Anatomy of Risk Management Practices in the Mortgage Industry

Abstract

No single factor was responsible for the significant expansion of credit and mortgage products during the period leading up to the mortgage crisis. However, there are indications that greater risk-taking could be attributed to the following factors: An over-reliance on performance metrics not adjusted for risk which would lead management toward riskier products; Data and analytical limitations and blind spots that led risk managers to grossly underestimate; Credit losses; Cognitive biases among senior business managers that over time led them to take greater risks, and in the process reduced the effectiveness of risk management practices; Incentive problems leading to regulatory actions that wound up not being in the best interest of the taxpayer. Some of the questions the study seeks to answer include: How did the proliferation of mortgage products such as option ARMs come about so quickly? How did risk layering factor into decisions to originate, hold and sell mortgage products? What were the competitive forces weighing on mortgage originators and how did the governance process work in some institutions and not in others? What were the market forces underlying risk decisions and how did early warning systems and leading indicators woefully underestimate risk in such a significant way? What explains some of the regulatory responses to firm risk taking during this period?

Keywords: Risk Management, Mortgage Industry, Risk-Adjusted Returns, Cognitive Bias