The subprime mortgage debacle and its linkages to corporate governance

Abstract

Two alleged contributing factors of the subprime mortgage debacle are (1) ‘misaligned incentives’ linked to securitisation–disintermediation and (2) ‘asymmetric information’ wherein the most informed assessments of specific individual residential mortgage defaults are held by residential borrowers and not by loan originators, investment banking securitisers, and institutional investors purchasing mortgage back securities. The empirical evidence supports the proposition that the securitisation–disintermediation increased substantially the magnitude of lending to riskier residential mortgages (ie subprime residential mortgages) and, in due course, to a high default rate. One particularly relevant empirical study supportive of the above conclusions is by professors Atif Mian and Amir Sufi of the University of Chicago. They utilise a flow of funds income level–mortgage originations–mortgage default–zip code methodology. As to the ‘asymmetric information’ proposition, there is an abundance of ad hoc as well as survey information suggesting that residential mortgage borrowers were borrowing rate and transaction costs uninformed. A useful and informative survey by two Federal Reserve System economists was conducted by Brian Bucks and Karen Pence, ‘Do Homeowners Know Their House Value and Mortgage Terms?’, Federal Reserve System — Board of Governors, Washington, DC, January, 2006, which indicated that homeowners were unaware of their mortgage terms. Indeed, Mark Zandi, the chief economist of Moody's, feels that the fundamental cause of the subprime mortgage debacle was the financial illiteracy of homebuyers. The most important corporate governance failure of the subprime mortgage debacle was the executive compensation of chief executive officers (CEOs). More specifically, the executive compensation of CEO was not remotely linked to either corporate performance or actual realised returns of the equity shareholders. The three marquis names of excessive compensation in the subprime mortgage area were: (1) Countrywide Financial and Angelo Mozilo, (2) Citigroup and Charles Prince, and (3) Merrill Lynch and Stanley O'Neil. According to Lucian Bebechuk, Alan Greenspan, and Jack and Suzy Welch and others, the culprit in the excessive compensation (ie pay without performance) are the independent directors of public corporations.