Finance Essay

3850 Words Jul 2nd, 2012 16 Pages
The Role of Financial Institutions
Risk Management in Subprime Crisis

Vikrant Joshi

The Role of Financial Institutions & Risk Management in The Subprime Crisis
This paper discusses the role of financial institutions & their risk management strategies in the subprime mortgage crisis. The downturn in the housing and mortgage markets precipitated the first phase of the financial crisis in August 2007 when the solvency of a number of large financial firms was threatened by huge losses in complex structured financial securities. Why did these firms have such high concentrations in mortgage-related securities? Given the information available to firms at the time, these high concentrations in
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This overconfidence led firms to underprice risk and to engage in excessive risk taking.
I argue that, based on information available at the time, the application of fundamental principles of modern risk management would have protected large and complex financial firms from being as vulnerable as they proved to be to shocks in the mortgage market. Why did large, sophisticated financial firms fail to appropriately apply these risk management principles to avoid the impact of the mortgage crisis? The paper discusses two potential explanations for this failure of risk management. First, given government policies of ‘too-big-to-fail (TBTF)’, large financial firms did not have appropriate incentives to worry about “tail risk” — the risk of large losses from low-probability events. Second, issues related to corporate governance and principal-agent conflicts have inhibited the function of a firm’s internal control and risk management system.

Economic Fundamentals Leading to the Mortgage Crisis:

Figure 1 shows the unprecedented rate of housing price appreciation in the U.S. between 2000 and 2006. The boom in housing prices fueled the demand of buyers who saw housing as a profitable investment opportunity. The boom in house prices also helped fuel the supply of mortgage loans, since rising prices increase a borrower’s equity, thereby lowering default rates. During this period there was also a pronounced decline in

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