The Mortgage and Financial Crises: The Role of Credit Risk Management and Corporate Governance

This paper discusses the role of risk management and corporate governance as causal factors in the onset of the financial crisis. The boomand bust in the housingmarket precipitated serious strains in financial markets. These strains resulted in the onset of the financial crisis in August 2007 with the collapse of the asset-backed commercial paper market. This collapse occurred because 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 mortgagerelated securities violated basic principles ofmodern riskmanagement. We argue that this failure to apply well-understood risk management principles was a result of principalagent problems internal to the firms and to breakdowns of corporate governance systems designed to overcome these principal-agent problems.