The Subprime Crisis: A Case Study in Risk Management
The Knowledge@Wharton newsletter (http://knowledge.wharton.upenn.edu) recently published a series of articles on the subprime mortgage crisis. Here’s my re-cap.
The subprime mortgage crisis started as a small tremor and has now turned into a massive earthquake, threatening to plunge the U.S. economy into its first recession since 2001. Who is to blame? There is no single culprit. Wall Street executives, overeager borrowers, and aggressive lenders all let their eye for opportunity trump their nose for risk.
The crisis has its roots in the U.S. housing boom that began early in the decade right after the dot-com meltdown. Low interest rates allowed home buyers to take out larger loans, giving them money to bid up home prices and ultimately buy “more home” than they could truly afford. At the same time, advances in loan securitization and automated mortgage underwriting made it easy and profitable for Wall Street to convert newly issued mortgages into securities that could be sold to investors.
Wall Street found new ways to turn risky mortgages (the subprime loans originally designed for borrowers with low income or poor credit) into securities that looked almost risk-free. Investors were eager to buy these securities, which promised higher yields than U.S Treasury bonds and other “safe” holdings. Big mistake.
The first signs of trouble began to appear in 2006. Most subprime loans came with adjustable interest rates, and growing numbers of borrowers were falling behind after annual interest-rate resets began to push up their monthly payments. By the summer of 2007, prices of securities based on subprime loans were in a downward spiral, as investors worried they would not get the interest and principal payments promised. Surprised about the depth of the subprime problem, investors started to lose confidence in many other types of securities that were based on various forms of debt. As a result lenders became reluctant to lend.
Worried that this credit crunch would stall the economy, the Federal Reserve began an aggressive series of interest-rate cuts and initiated new lending programs to brokerage houses and commercial and investment banks, accepting risky mortgage-backed securities as collateral for the first time. Congress and President Bush approved an economic stimulus package early in 2008, and Washington was thrown into a debate over whether to help the estimated two million homeowners at risk of foreclosure. It even became a stump issue for the presidential candidates.
While the credit crunch is showing signs of easing, the analysis and finger-pointing is likely to continue for some time. How can borrowers and lenders be helped without encouraging risky behavior in the future? Should the system for turning loans into securities be modified? Is the patchwork of regulatory agencies pieced together since the 1930s equipped to handle today’s financial and economic issues?
Time will tell.
In the meantime, the financial services industry has much work to do in order to clean up their books and also prevent a disaster like this from occurring again. The management consulting industry will likely be an early beneficiary: as the large financial institutions reduce their workforces and cast out the “responsible” executives there will be a lot of clean-up work to be done. Many of these downsized knowledge workers, now seasoned industry experts, will elect to return to the workforce as consultants.
