Study explores role of risk management in housing crisis

Multiple factors including poor data, incomplete performance metrics and short-term focus and unrealistic optimism among senior business managers contributed to the U.S. housing and mortgage crisis, according to a study released May 26 by the Mortgage Bankers Association.

The study, “Anatomy of Risk Management Practices in the Mortgage Industry” analyzes the risk management processes employed by mortgage lenders leading up to the housing crisis and discusses lessons learned for future risk managers.

“As home prices increased, lenders were pressured to offer innovative products that could help borrowers afford a home. The resulting increase and expansion of risk layering and change in borrower behavior, left risk managers unable to offer reliable risk estimates,” said University of Maryland Professor Cliff Rossi, who conducted the study, in a news release. “Moving forward, it will be essential for the industry to develop early warning measures of the level of risk in new originations and less reliance on imprecise historical performance of new loan products.”

Key findings:
• Subprime loan underwriting criteria for several risk attributes expanded between 1999 and 2006. In particular, combined loan-to-value ratios increased with time as the percentage of loans with silent second liens attached to the property also increased.

At the same time, the percentage of loans with full documentation declined. The resulting increase in risk layering created a gap in understanding the long-term risk profile of these new product combinations and greatly altered the standard products.

• The relative lack of geographic and product diversification by several of the largest mortgage lenders was rationalized by investment opportunity costs and relative value.

For risk managers, building a strong empirical case for concentration risk limits was challenged by limited and changing information.

• A false sense of security with new products originated prior to 2007 occurred as a result of above average economic conditions coupled with a lack of information regarding subtle but real changes in borrower and counterparty behavior. As a result, models using such macroeconomic conditions as key inputs to explain mortgage default and prepayment were biased toward lower loss estimates.

• Cognitive bias toward risk management may have combined with management views on loss-taking to view risk managers as overly conservative and inefficient, which would explain senior management’s actions that ultimately placed their firms at risk. Limiting both the size and stature of the risk management organization would have made sense to senior management based on a lower aversion to losses. Where business managers could point to tangible, immediate losses in revenues from tighter standards, risk managers could only appeal to probable risks from estimated loss distributions subject to significant uncertainties.

“As the industry is now compensating for the resulting losses through tighter underwriting standards and a lower appetite for risk, it will be vital for executive management to instill a culture where all employees are on guard for risks that exceed the risk appetite of the company,” Rossi said.[[In-content Ad]]