There is evidence to support the claim that the subprime mortgage crisis in the US may have had its roots in operational risk problems. But just what caused the crisis, and could it have been averted if the firms involved had robust op risk frameworks in place? Victoria Pennington reports The deeper you delve into the causes of the US subprime mortgage crisis – or market "correction" as some prefer to call it – the more convinced you become that operational risk problems were a central factor. Even though credit risk issues play a significant role, the fact that operational risk processes and procedures were relaxed or manipulated certainly contributed to the scale of the problem. Subprime mortgages are loans secured on real estate offered to consumers with low credit scores, mostly at higher interest rates than prime mortgages. The risk of default is of course much higher on these products, but the high rate of return makes them very attractive for banks and lenders chasing better yields. The current situation consists of a very high level of defaults, particularly early payment defaults – that is defaults made in the first eight months of the life of the loan. The subprime crisis has not been caused just by bad credit risk management, but by a multitude of factors in which operational risk features prominently. In the first half of this decade the US enjoyed a benign economic period, with low interest rates and rising house prices. Excited by the booming market, more and more new players entered the mortgage sector to take advantage of the high margins to be made on subprime mortgages. During the boom time, smaller mortgage lenders experienced a phenomenal level of growth. Share capital in one company rose from $5 million to $66 million in just three years and in 2006, subprime mortgages accounted for 20% – or $600 million – of all mortgages issued in the US, according to figures published in The Wall Street Journal. Mortgage lenders were also quick to sell on their mortgages in the secondary market or to sell them to investment banks to be securitised, resulting in even more profits for the lenders. The abundance of capital has also accelerated the problem: "As banks and funds become awash with capital they begin to seek higher returns. While on paper the subprime mortgage sector can generate good returns, it is accompanied by a lot of volatility and risk," says Cory Gunderson, managing director of risk consultants Protiviti. The highly liquid market became increasingly competitive, as more and more companies sought to attract subprime borrowers with tempting loan products that fixed mortgages at low interest rates for two years. However, these products – known as adjustable-rate mortgages (ARM) – would switch to a variable rate after that period. When the real estate boom ended in 2006 and interest rates began to rise, subprime borrowers were hit first and delinquencies began to rise. Once mortgages began to default, lenders that had sold the loan onto investment banks for securitisation were hit with compulsory repurchases, and those that did not have an effective credit risk policy in place were forced out of business. Most of the banks caught out in the crisis are smaller 'pure-play' mortgage lenders, as the larger commercial banks also active in the subprime sector paid much closer attention to origination and due diligence of loans, and had efficient processes in place to flag up op risk issues. The smaller companies that quickly sold loans onto the secondary market or securitised them were hit hardest, and the investment banks that invested in subprime loans in mortgage-backed securities have also suffered. Bear Stearns and Goldman Sachs are the latest victims of the subprime crisis, with the recent announcement that second-quarter earnings were hampered by rising defaults on subprime loans. The Wall Street Journal has also reported that Bear Stearns is rushing to sell off large tranches of the High-Grade Structured Credit Strategies Enhanced Leverage Fund and its sister mortgage fund, both of which operate via bets backed by mortgages, a large proportion of which are subprime. Swiss bank UBS is also closing its Dillon Read Capital Management hedge fund, following a loss of $123 million, due to subprime difficulties. Op risk failures Problems in the subprime market were caused by myriad different op risk issues, as highlighted in research published by risk consultants Algorithmics, based on information stored in its FIRST database. "We analysed 35 case studies dealing with subprime issues, of which 83% fell into the category of relationship risk problems – including sales, suitability issues, legal and regulatory issues," says Penny Cagan, a managing director at Algorithmics. "You see a confluence of issues in the subprime events. There were credit issues, plus operational issues such as incorrect interest rate calculations caused by inexperienced processing personnel. A lack of documentation has also opened up banks to potential fraud and disclosure is a big problem – firms are not completely disclosing to clients the true cost of some loans, including fees and interest-rate fluctuations. All these issues are present at the same time, intertwined with questionable corporate governance practices at the top of the firm, so it's difficult to put these events into one risk bucket. It's important to manage them from a holistic multi-disciplinary approach." Data gathered by Walzak Risk Analysis, which delivers standardised measurements that quantify mortgage product quality as well as offering risk management services, also pinpoints several op risk management failures that led to the subprime crisis. Many of these failures stemmed from the significant rate of growth mortgage lenders were experiencing. The fast-expanding mortgage companies hired more staff quickly, often with insufficient or no training. "A number of people who had never been in the mortgage business decided to take advantage of the increase in demand and set up business, and hired people off the street without taking the time or expense to properly train them in the products they were offering," says Rebecca Walzak, president and chief executive of Walzak Risk Analysis. "The consequences of insufficient training for new personnel resulted in operational processes and procedures not being followed correctly and when those operational risks were realised, these lenders were struck with repurchases they hadn't planned for, and that was when they started to go out of business." Gunderson takes a similar view: "From a key performance indicators (KPI) perspective, significant growth meant a lot of organisations would've been required to hire more personnel, many of whom would've been unfamiliar with the processes of that particular organisation, which can result in a slackening of the underwriting process, manual errors and file mismanagement," he says. "Fraud is also an issue – either from external parties such as brokers seeking to push loans through, or from borrowers who take advantage of the [meagre] documentation and stressed system to tender fraudulent applications." Unscrupulous salespeople There have been countless stories in the US press concerning underwriters who were incentivised – in some cases forced – by their employers to push through questionable mortgage applications. There are also examples of unscrupulous salespeople exaggerating the income of some clients to allow them to qualify for the loan. "Our risk model screens op risk mistakes, and it came up with a number of different scenarios," says Walzak. "A lot of loan officers saw that these products were income-based loans, and so started falsifying incomes to get clients qualified. In one case a borrower said he made $6,000 a month working as a teacher, but neither the loan officer nor the underwriter questioned whether he earned this amount for the 10 months of the year schools are in session, or whether it was a year-round salary. As a result, he was incorrectly qualified for a loan with ratios that exceeded the guidelines." Disclosure is also a major factor concerning ARM products. Even though rates could be fixed at 1%–2% for six months, they would adjust significantly afterwards, but borrowers often did not understand by how much. That said, for ARM products, disclosure and information was based on historical data, and recent history had been characterised by a benign economic environment with a declining interest rate and high appreciation of house prices. But this could have been mitigated by the use of effective op risk management techniques. "The use of stress-testing scenarios may have helped management to look past this benign period and to look at how loan applicants could have handled a series of interest-rate rises," says Gunderson. Fraudulent appraisals also feature highly as a factor in the rise in defaults. "There are many instances of fraudulent appraisals that contributed to pushing up house prices," says Walzak. "These should have been identified and reviewed at the underwriting stage, but many were either missed or pushed through regardless. This wasn't a problem as long as house prices continued to appreciate, but once they began to fall, value of houses with exaggerated appraisals fell quickly. We have examples of the value of houses from loans that are only eight months old dropping by 35%. This shouldn't happen over such a short time period, and clearly shows that the original value was much higher than it should have been." The meagre documentation requirement of these products also increased instances of fraud, and increased the volume of early payment defaults – those that occur in the first three months. "The volume of early payment defaults on subprime mortgages, despite a relatively low unemployment rate and low mortgage rates, has been surprising. Such defaults should not be in the interest of the borrower or lender, and indicate that more thought should be given to the underwriting process," says Eric Rosengren, executive vice-president, supervision, regulation and credit at the Federal Reserve Bank of Boston, who will also take up the role of president and chief executive from July. There are also instances of borrowers who should have qualified for prime mortgages being sold subprime loans by salespeople to ensure approval. Even though these clients are not at risk of default, they are now exposed to higher interest rates than they would have been if sold a prime loan. Lacking diversity Another factor is the lack of diversification for many of these pure-play mortgage companies, which should have required a greater degree of op risk management. "If an organisation is heavily dependent on one industry or segment, op risk controls need to be tighter to ensure the risk of default is minimised," says Gunderson. "But abundant growth masks evils and keeps the denominator high – in charge-off calculations for example – and creates a lack of seasoning in the portfolio. Problems arise when the music stops; when you can't originate anymore and all the losses come to bear." Any piece of the process from origination to closing involves inherent operational risks: from unethical salespeople working on commission deliberately mis-selling loans or manipulating data, to appraisers pushing up values and due diligence teams missing or ignoring mistakes. There are also operational risks inherent in the default management area. "When a loan goes into default, it requires competent management to identify which cases to try to work out with the customer, and which ones to encourage the borrower to sell the house – even at a lower value than the original loan – to try to recoup some losses. It will be interesting to see how companies manage the default process, especially the Loss Mitigation programmes (established by the federal government and the mortgage industry to curb foreclosures) required by investors. In particular, the Federal Housing Administration (FHA) can charge triple damages if the company servicing the loan does not comply with the FHA's Loss Mitigation requirements and then files a claim for losses," Walzak says. Walzak is also quick to criticise the shortcomings in controls over policies and procedures in the mortgage industry by Fannie Mae and Freddie Mac, which she describes as an antiquated manual review that has no relevance to what can be expected from failing to follow the correct processes. Averting the crisis It would be simplistic to state that if these companies had had a robust operational risk framework in place the crisis could have been averted, particularly as some larger international banks with op risk management programmes already in place were also caught up in the crisis. The sheer volume of subprime loans putting stress on an already buckling system, the about-face in the economic cycle after an unusually long benign period, coupled with evident op risk failures and the high level of fraud all contributed to the problem. That said, having a good risk-management and corporate-governance programme in place would have softened the blow and helped to mitigate the situation. "The sector should've been covered by a strong risk management and control framework, with scenario analysis that would have given organisations the ability to identify the extent of their exposure earlier and would probably have reduced the impact of the crisis. But it certainly would not have averted it altogether," says Bjorn Petterson, vice-president of business consultants CRA International. Gunderson agrees: "Prudent risk management includes stress-testing assumptions," he says. "Having KPIs could have helped recognise the problem faster and may have prevented one or two buybacks. But you have to remember that op risk as a discipline is still very young – even the largest institutions don't have a fully fledged op risk management system in place. When you see smaller organisations experience a period of high growth, risk-management and governance structures often take longer to catch up." The industry has learned a valuable lesson about the importance of operational control processes. But the danger is that questions are being asked on Capitol Hill about how this situation was allowed to occur and what needs to be done to ensure it doesn't happen again, raising the spectre of regulation in the subprime sector. There is also the danger that regulators could come down hard on subprime products, which serve a good purpose by helping consumers with lower credit scores to buy a home. Roger Cole, director of the division of banking supervision and regulation at the US Federal Reserve, stated in his testimony to the Committee on Banking, Housing and Urban Affairs of the Senate in March, that the Fed has looked at such issues as quality control processes concerning third-party originations and residential lending appraisal practices. He spoke of the introduction of "new product review processes to ensure that disciplined approaches are being brought to new lending products and programmes." With many in the industry already fatigued from too much regulation in the financial services industry, this is the last thing they want. It is therefore up to the mortgage industry to better regulate subprime lenders, to ensure they are accountable to borrowers and investors for the quality of their products. Most in the industry hope that regulation is not needed to monitor policy and procedures in the subprime mortgage sector, but it should serve as a wakeup call to mortgage firms and others that having efficient risk-management programmes in place is essential for good corporate governance. "This crisis is a great example of the importance of having an integrated risk management system," Gunderson says. "An event such as this creates a dialogue in the boardroom about how to ensure it doesn't happen to them. Most regulation has been in response to a seismic event in the financial markets. But once concern over the event dies down, the industry begins to get comfortable and the same thing happens again. The subprime mortgage problem is certainly getting the publicity of a seismic event, but the actual losses have had only a small impact so far and strong house prices have helped to mitigate a disaster, so we'll wait and see on that one," he adds. But subprime lenders are not out of the woods yet, as there is still the issue of how well it deals with default management issues and whether there will be any ensuing lawsuits from the crisis....
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