Appendix A Credit-Rating Agencies and the Subprime Mortgage Securitization Process
Until the turn of the millennium, most mortgage loans were made to borrowers with good credit histories conforming to underwriting standards set by government-sponsored agencies; these loans are referred to as conforming loans. However, during 2000–8, subprime and Alt-A loans rapidly increased their market share. Subprime mortgages refer to borrowers that have poor credit histories. Alt-A loans are made to borrowers with good credit histories but with aggressive underwriting, such as no documentation of income.
Most lending institutions that issue mortgages to homeowners do not carry these mortgages on their balance sheets but sell these mortgages to issuers who, in turn, sell them (eventually) to investors as fixed-income securities. Both subprime loans and Alt-A loans experienced significant increases in the securitization of the loans as a percentage of loans originated. The process of conversion of mortgages to risky fixed-income securities is known as securitization. A simplified version of the securitization process is illustrated in Figure A.1.
Figure A.1 Securitization of mortgage-backed securities.
The securitization process starts when a homeowner/mortgagor finances the purchase of a home or refinances a home. The originator/lender sells the mortgage to a government-backed agency (e.g., Fannie Mae or, Freddie Mac) or an investment bank acting as a mortgage-backed security (MBS) sponsor. The MBS sponsor keeps only a small percentage of the mortgages and pools the rest with similar mortgages and sells them to a bankruptcy-remote trust. The trust issues bonds to institutional investors (e.g., pension funds and hedge funds). The issuer is bankruptcy remote in the sense that if the MBS sponsor goes bankrupt, the assets of the trust/issuer will not be distributed to the creditors of the MBS sponsor. Marketability of the bonds is enhanced by the credit ratings from bond-rating agencies (e.g., Moody’s, Standard and Poor’s [S&P], and Fitch).
Conflict of Interest between the Credit-Rating Agencies and the MBS Sponsor
The trust/issuer of the mortgage-backed bonds can be viewed as an investment company, as defined in the Investment Company Act of 1940, and hence would be subject to the extensive requirements of the act (see Bethel, Ferrell, and Hu Reference Bethel, Ferrell and Hu2008). However, the trust/issuer can claim exemption from the act if it issues only fixed-income securities that, at issue, received one of the four highest ratings from a nationally recognized rating agency (e.g., S&P, Moody’s, and Fitch).
This situation has the potential to create a conflict of interest between the credit-rating agencies and MBS sponsors that set up the trust/issuer because the trust’s ability to claim exemption from the 1940 act depends on the ratings provided by the rating agencies. Figure A.2 shows Moody’s revenues from rating various securities. While in the first quarter of 2001 Moody’s quarterly revenue from rating structured securities (including MBS securities) was slightly greater than from rating corporate securities, by the fourth quarter of 2006, Moody’s quarterly revenue from rating structured securities (including MBS securities) was about three times than from rating corporate securities. To the extent that there was a conflict between the credit-rating agencies and MBS sponsors, this was severely exacerbated by 2006.
Figure A.2 Moody’s quarterly revenues from rating various securities. In the first quarter of 2001, Moody’s quarterly revenue from rating structured securities (including MBS) was slightly greater than from rating corporate securities. By the fourth quarter of 2006, Moody’s quarterly revenue from rating structured securities (including MBS) was about three times that from rating corporate securities.
The aforementioned conflict is similar to the conflict of interest noted in the accounting literature between the auditors and shareholders of firms they were auditing, driven by the large nonaudit fees the auditors were earning from the companies they were auditing in the pre-Sarbanes-Oxley era (see Dhaliwal et al. Reference Dhaliwal, Gleason, Heitzman and Melendrez2008; Hoitash, Markelevich, and Barragato Reference Hoitash, Markelevich and Barragato2007).
Conflict of Interest between the Credit-Rating Agencies and Investment Managers
Until now, credit-rating agencies have used the same rating system to rate mortgage-backed bonds as they do to rate corporate bonds. The methodology to rate corporate bonds is well understood and has been validated by empirical data going back almost a century. Credit-rating agencies are required to and do disclose their criteria and methodology for rating mortgage-backed bonds. However, there are concerns about the complexity and transparency of the models used by the rating agencies (see Mason and Rosner Reference Mason and Rosner2007). Perhaps even more important, given the brief existence (less than a decade in some cases) of the ever-more-complex MBS, we do not have the empirical validity of these models to the same level of statistical confidence as for corporate debt.
In 2007, Moody’s downgraded several AAA-rated mortgage-backed bonds to junk status within a matter of weeks (see Crouhy and Turnbull Reference Crouhy and Turnbull2008). Such a significant drop in rating in such a short period is almost unheard of for corporate bonds (see Hirsch and Bannier Reference Hirsch and Bannier2008). This suggests that AAA-rated mortgage-backed bonds have a higher credit risk than AAA-rated corporate bonds.
Pension funds, hedge funds, and other institutional investors that invest in mortgage-backed bonds usually do so via an investment manager(s) who has discretion over which and how much of various MBS to hold. Part of the incentive compensation of these fund managers depends on the extent to which their portfolios’ returns exceeds a benchmark. A mortgage-backed bond portfolio invested in AAA-rated bonds would usually have the AAA return (from investing in a representative basket of AAA-rated corporate and mortgage-backed bonds) as a benchmark. However, as noted earlier, AAA-rated mortgage-backed bonds are riskier than AAA-rated corporate bonds. Hence a portfolio of AAA-rated mortgage-backed bonds would have a higher expected return than a representative basket of AAA-rated corporate and mortgage-backed bonds.
Appendix B Data Used in This Book: Available Online
We provide the following three databases used in the empirical analysis in this book. They are available online.
1. This database lists insider trading by TBTF bank CEOs and No-TARP bank CEOs during 2000–8 and motivates our recommendation for executive compensation reform:
http://leeds-faculty.colorado.edu/bhagat/Bhagat-JCF-2014.xlsx
2. This database indicates corporate governance and director ownership and motivates our recommendation for director compensation policy:
http://leeds-faculty.colorado.edu/bhagat/Bhagat-DirectorOwnershipData.xlsx
3. This database provides an analysis of bank risk and bank size:
http://leeds-faculty.colorado.edu/bhagat/Bhagat-BankRiskSize.xlsx
Table B.1 TARP Recipient Information
| Bank | TARP amount received ($000) | Date received initial TARP funding | Bank | TARP amount received ($000) | Date received initial TARP funding | ||
|---|---|---|---|---|---|---|---|
| (1) | Anchor Bancorp, Inc./WI | $110,000 | January 30, 2009 | (27) | Provident Bankshares Corp. | $151,500 | November 14, 2008 |
| (2) | Associated Banc-Corp. | 525,000 | November 21, 2008 | (28) | Regions Financial Corp. | 3,500,000 | November 14, 2008 |
| (3) | BB&T Corp. | 3,133,640 | November 14, 2008 | (29) | South Financial Group, Inc. | 347,000 | December 5, 2008 |
| (4) | Boston Private Financial Holdings | 154,000 | November 21, 2008 | (30) | Sterling Bancorp/NY | 42,000 | December 23, 2008 |
| (5) | Cascade Bancorp | 38,970 | November 21, 2008 | (31) | Sterling Bancshares/TX | 125,198 | December 12, 2008 |
| (6) | Cathay General Bancorp | 258,000 | December 5, 2008 | (32) | Sterling Financial Corp./WA | 303,000 | December 5, 2008 |
| (7) | Central Pacific Financial Corp. | 135,000 | January 9, 2009 | (33) | Suntrust Banks, Inc. | 4,850,000 | November 14, 2008 |
| (8) | City National Corp. | 400,000 | November 21, 2008 | (34) | Susquehanna Bancshares, Inc. | 300,000 | December 12, 2008 |
| (9) | Comerica, Inc. | 2,250,000 | November 14, 2008 | (35) | SVB Financial Group | 235,000 | December 12, 2008 |
| (10) | East West Bancorp, Inc. | 306,546 | December 5, 2008 | (36) | Synovus Financial Corp. | 967,870 | December 19, 2008 |
| (11) | Fifth Third Bancorp | 3,408,000 | December 31, 2008 | (37) | TCF Financial Corp. | 361,172 | November 14, 2008 |
| (12) | First Bancorp | 424,174 | January 16, 2009 | (38) | US Bancorp | 6,599,000 | November 14, 2008 |
| (13) | First Financial Bancorp, Inc./OH | 80,000 | December 23, 2008 | (39) | UCBH Holdings, Inc. | 298,737 | November 14, 2008 |
| (14) | First Horizon National Corp. | 866,540 | November 14, 2008 | (40) | Umpqua Holdings Corp. | 214,181 | November 14, 2008 |
| (15) | First Midwest Bancorp, Inc. | 193,000 | December 5, 2008 | (41) | United Community Banks, Inc. | 180,000 | December 5, 2008 |
| (16) | First Niagara Financial Group | 184,011 | November 21, 2008 | (42) | Wachovia Corp. | 239 | July 1, 2009 |
| (17) | Firstmerit Corp. | 125,000 | January 9, 2009 | (43) | Washington Fed Inc. | 200,000 | November 14, 2008 |
| (18) | Flagstar Bancorp Inc. | 266,657 | January 30, 2009 | (44) | Webster Financial Corp. | 400,000 | November 21, 2008 |
| (19) | Huntington Bancshares | 1,398,071 | November 14, 2008 | (45) | Westamerica Bancorporation | 83,726 | February 13, 2009 |
| (20) | Independent Bank Corp./MI | 74,426 | December 12, 2008 | (46) | Wilmington Trust Corp. | 330,000 | December 12, 2008 |
| (21) | Keycorp | 2,500,000 | November 14, 2008 | (47) | Wilshire Bancorp. Inc. | 62,158 | December 12, 2008 |
| (22) | M&T Bank Corp. | 600,000 | December 23, 2008 | (48) | Wintrust Financial Corp. | 250,000 | December 19, 2008 |
| (23) | Marshall & Ilsley Corp. | 1,715,000 | November 14, 2008 | (49) | Zions Bancorporation | 1,400,000 | November 14, 2008 |
| (24) | Northern Trust Corp. | 1,576,000 | November 14, 2008 | ||||
| (25) | PNC Financial Services Group, Inc. | 7,579,200 | December 31, 2008 | Total | $50,437,016 | ||
| (26) | Popular, Inc. | 935,000 | December 5, 2008 |
Note: This table shows how much TARP money each of the 49 L-TARP firms received and when they first received TARP funding.
Table B.2 CEOs during 2000 and 2008 by Firm
| Company | 2000 CEO | 2008 CEO | |
|---|---|---|---|
| TBTF sample | |||
| (1) | AIG | Maurice Greenberg | Edward Liddy |
| (2) | Bank of America | Ken Lewis | Ken Lewis |
| (3) | Bank of New York | Thomas Renyi | Robert Kelly |
| (4) | Bear Stearns | James Cayne | Alan Schwartz |
| (5) | Citigroup | Sandy Weill | Vikram Pandit |
| (6) | Countrywide Financial | Angelo Mozilo | Angelo Mozilo |
| (7) | Goldman Sachs | Henry Paulson | Lloyd Blankfein |
| (8) | JP Morgan | William Harrison | James Dimon |
| (9) | Lehman Brothers | Richard Fuld | Richard Fuld |
| (10) | Mellon Financial | Martin McGuinn | Robert Kelly (2007) |
| (11) | Merrill Lynch | David Komansky | John Thain |
| (12) | Morgan Stanley | Philip Purcell | John Mack |
| (13) | State Street | Marshall Carter | Ronald Logue |
| (14) | Wells Fargo | Richard Kovacevich | John Stumpf |
| L-TARP sample | |||
|---|---|---|---|
| (1) | Anchor Bancorp, Inc./WI | Douglas J. Timmerman | Douglas J. Timmerman |
| (2) | Associated Banc-Corp. | Robert C. Gallagher | Paul S. Beideman |
| (3) | BB&T Corp. | John A. Allison, IV | John A. Allison, IV |
| (4) | Boston Private Financial Holdings | Timothy Landon Vaill | Timothy Landon Vaill |
| (5) | Cascade Bancorp | Patricia L. Moss | Patricia L. Moss |
| (6) | Cathay General Bancorp | Dunson K. Cheng, Ph.D. | Dunson K. Cheng, Ph.D. |
| (7) | Central Pacific Financial Corp. | Joichi Saito | Clint Arnoldus |
| (8) | City National Corp. | Russell Goldsmith | Russell Goldsmith |
| (9) | Comerica, Inc. | Eugene A. Miller | Ralph W. Babb, Jr. |
| (10) | East West Bancorp, Inc. | Dominic Ng | Dominic Ng |
| (11) | Fifth Third Bancorp | George A. Schaefer, Jr. | Kevin T. Kabat |
| (12) | First Bancorp | Angel Alvarez-Perez | Luis M. Beauchamp |
| (13) | First Financial Bancorp, Inc./OH | Stanley Pontius | Claude Davis |
| (14) | First Horizon National Corp. | Ralph Horn | Gerald L. Baker |
| (15) | First Midwest Bancorp, Inc. | Robert P. O’Meara | John M. O’Meara |
| (16) | First Niagara Financial Group | William Swan | John R. Koelmel |
| (17) | Firstmerit Corp. | John R. Cochran | Paul Greig |
| (18) | Flagstar Bancorp, Inc. | Thomas J. Hammond | Mark T. Hammond |
| (19) | Huntington Bancshares | Frank G. Wobst | Thomas E. Hoaglin |
| (20) | Independent Bank Corp./MI | Charles van Loan | Michael M. Magee, Jr. |
| (21) | Keycorp | Robert W. Gillespie | Henry L. Meyer, III |
| (22) | M&T Bank Corp. | Robert G. Wilmers | Robert G. Wilmers |
| (23) | Marshall & Ilsley Corp. | James B. Wigdale | Mark F. Furlong |
| (24) | Northern Trust Corp. | William A. Osborn | Frederick H. Waddell |
| (25) | PNC Financial Services Group, Inc. | James E. Rohr | James E. Rohr |
| (26) | Popular, Inc. | Richard L. Carrion | Richard L. Carrion |
| (27) | Provident Bankshares Corp. | Peter M. Martin | Gary N. Geisel |
| (28) | Regions Financial Corp. | Carl E. Jones, Jr. | C. Dowd Ritter |
| (29) | South Financial Group, Inc. | Mack I. Whittle, Jr. | Mack I. Whittle, Jr. |
| (30) | Sterling Bancorp/NY | Louis J. Cappelli | Louis J. Cappelli |
| (31) | Sterling Bancshares/TX | George Martinez | J. Downey Bridgwater |
| (32) | Sterling Financial Corp./WA | Harold B. Gilkey | Harold B. Gilkey |
| (33) | Suntrust Banks, Inc. | L. Phillip Humann | James M. Wells, III |
| (34) | Susquehanna Bancshares, Inc. | Robert S. Bolinger | William John Reuter |
| (35) | SVB Financial Group | John C. Dean | Kenneth Parmalee Wilcox |
| (36) | Synovus Financial Corp. | James H. Blanchard | Richard E. Anthony |
| (37) | TCF Financial Corp. | Bill Cooper | Lynn A. Nagorske |
| (38) | U S Bancorp | Jerry A. Grundhofer | Richard K. Davis |
| (39) | UCBH Holdings, Inc. | Thomas S. Wu | Thomas S. Wu |
| (40) | Umpqua Holdings Corp. | Raymond P. Davis | Raymond P. Davis |
| (41) | United Community Banks Inc. | Jimmy Tallent | Jimmy Tallent |
| (42) | Wachovia Corp. | G. Kennedy Thompson | G. Kennedy Thompson |
| (43) | Washington Fed, Inc. | Guy C. Pinkerton | Roy Whitehead |
| (44) | Webster Financial Corp. | James C. Smith | James C. Smith |
| (45) | Westamerica Bancorporation | David L. Payne | David L. Payne |
| (46) | Wilmington Trust Corp. | Ted Thomas Cecala | Ted Thomas Cecala |
| (47) | Wilshire Bancorp, Inc. | Soo Bong Min | Joanne Kim |
| (48) | Wintrust Financial Corp. | Edward Joseph Wehmer | Edward Joseph Wehmer |
| (49) | Zions Bancorporation | Harris H. Simmons | Harris H. Simmons |
| No-TARP sample | |||
|---|---|---|---|
| (1) | Astoria Financial Corp. | George L. Engelke, Jr. | George L. Engelke, Jr. |
| (2) | Bank Mutual Corp. | Michael T. Crowley, Jr. | Michael T. Crowley, Jr. |
| (3) | Bank of Hawaii Corp. | Lawrence M. Johnson | Al Landon |
| (4) | Brookline Bancorp, Inc. | Richard P. Chapman, Jr. | Richard P. Chapman, Jr. |
| (5) | Chittenden Corp. | Paul A. Perrault | Paul A. Perrault (2007) |
| (6) | Colonial Bancgroup | Robert E. Lowder | Robert E. Lowder |
| (7) | Commerce Bancorp, Inc./NJ | Vernon W. Hill, II | Vernon W. Hill, II (2007) |
| (8) | Compass Bancshares, Inc. | D. Paul Jones Jr. | D. Paul Jones Jr. (2006) |
| (9) | Corus Bankshares, Inc. | Robert J. Glickman | Robert J. Glickman |
| (10) | Cullen/Frost Bankers, Inc. | Richard W. Evans, Jr. | Richard W. Evans, Jr. |
| (11) | Dime Community Bancshares | Vincent F. Palagiano | Vincent F. Palagiano |
| (12) | Downey Financial Corp. | Daniel D. Rosenthal | Daniel D. Rosenthal |
| (13) | First Commonwealth Financial Corp./PA | Joseph E. O’Dell | John J. Dolan |
| (14) | First Indiana Corp. | Marni McKinney | Robert H. Warrington (2007) |
| (15) | Firstfed Financial Corp./CA | Babette E. Heimbuch | Babette E. Heimbuch |
| (16) | Franklin Bank Corp. | Anthony J. Nocella | Anthony J. Nocella (2006) |
| (17) | Fremont General Corp. | James A. McIntyre | James A. McIntyre (2007) |
| (18) | Glacier Bancorp, Inc. | Michael J. Blodnick | Michael J. Blodnick |
| (19) | Greater Bay Bancorp | David L. Kalkbrenner | Byron A. Scordelis (2007) |
| (20) | Hanmi Financial Corp. | Chung Hoon Youk | Jay Seung Yoo |
| (21) | Hudson City Bancorp, Inc. | Leonard Gudelski | Ronald E. Hermance, Jr. |
| (22) | Indymac Bancorp, Inc. | Michael W. Perry | Michael W. Perry |
| (23) | Investors Financial Services Corp. | Kevin J. Sheehan | Kevin J. Sheehan (2007) |
| (24) | Irwin Financial Corp. | William I. Miller | William I. Miller |
| (25) | Jefferies Group, Inc. | Frank E. Baxter | Richard B. Handler |
| (26) | MAF Bancorp, Inc. | Allen H. Koranda | Allen H. Koranda (2007) |
| (27) | Mercantile Bankshares Corp. | H. Furlong Baldwin | Edward J. Kelly, III (2007) |
| (28) | National City Corp | David A. Daberko | Peter E. Raskind |
| (29) | New York Community Bancorp, Inc. | Joseph R. Ficalora | Joseph R. Ficalora |
| (30) | Prosperity Bancshares, Inc. | David Zalman | David Zalman |
| (31) | SLM Corp. | Albert L. Lord | Albert L. Lord |
| (32) | Sovereign Bancorp Inc. | Jay S. Sidhu | James Campanelli |
| (33) | TD Banknorth, Inc. | William J. Ryan | William J. Ryan (2007) |
| (34) | Trustco Bank Corp/NY | Robert A. McCormick | Robert J. McCormick |
| (35) | Unionbancal Corp. | Takahiro Moriguchi | Masaaki Tanaka |
| (36) | United Bankshares, Inc./WV | Richard M. Adams | Richard M. Adams |
| (37) | Washington Mutual, Inc. | Kerry K. Killinger | Kerry K. Killinger |
Table B.4 Variable Definitions and Data Sources for Chapter 8 Analysis
| Variable | Definition | Original sources |
|---|---|---|
| Risk measures | ||
| Z-score | Equals (ROA + CAR)/σ(ROA), where ROA is return on assets and CAR = E/A, where E = (total assets – total liabilities) and A is total assets. Higher Z-score implies more stability. | Compustat |
| Merton Distance to Default (DD) | The market value of the firm minus the face value of the firm’s debt divided by the volatility of the firm value. The estimates of firm value and volatility are obtained by applying the Merton (Reference Merton1974) option valuation model. Higher Merton DD implies more stability. | |
| ROA | Return on assets, Net income divided by total assets. Higher value implies more stability. | Compustat |
| CAR | Capital asset ratio = equity divided by total assets. Higher value implies more stability. | Compustat |
| σ(ROA) | Standard deviation of ROA, rolling five-year periods. | Compustat |
| σ(RET) | Standard deviation of daily stock returns. | CRSP |
| Write-down | Sum of accounting write-downs for 2007 and 2008. | Bloomberg and 10-K, 10-Q |
