‘teaser’’ loans look much less
attractive when interest rates increase, meaning that increased repayment obligations
are being faced by weak borrowers with little, or no, cushion of home equity. While
extensions of term can offer some relief to borrowers, extensions also mean that
borrowers face larger total interest payments and face longer repayment periods.
Moreover, if interest rates rise sufficiently, the ability to keep payments low by
granting extensions is limited. These factors mean that borrower default becomes
increasingly likely as interest rates rise, since the probability of borrower default is
greater, the smaller the value of the borrower’s equity in the home.

1.5 Who’s minding the store?

The subprime mortgage meltdown highlights the potential for problems with largely
self-regulated organizations. Risk was assumed at two levels: the level of the mortgage
contract and at the level of the mortgage pool instruments. The risk levels assumed by
some lenders should have been monitored by regulators and, where necessary,
intervention should have occurred. The opaqueness of the asset portfolios underlying
the pool securities required extra diligence on the part of rating agencies, which
apparently was not exercised in many cases[8].
US federal regulators were aware of potential problems with the industry early in its
evolution. In 2001, the four federal banking agencies (the Federal Reserve System, the
Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency,
and the Office of Thrift Supervision) issued ‘‘expanded guidance intended to strengthen
the examination and supervision of institutions with significant subprime lending
programs[9]’’. The guidelines outlined loan and lease losses, capital adequacy
standards, loan review and classification requirements, cure programs, and predatory
lending standards. The authors do not have access to the level of compliance and
supervision which occurred in subsequent years, but it is apparent from recent
developments that the spirit of the expanded guideline was not satisfied.
The role of the bond rating agencies is also worthy of note. Investors need to know
the risk and return characteristics of their potential investments. With opaque
collateralized instruments containing a myriad of underlying assets, proper risk
assessment and rating is essential. The decline in value and actual default of several of
these instruments (which previously had the highest ratings) casts doubt on the
diligence of the rating agencies in inspecting and monitoring the securities, as do the
incomes the agencies earned by making the ratings.
MRN 1.6 Summary of distribution of risks
Figure 1 summarizes schematically the players, their risk exposures, and the relevant
31,1 agencies responsible for ensuring the integrity of the various transactions. The
fundamental risk exposure is default of the mortgage contract. Besides internal lender
safeguards, the external parties involved here are mortgage insurers and government
regulators. It is unknown how much mortgage insurance played a role in this market,
since most original loans would not have had the minimum down payment/equity
18 component required by most insurers. Federal regulators did issue expanded
guidelines for the industry, but, as discussed above, supervision of compliance seems
to have been deficient.
Investors’ risk exposure is through both market and default risk. When markets
become illiquid, products cannot be priced and credit spreads increase dramatically.
We have discussed default of the underlying mortgages and of the pool securities
above, along with the performance of the rating agencies. Our analysis suggests that
the problem developed at the level of the mortgage contract, but we also show the part
played by other players and agents in the system.

2. Financial governance: theory

This section outlines our theory of how risk and risk control evolved in the subprime
lending industry. The static form of the theory argues that financing of any type
involves an alignment of loan default risk and financiers’ risk control capabilities. It
argues further that cost-effectiveness considerations influence the alignments[10]. If
the static alignment is such that loan default risks exceed the capabilities of financiers
for risk control, realized defaults will eventually mount, exceeding their original
estimates. The problem is easy to recognize if the original lenders suffer the default
risks. It becomes harder to recognize if mortgages are granted by brokers who are paid
commissions to place the instruments on the books of the lender. It becomes still harder
to recognize if the lender passes on some or all of the risks, either to insurers or to
institutional investors.
The dynamics of changing risk add further to the complexity of the situation. If
risks are increasing, lender capability needs to be increasing commensurately if the
realized defaults are to be controlled. Again, the problem is easier to recognize if it is
only the original lender who bears the costs of default. If those costs are spread among

Figure 1.
Distribution of risks
lenders, insurers, and investors, monitoring incentives are attenuated and defaults Subprime
inadequately supervised. The most obvious signs of this kind of dynamic evolution are mortgage
high and rising profits, evidence of competitive pressures, and the use of new
instruments that, while merely redistributing risks, give the illusion of eliminating market
To develop the main concept underlying our analysis, we first outline the static
relations between lenders’ risk control capabilities and the default risks of the loans 19
they place on their books[11]. We then outline the dynamics of adjusting capabilities to
align them with increasing risk. Finally, we consider the effects of redistributing the
default risks beyond the original lenders.
Consider a portfolio whose average risk is indicated by point A in Figure 2. The
straight line in the diagram, the Capital Market line, indicates the risk–return tradeoffs
available in the securities market. The portfolio of original mortgages, however, is
administered by an intermediary and is not at this point regarded as a marketable
security[12]. The left-hand curve indicates the effective rates of return obtainable on a
mortgage portfolio by a lender whose capabilities for risk control are matched against
the average risk shown by point A. The effective rate of return curve rises as loan risk
is increased to point A, reflecting the increased earnings available on loans of greater
risk if the lender has the capability to control those risks. The curve falls after point A,
reflecting that if loans of too great a risk are taken on, the realized defaults will
eventually rise and the net earnings on the loans will diminish. In other words, a lender
whose risk control capabilities are matched against point A will maximize the return
on his portfolio if he makes loans whose average risk is measured by point A. At that
point his return will exceed the return given by the capital market line because
intermediated loans require more expensive governance than do capital market
securities, and consequently portfolio earnings must be higher to defray the greater
governance costs[13].
Now consider a loan portfolio whose average risk is B, greater than A. If the original
lender with capacity A were to assume this portfolio, he would suffer greater default
risk than anticipated and his expected earnings would fall below the capital market
line as shown by point A0 on the left-hand curve. On the other hand, a lender with

Figure 2.
Costs of governance
MRN greater risk control capability B, who moves along the right-hand curve, would profit
from this loan portfolio in the same way that the lender with capability A profited from
31,1 the first portfolio. B’s greater risk control capability can be attained by increasing the
stringency of application procedures, by more aggressive pursuit of loans whose
repayment was falling behind schedule, and by more aggressive pursuit of defaulting
borrowers. Both the interest rates charged by lender B and the costs he incurs would be
higher than they were for A.
20 So far we have only analyzed a situation in which the lender did not securitize or sell
the original loan portfolio. However, a similar analysis could be done for the group of
agents involved in originating, securitizing, and investing in the securitized portfolio.
The main difference is that the default risks are now spread among agents, and those
agents may also pursue defaulters less aggressively. Consequently the agents’
combined incentives to improve risk control procedures are attenuated, as indeed are
their capabilities to do so.
The above example demonstrates the relationships among mortgage risk, risk
control (governance) capability, governance cost, and return. It is a special case of
transaction cost economics theory, which argues that throughout a financial system,
agents who take a comprehensive view of the costs and benefits to lending strive to
align governance capability and deal attributes to obtain the most efficient governance
framework. For perspective’s sake, the more general theory is outlined in the

3. Analysis
We now apply the theory of section 2 to the subprime market. Our analysis focuses on
how the risk of subprime lending increased even as the lenders decreased their risk
control capabilities. It also examines how incentives affected the different agents’
actions and thus contributed to increasing the misalignment of loan attributes against
financier governance.

3.1 Homeowner attributes

The riskiness of subprime mortgages stems in large part from adverse selection.
Subprime market borrowers are poorer than those who can obtain mortgages at lower,
usually fixed rates. Moreover subprime borrowers have tended to enter the housing
markets when prices were already high, meaning that the amounts they borrow tend to
be relatively large in relation to income. The adverse selection problem also has a
dynamic aspect: it becomes worse as interest rates increase and the introductory low
rates on adjustable rate mortgages expire. As loan rates rise, monthly payments on
ARMs can increase substantially, outrunning the means of borrowers who were able to
make their payments when interest rates were lower.
Moral hazard problems further affect subprime mortgages’ attributes. First, since
the approval process required little documentation, many borrowers did not have the
assets or income their applications suggested. The most egregious example of this type
of moral hazard arises with ‘‘liar’’ loans, where none of the borrower claims was
verified[14]. A second example involves approving high loan-to-value applications:
with little or no equity in the home, the borrower has considerable incentive to default
if payments rise. Borrowers also appear to have been caught up in a moral hazard
problem of industry making – would-be homeowners were sometimes encouraged to
borrow, regardless of their credit status, by mortgage brokers. Sometimes applicants
were provided with second mortgages as well. The brokers involved appear to have
been motivated more by their placement fees rather than by a concern with clients’ Subprime
ability to repay[15].
3.2 Lender incentives market
Both mortgage brokers and mortgage lenders have several motives for
underestimating the default risks in the subprime market. First and as already
mentioned, mortgage brokers earn fees for originating mortgages, not for controlling
mortgage risks. Second, mortgage lenders’ earnings increase as they create mortgage
pools and securitize the funding of those pools. Apparently the lenders looked mainly
to these earnings, without much consideration of the greater default losses that would
later accompany riskier loans[16]. Third, if lending standards are changing then
default rates are likely to be changing commensurately, but it is questionable whether
the software programs were adapted to reflect the increased risks. Indeed, there are
documented cases of lenders reducing the standards used in the software programs. In
part such problems could be ascribed to inexperience of some subprime lenders, but a
more compelling reason can be found in competitive pressures to maintain loan
volumes. The competitive pressures appear to have outweighed one of the first
principles of the lending business: to ensure that default risks are managed, not
ignored or understated. This diligence becomes particularly important when the
mortgage lenders normally responsible for risk control face attenuated incentives
themselves, and accept with little or no screening loans originated by brokers whose
goals are mainly to increase the amount of loans granted.
Although it is also tempting to blame securitization for some of the loosening of
credit standards, the principal reason is that the mortgage originators did not exert
sufficient risk control[17]. Mortgage brokers faced no incentive to do so, and the
incentives facing mortgage lenders were attenuated by loan resales and default
insurance. Institutional purchasers of mortgage pool securities did not appear to
exercise the kind of diligence that would have provided lenders with the incentive to
screen appropriately. This is the behavior modeled in Figure 2, where the low level of
governance inherent in credit screening technology permitted moral hazard on the part
of lenders to erode the cost savings from credit screening.

3.3 Recognizing consequences

During the continuing boom, some 40 per cent of all mortgage originations were
subprime or Alt-A. One study calculates that 60 per cent of all adjustable-rate loans
made since 2004 will be reset to payments that will be 25 per cent higher or more.
A fifth will see monthly payments soar by 50 per cent or more. Higher payments and
negative equity clearly increase default probabilities. The study concludes on the basis
of mid-2007 prices that some $42 billion worth of ARMs originated between 2004 and
2006 are heading for repossession in the next few years. The defaults will be
concentrated: only 7 per cent of mainstream adjustable mortgages will be affected,
whereas one in three of the recent ‘‘teaser’’ loans will end in default. The peak in default
rates is currently projected to be in 2008, when many mortgages will be reset and few
borrowers will have much equity. The greatest difficulties threaten borrowers whose
house is worth less than their mortgage, and some 7 per cent of all American
homeowners had negative equity at the end of December 2006[18]. Among recent
homebuyers, the share is even higher: 18 per cent of all people who took mortgages out
in 2006 now have negative equity. A quarter of all mortgages due to reset in 2008 are
forecast to have the same problems.
MRN On 13th March 2007 the Mortgage Bankers Association reported that 13 per cent of
subprime borrowers were behind on their payments. Some 30 of America’s subprime
31,1 lenders had closed their doors in the early part of 2007. The cost of insurance against
default on the riskiest tranches of subprime mortgage pool debt has soared, reflecting
insurers’ changing views of the creditworthiness of the pools created by the original
mortgage lenders.
Given the slackness of subprime lending standards there is an argument for tighter
22 oversight of non-bank mortgage companies, and at the federal rather than state level.
However, it is important to recognize that to the extent regulatory failure is involved,
for the most part the failures have been those of omission rather commission. In
particular, federal regulators did not always have jurisdiction over original lenders in
the subprime markets. Many of the riskiest mortgages were made by independent, non-
bank lenders – such as New Century, Ownit and Fremont. These companies (which are
now collapsing) are overseen by state regulators and the quality-of-state oversight
varies widely. Moreover, only about half of all states have laws against predatory

3.4 Lessons from the theory

Our application of risk control theory shows clearly that regulatory authorities could
have been more sensitive to the perverse incentives affecting homeowners, mortgage
brokers, and mortgage lenders. Given borrower attributes and the volatility of the
housing market, lenders actually needed enhanced rather than weaker screening,
monitoring, and governance capabilities. Initial approvals should have been subject to
more extensive screening, and outstanding mortgages should have been monitored
more closely as market conditions changed. The role of regulation is to impose stiffer
standards if lenders are unable or unwilling to do so themselves. Proper application of
prudent policies would have mitigated many of the current problems now being faced
by both borrowers and lenders. Such policies would have reduced new lending sooner,
while at the same time pursuing defaulters earlier and more aggressively.
Our theory provides a checklist of potential trouble sources as changing loan
attributes outstrip changing governance capabilities. In many cases, the best qualified
regulators had no responsibility to supervise and attempt to check the changes but by
inference, concerned regulators could have sought increased authority to deal with the
signals of emerging problems. In confirmation of this view, recently America’s four
federal bank regulators proposed stricter lending guidelines on adjustable-rate
subprime loans.

4. Conclusions
The direct damage to Wall Street has yet to be determined. Although there has been
concern that the failure of some hedge funds could lead to more systemic problems, the
underlying loss potential may not be as great as the market gloom of mid-August 2007
suggests[19]. A repossessed property will eventually be sold, albeit at a discount. Mr
Cagan’s estimate of $326 billion of repossessed mortgages translates into roughly $112
billion of losses, spread over several years. In comparison, about $600 billion was
wiped out on the US stock markets as share prices fell on 27th February 2007.
Although the subprime market poses a small direct threat to Wall Street it could still
affect bankers and the broader economy in other ways. Investors are now shunning
subprime and all other mortgages that seem risky. Spreads have dramatically widened
on the pooled and debt-laden CDOs based on them, and currently the issuance of
subprime-related CDOs has plunged. Indeed, the spreads on other CDOs are also Subprime
widening, not least because it is far from easy to determine who shoulders the burden mortgage
in the case of pool defaults.
Lenders’ current reluctance to commit additional funds, along with tightening loan market
standards, may combine to form a classic credit crunch. Several lenders have stopped
making no-money-down mortgage loans. HSBC has cut back on second-mortgage
loans. Freddie Mac recently announced it would no longer buy some subprime loans.
No one is sure how dramatic, or lasting, the pull-back will be, but Credit Suisse thinks
the number of originations in subprime markets could fall by some 50 per cent in the
next couple of years and Alt-A loans may fall by a quarter.
What about the way forward? For new subprime loans, regulators must tighten
credit standards if lenders are unable or unwilling to do so. Regulators should inspect
software to ensure that appropriate standards are in place, and ensure that loans
originated by mortgage brokers are subsequently authorized by credit officers who are
not paid volume commissions. For existing loans, where possible lenders should extend
terms rather than increase payments in an attempt to minimize the number of defaults.
Studies carried out to clarify the incidence of realized default risks would help agents
to make better decisions in the future.
Financial history contains many examples of the cycle characteristic of the
subprime market: discovery of profitability, expansion of credit activity, weakening of
credit standards as competitive pressures to maintain volumes increase, followed by
subsequent collapse. The subprime cycle is unique mainly in the lack of clarity
regarding the distribution of mortgage default risks, especially in the failure to
recognize that even the mortgage trusts might suffer enough writeoffs that their own
securities could be wholly or partially defaulted. The principal lesson from each of
these cycles is that risk control needs to be tougher during the upswing of the cycle,
just when everyone believes it to be unnecessary. If the industry cannot control risks on
its own – regardless of how confusing the allocation of the risks might be – then
regulators must ensure they do so. Sadly, in the many cycles where the foregoing
effects have been observed, regulatory corrective action is almost always too little and
too late to offset some painful losses.

1. This has not been wholly true with all insurers. For example, the monolines MBIA and
Ambac have very little subprime exposure, and are said to be highly conservative in
issuing liabilities. In particular, they had little exposure to the largest failure to date,
New Century (The Economist, 28 July 2007).
2. Patricia McCoy, law professor at the University of Connecticut, quoted in the New York
Times, 23 March 2007.
3. Scott Berry, executive vice president at Countrywide Financial, quoted in Bank Systems
& Technology, Summer 2004.
4. Automating the underwriting software moved what was in 1999 a niche product into the
mainstream. The software speeded up processing, reduced processing costs, and made it
easier to design an array of new mortgage types such as no down payment and interest-
only mortgages.
5. The Economist, 24 March 2007.
6. Quoted in The New York Times, 23 March 2007.
7. The New York Times, 23 March 2007.
MRN 8. The unusually optimistic ratings were not just restricted to mortgage pool securities.
They also affected asset based commercial paper.
9. Joint press release issued by the four agencies, dated 31 January 2001.
10. The theory of this section is a special case of the governance theory outlined in the
11. Relations between apparently different types of financing are also stressed by Cochrane
24 (2005) who compares the risk and return in venture financing with the risk and return
for small NASDAQ stocks.
12. Securitization will involve issuing marketable instruments against the non-marketable
13. See, for example, Freixas and Rochet (1997). The authors and the references they cite
model intermediated transactions as being more costly than capital market
14. In 2006, a 24-year-old web designer from Sacramento, Casey Serin, bought seven
houses in five months. He lied about his income on ‘‘no document’’ loans and was never
asked for a deposit in any of his seven loan applications. Today Mr Serin has debts of
$2.2m. Three of his houses have been repossessed so far. On the whole, one subprime
borrower in eight is currently behind with payments. Source: The Economist, 24 March
15. See Shiller and Weiss (2000) for discussion of moral hazard in home equity conversion.
16. Securities issued against mortgage pools often carry default insurance, thus protecting
the institutional investors who buy into the pool. The original mortgages may or may
not be protected by default insurance. If they are, lenders face fewer incentives to
monitor the risks of those original mortgages.
17. See Franzini (2007) for a discussion of the importance of proper risk management
principles to subprime lenders.
18. Christopher Cagan, using a sample of 32 m houses. Reported in The Economist, 24
March 2007.
19. Of course, much of that market gloom seems to stem from repricing risks of many
securities types. To that extent, the role of subprime pool securities is rather more
symptomatic than directly causative.

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Carlin, W. and Mayer, C. (2003), ‘‘Finance, investment and growth’’, Journal of Financial
Economics, Vol. 69, pp. 191-226.
Franzini, L.M. (2007), ‘‘The management of risk in subprime lending’’, The RMA Journal, Vol. 89
No. 8, pp. 46-9.
Freixas, X. and Rochet, J.C. (1998), Microeconomics of Banking, MIT Press, Cambridge, MA.
Johnson, L.D. and Neave, E.H. (1992), ‘‘Strategic real estate management: the case of Olympia &
York’’, Canadian Investment Review, Vol. V No. 2, pp. 51-61.
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Finance, Vol. 20 No. 8, pp. 54-68.
Neave, E.H. (2005), Financial System Economics: Theory and Application, Thomson Nelson,
Passmore, W. and Sparks, R.W. (2000), ‘‘Automated underwriting and the profitability of
mortgage securitization’’, Real Estate Economics, Vol. 28 No. 2, pp. 285-305.
Shiller, R.J. and Weiss, A.N. (2000), ‘‘Moral hazard in home equity conversion’’, Real Estate Subprime
Economics, Vol. 28 No. 1, pp. 1-31.
Williamson, O. (1996), The Mechanisms of Governance, Oxford University Press, Oxford.
Appendix. Governance complementarities: further analysis
Our theory of aligning loan default risk and lender risk control is a special case of the
transactions economics theory of financial governance. In this theory, financiers and their clients
seek cost-effective forms of transacting (Williamson, 1996; Neave, 2005; Johnson and Neave, 25
1992, 1994; Allen and Gale, 2000; Carlin and Mayer, 2003) that involve aligning loan attributes
with financier capability. The theory identifies three main classes of governance structure:
markets, intermediaries (hybrids), and hierarchies, each with different capabilities for governing
deal attributes. Each main class has subclasses of governance structures. The theory in the main
part of our paper refers to two classes of mortgage lending intermediaries, one with higher
capabilities for risk control than the other.

Types of governance structures

Markets are well suited to complete contracting, i.e. deals in which there is little perceived need
for adjustment of the initial arrangement. These kinds of deals are typically extended under risk
rather than under uncertainty.
Intermediaries offer a governance advantage relative to markets, since they have both greater
initial screening capabilities and greater capabilities for monitoring and control. They have some
ability to adjust contract terms during the course of the deal, and can rectify past errors at lower
costs than market agents, since the principal means of effecting an adjustment is to sell out an
investment position.
Hierarchical (internal) governance offers the greatest potential for intensive screening,
continued monitoring, continued control over operations and adjustment of deal terms. Internal
governance will normally be used to govern deals whose uncertainties are greater than those
acceptable to intermediaries, e.g. in cases of incomplete contracting.

Attributes, capabilities, and alignment

Our theory is summarized in Figure A1. Moving from left to right in the attributes section of
Figure A1 represents increasingly greater informational differences between the two parties (the
financiers typically having less information). Increasing differences are seen as involving higher
degrees of risk, or as presenting uncertainty instead of risk. The higher-risk and more uncertain
deals pose greater need for continuing governance, not least because they can present increasing
costs of default. Uncertainty and asset illiquidity render market valuations more difficult than
they are for risky, liquid assets.
The second section of Figure A1 specifies the principal capabilities of financiers and suggests
that different governance structures utilize them in different degrees. For example, hierarchical
financings offer greater monitoring and control capabilities than market financings. The third
section is a reminder that greater capabilities are normally mustered at increasing cost.
The three principal types of governance structure are listed in the last section of Figure A1,
along with illustrations of each type. The listing from left to right indicates increasing
governance capability. For example, public markets are shown to the left of private markets,
since private market agents usually have greater investigative capability, and in some cases
greater freedom to negotiate terms. Similarly, commercial and industrial banks usually have less
highly developed governance capabilities than do venture capital firms that make greater use of
discretionary arrangements. Financial conglomerates and the Japanese keiretsu are examples of
hierarchical governance. Capabilities closer to those of the hierarchical form are also offered by
universal banks (such as those found in Germany) that enter into long-term lending and share
purchase arrangements with their clients.
As shown by the relations between the different sections of Figure A1, deals’ attributes are
matched against different governance capabilities in attempts to achieve cost-effective


Figure A1.
Deals’ attributes,
governance capabilities,
and alignment

governance. Market deals tend to be more standardized, and to have smaller informational
differences among the parties. The governance costs of market deals are relatively low, mainly
because market governance uses relatively few monitoring and control capabilities. The costs of
hierarchical governance tend to be higher, because of its greater monitoring, control, and
adjustment capabilities. Thus, financings under uncertainty are likely to have higher governance
costs, which must be compensated for by higher returns on the investment.

Corresponding author
Lewis D. Johnson can be contacted at:

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